As the financing of international trade migrates rapidly to open account, and Covid-19 stimulates a surge in firms’ appetite for liquidity, supply chain finance is experiencing unprecedented growth. And not without good reason. With a global revenue pool of between $50 billion and $75 billion even pre-pandemic, according to the International Chamber of Commerce (ICC), supply chain finance (SCF) offers investors low-risk exposure to trade flows that fuel the real economy. For SME suppliers it provides an affordable liquidity boost while promising their buyers a more resilient and reliable supply chain.
As the use of SCF grows, however, understanding its principles and processes has not always kept pace. The high-profile collapse of a handful of blue-chip corporates that used SCF alongside numerous other financing tools has proven particularly damaging, triggering speculation that use of SCF contributed to their demise.
The low-risk reality
Supply chain finance has in fact proven historically to be one of the lowest-risk assets for funds, family offices and other institutional investors to back. For example, the International Chamber of Commerce (ICC) Banking Commission’s 2019 Trade Register report, published in May 2020, not only revealed that trade finance continues to enjoy low and stable default risk, but that risk for supply chain finance is similar to – and by some measures lower than – that for other trade finance products.
Drawing on data covering $16 trillion of exposures from 32 million transactions across 25 banks globally, it calculated that transaction-weighted default rates for SCF payables finance was just 0.01% in 2018, compared with 0.16% for performance guarantees, 0.22% for import/export loans, 0.01% for export letters of credit (LCs) and 0.16% for import LCs. And while the collapse of UK construction giant Carillion was partly responsible for an uptick in obligor-weighted defaults for SCF compared with 2017, it was still lower than for all documentary trade finance products apart from export LCs.
Krishnan Ramadurai, chair of the ICC’s Trade Register project, argued in May that while pandemic-related stresses would likely push up default rates across the entire economy this year, the shorter maturities and recovery times associated with trade finance overall should make it more resilient than many other assets.
Transparency and disclosure
Still, a string of recent negative media reports, many of them based on the confusion around how SCF works and the benefits it brings, have raised concerns among potential investors.
One such claim is that because buyers are usually not mandated to disclose their use of SCF in company filings, payables finance is highly vulnerable to abuse. It has been wrongly blamed for the failure of a handful of industry titans that appeared to use it to hide payment obligations or artificially inflate their balance sheets. As a result, rating agencies have called for the way companies make financial disclosures to be reformed, with SCF receivables booked as bank debt rather than simply trade receivables or accounts payable, or at least disclosed as a possible risk to liquidity. The US Securities and Exchange Commission has also launched its own investigation into payables finance, writing to a string of blue-chip firms – including Boeing and Coca-Cola – in June to learn more about their SCF arrangements.
In reality, however, SCF liabilities do not generate any additional risks on top of those that buyers and sellers automatically accept when they trade with each other. Payables finance may have helped increase the leverage of several firms that were determined to defraud or deceive investors, but there is little evidence that it was the direct cause of their collapse. And as long as detailed credit analysis of a firm’s balance sheet is undertaken before programmes are funded, SCF represents a considerably lower risk to investors than traditional bank debt.
The industry is also now striving towards a consensus that creating visibility around the existence of SCF facilities through notes on companies’ accounts while maintaining the financing as payables rather than categorising it as debt, would be more than sufficient to resolve this issue.
The power of technology
As advances in digital technology accelerate, SCF programmes will benefit from greater speed, seamlessness and transparency, with the growing availability of increasingly rich and granular data strengthening credit assessments while initiatives like the legal entity identifier (LEI) provide further safeguards against fraud. The result will be a healthier, more vibrant SCF marketplace that allows a wider pool of investors to participate.
Platforms like Finverity, for example, already offer investors an extra layer of risk mitigation by allowing them to cherry-pick not only broad industries but the exact balance-sheet structures, suppliers and underlying traded goods that they want to finance, notes co-founder and COO Alex Fenechiu.
Finverity undertakes the digital onboarding of all parties, including Know Your Customer (KYC) and Anti Money Laundering (AML) checks, as well as integration into buyers’ systems to provide invoice confirmation and mitigation of fraud risk. Investors gain full visibility into how chosen suppliers are utilising a programme, with a real-time data feed instantly alerting them to any payment delays or other issues. Lenders, buyers and suppliers also have access to a detailed audit trail, in case an investigation is required, with every payment fully tracked and backed up by the transfer of legal title.
Additionally, Finverity’s tech provides institutional-level payment infrastructure, including segregated bank accounts and FX hedging. This can be used to mimic a special purpose vehicle (SPV) structure or be combined with a traditional structured route to lower the cost of entry into the asset class for a wider pool of investors and enable them to capture higher margins without sacrificing security, adds co-founder and CEO Viacheslav Oganezov.
Abuse and misuse
Another myth that stands up poorly to examination is that smaller suppliers are being pressured into joining SCF programmes and accepting longer payment terms for the goods and services they provide. Australia’s ombudsman for small businesses has further accused SCF providers of exploiting suppliers by using artificial intelligence to justify charging them high prices for the product.
The Global Supply Chain Finance Forum (GSCFF) has been swift to hit back, publishing in August a white paper that counters such criticisms and corrects common misconceptions about SCF.
While acknowledging that no financing mechanism is immune to abuse, the paper states that instances of such behaviour in SCF are far more isolated than the heavy press coverage they have generated might suggest. Also, the handful of recent cases where buyers sought to lengthen payment terms were simply short-term responses to the Covid-19 crisis and are not reflective of the payables finance industry overall, it argued.
The idea that suppliers would be ‘bullied’ into joining SCF programmes is illogical, according to Oganezov. For the vast majority of such firms – especially those located in the Middle East and other emerging markets, where SMEs typically have limited borrowing options – the cost of capital with an SCF facility is considerably lower than would be available with traditional bank finance, he notes.
Using a platform like Finverity, which specialises in emerging markets, also means that a facility can be more accurately priced to reflect the true risk of the buyer, whose suppliers would be prepaid, without them being unjustly penalised for their location and size. This ensures a fair deal for everyone, he argues.
Supply chain finance is a loose term that is used to refer to a variety of financing techniques, including factoring, payables finance and pre-shipment finance, all of which share a common theme but have subtle differences. With payables finance, one of the most common forms of SCF, sellers in a buyer’s supply chain are reimbursed for goods and services they have provided before payment of their invoices is due. The ‘discount’ or fee they pay for this funding reflects the creditworthiness of their typically larger buyer rather than their own, making it more affordable than most other forms of borrowing, especially for SMEs.