The Hong Kong Monetary Authority (HKMA) and the BIS Innovation Hub have launched Project Dynamo, which aims to use DeFi, blockchain and smart contracts to help small and medium enterprises (SMEs) get better funding. They intend to explore the impact on funding costs, and the pool of funds available.
Numerous studies have shown that SMEs are enormously important for economies. A World Bank reports states they make up 90% of companies and account for 50% of employment. It’s widely known that SMEs struggle with funding. The International Finance Corporation (IFC) says there is $5.2 trillion in unmet demand for financing annually. That means the funding provided only addresses just over 40% of what SMEs need.
There are several reasons for this shortfall, but two stand out. The first is a matter of trust.
Blockchain reduces the need to trust the SME
Large companies have better credit track records and lower failure rates, representing a much lower risk to banks. Supply chain finance was a major breakthrough because instead of a small company saying I’m owed $100,000, the large client not only confirms that it owes the SME the amount but often uses its own credit standing to help fund the SME’s cash flow.
Blockchain could split this approach, allowing suppliers to confirm invoices are valid, reducing the level of trust needed. The technology is also a potential approach to prevent fraud whereby the small company tries to raise finance multiple times on the same invoice. However, one of the blockchain startups that addressed this, Monetago, has moved away from blockchain to a centralized system.
Additionally, blockchain can be used to tap alternative sources of finance other than banks. Startups like Centrifuge, Credix, Triterras, Tradeteq and XinFin are exploring this approach. Ant’s Trusple uses blockchain for SME trade financing but with banks.
One of the main applications for DeFi is for lending pools, matching borrowers and lenders. To date, the borrowing has mainly used cryptocurrency as collateral for lending, but in some of the above cases, they are using trade finance invoices instead.
Decentralized identity may or may not help
The interaction between identity and anti-money laundering (AML) is a second reason for funding and SME transaction challenges. Some companies struggle even to open bank accounts, never mind getting funding. The BIS said it is interested in exploring decentralized identity.
SMEs bear most of the adverse side effects of AML procedures. Never mind funding, just sending and receiving cross border payments is a massive hurdle for many SMEs, with transactions regularly blocked through compliance. Larger firms executing the same transactions don’t encounter equivalent hurdles because they are more valued customers of the banks.
For banks, there’s often a poor trade-off between the high costs of compliance versus the low value of the SME customer to the bank. If there are any perceived AML risks, whether or not it’s a false positive (which it often is), it’s easier for the bank to block funds or shutter or deny a bank account to the SME customer. Often the problem is overly simplistic rules such as considering all transactions with particular countries as suspicious even if 90% are legitimate. Blockchain will not fix this.
Two years ago, the G20 proposed a decentralized identity solution, a Global Value Chain (GVC) Passport. While it may be a step in the right direction, unless there’s a move away from simplistic AML rules, it could make matters worse. For example, it could result in a company getting completely blocked on invalid grounds. For example, if they employ a remote software developer in Ukraine.
This is not just an emerging market issue. It happens in the developed world as well.
The BIS also mentioned it was interested in the use of artificial intelligence for assessing SME credit risk, innovative supply chain financing solutions, and the interoperability of payment solutions such as stablecoins and central bank digital currency.
