By Dr. Philipp Schönbucher, co-founder and Chief Data Scientist at Previse
Trade credit must be data-driven
Supply chains and the financial flows associated with them are at the heart of the economic crisis caused by the global Covid-19 pandemic. Disruptions and shutdowns propagate up the supply chains, and the financial and cash flow consequences threaten a credit chain reaction in the financial system. At the same time, massive but blunt central bank and government interventions are struggling to reach the recipients most in need of support.
Going forward we need to add flexibility and resilience to the system so that shocks can be buffered and bridged. It is also of central importance that the new structures optimally support the rapid recovery of the economy after this crisis: We need to find much more efficient and scalable ways to finance economic activities.
Even before the crisis, the system of trade- and supplier financing was not able to properly meet the needs of a growing, globalised and interconnected economy. Just for cross-border trade alone, the ABI identified a trade finance funding gap of $1.5trn for the year 2019, i.e. about 10% of the world’s trade did not receive sufficient financing. If one includes domestic B2B transactions, the size of the finance gap is even larger, by orders of magnitudes. At the same time, bank profitability was under pressure, interest rates were at record lows or negative, margins were very tight, and also institutional investors were desperately looking for investment opportunities with sensible yields at acceptable risks.
So, even in a world awash in liquidity looking for ways to deploy funds, we had at the same time unmet demand for $1.5trn of financing. It is highly extraordinary that both demand and supply are massive in size and remain unsatisfied over longer periods of time. Unblocking these flows is a business opportunity of historical scale, and it would also massively boost global economic growth and recovery.
Enabling the banking sector to bridge the finance gap
How can we bridge the finance gap? We believe that the solution to this problem is to combine the existing strengths of the banking sector with the scalability, flexibility and speed of a modern data-based platform. This will:
- realise vast efficiencies and scalability using direct data feeds driving automated processing, scoring, risk management, settlement, and reconciliations end-to-end, and
- add a badly needed layer of transparency through the use of objectified, quantitative, data-based scoring, and by removing less familiar risks such as dilution and fraud risk through insurance cover and other risk mitigation instruments.
This approach will enable the much easier distribution of supplier finance assets, a better allocation of risk capital, and the sourcing of funding from the most efficient provider. In addition, the scalability and data-driven approach is the basis for expanding the product offering to include smaller corporates, as well as new products such as purchase order financing.
Such a platform already exists: Previse is live operating several programmes using a fully data-driven approach like the one described above.
The more banks participate, the larger the benefits for all involved. Distribution, risk-sharing, and simple operational efficiencies all scale with the participation rate.
Banks are a key part of the solution
Maybe a bit atypical for a fintech, but we do believe that the banking sector will continue to play the key role in the solution of this problem. Banks are and have always been the key providers of trade finance, dominating the market with over 90% market share. Banks should also be the ones filling the finance gap: they have the network and the contacts to the corporates, they have the experience, they have the funds and the balance sheet, and the distribution networks, and they already own time-tested (legal) infrastructure.
However, multiple factors make it very difficult for the banks to fill the gap. Regulation, in the form of capital charges as well as due diligence requirements, have put a high cost on doing business, in particular with smaller customers i.e. SME suppliers. Furthermore, antiquated, organically grown, often paper- or spreadsheet-based systems and processes, frequently block scalability.
Distribution to institutional investors and between banks would be the obvious way to increase the capacity of the market. This would allow the trade finance banks to leverage their expertise while removing the cost of the capital requirements and balance sheet constraints. From the investors’ point of view, however, lack of standardisation and in particular the possibility of unusual and opaque risks (such as dilution and fraud) make supplier finance a difficult asset to invest in.
Initiatives are currently underway to standardise and digitise the legal documentation, in particular the move to digital and standardised trade documents is an obvious quick win. However, more needs to be done in the area of risk transparency and risk management. Veracity, dilution, and fraud risk, should be taken away from the investor’s responsibility and removed from the transaction.
The ingredient for providing this kind of risk transparency is data, data which can be sourced mainly from corporates buying goods and services, but also from the transaction networks, and the suppliers themselves. Using this, a centralised servicer will ensure that all assets have gone through a sophisticated pre-screening: fraud- and dilution-risk have been scored and insured, and the reporting, the collection and reconciliation of the settlements, and any other administration will also be handled by the servicer in the background using the data feeds without requiring additional intervention by the bank, the investor, the buyers or the suppliers.
We are convinced that the only truly scalable way to standardise, risk-score and add transparency is via data. A data-driven approach has the ability to reach beyond large buyers to the space of medium-sized companies, and also to related but new products such as purchase order financing. By using large volumes of data to inform reliable invoice assessments, Previse’s technology is able to unlock more liquidity than is possible using other approaches.
By centralising these services, banks can achieve multiple objectives: They can focus on the client relationships and origination of new assets, they benefit from the data-driven and operational economies of scale, and – by having removed the harder-to-price risks from the assets – they obtain the capability to distribute what they originated should they choose to do so.
This is about enabling the banks to continue doing what they do best: servicing their clients, sourcing funding, connecting financial flows, and distributing assets, while having taken the operational burden off their back.