The Time Value of Money, Supply Chain Finance & FinTech
Tags: Fintech, Supply Chain, Lending, Innovation, Technology

The Clewbay Blog

The Time Value of Money, Supply Chain Finance & FinTech

Reducing the marginal cost of lending, how FinTech can revolutionize Supply Chain Finance clewbay Follow Dec 20, 2020 · 10 min read

It could be argued that finance is as much to do with time as it is money — banks borrow short today and lend long for tomorrow. Your home purchase is desired today but likely cannot be afforded in its entirety until many tomorrows. In the case of supply chains, supplies are supplied today and paid for in 60, 90, 120 days.

For those that have done time in finance, the formula below will look very familiar. A sum of cash in the future (FV) is worth less today (PV) due to interest (r) and compounding (n). Most financial intermediaries are making money by helping people bridge the gap between the demand for something now and the supply of money later.

The Time Value of Money Formula

Zooming out

For many years now, disruptors within financial services have sought to take a chunk out of traditional finance’s most prized assets — the supposedly low hanging fruit — unbundling or deconstructing the income statements of banks and insurance companies, leveraging technology to democratize things like trading and wealth management, consumer credit and digital payments.

From hereon, innovators are going to have to be more creative in order to be successful. They must solve problems which are not in the spotlight already or those that are a little less obvious. That, or they may wish to find new ways to better existing solutions. Said another way, it’s unlikely that these companies take the form of existing players such as neobanks.

As is already becoming obvious, this next wave of innovation is all about the reconstruction or rebundling of financial services — partnerships, new tech and open architecture, things like embedded finance and as-a-service providers are increasing the market size and affecting less traditional verticals.

Despite the fact that FinTech and payments have developed magnificently in recent years, amazingly, we continue to see new solutions, products and services come to market — who would have thought that BNPL companies could simply re-engineer the delivery of consumer credit, sit themselves at the POS and leave traditional credit cards without a look in?

And whilst there are now a plethora of consumer finance products aimed at the under or even un-banked population, the same cannot yet be said for underserved SMEs. To us, this is where we will see a tremendous amount of focus over the coming years and where a huge white space exists for innovators to play.

The landscape for traditional finance

As we’ve touched upon in recent posts, the incumbent banks are finding themselves being attacked from all angles on all days of the week. On the surface, it seems as though they are reacting slowly, but either way, the one thing they can be certain of is that they still have the money.

In fact, financial institutions have never been more awash with money/liquidity (take the US banks for example — loan to deposit ratios are some 42% below that of the GFC at 61%, and they have found themselves taking trillions of dollars of deposits this year alone due to COVID stimulus). In turn, banks are very keen to hear from anyone who can help them deploy some of this liquidity into the market (and ideally make them some spread income whilst they’re at it).

See Clewbay articles on infrastructure/industry stacks and embedded finance, more and more non-fin companies are and will continue to leverage financial services as a way to attract customers to their platforms (think T-Mobile offering savings accounts). And herein lies one, among many other, interesting opportunities for FinTech.

Supply Chain Finance (SCF)

It is believed that the global trade finance market will be worth as much as $80 billion in just a couple of years time. SCF is thought to be almost 60% of this and factoring alone expected to account for as much as $9 billion by 2025. The trade finance gap as of 2019 was thought to be a stable, but sizable $1.5 trillion — this is the amount of requested trade finance that is rejected — all in all, a pretty huge market!

With this in mind, it is no wonder that the market continues to look for ways to differentiate and by harnessing technologies such as AI, machine learning, and predictive analytics, there is tremendous scope for continued and radical change. And it is these efforts that underpin the ability to develop technology solutions that streamline the financing process by allowing automated data flow via integration with enterprise-resource-planning (ERP) and procurement systems and with core systems.

All of these efforts are designed to create increased efficiency of working capital, reduce overheads and also importantly, maintain a healthy and happy supply chain (whilst very rare, COVID has starkly highlighted the fragility of global supply chains). Yet while the physical supply chain has improved, the financial supply chain, in general, has not. Whilst the process of debiting one bank account and crediting another is seemingly straightforward, supply chains often have it that the movement of funds takes longer than the physical movement of the goods. And that is by design.

After all, when you can delay beyond the point where the end product is sold and shipped before you have even had to pay for the materials, why would you want it any other way?

In its most refined form, this concept is known as a negative cash conversion cycle. It is how companies such as Gymshark managed to build huge companies without having to raise capital. Said another way, manufacturers are able to negotiate payment terms with their suppliers which essentially mimic that of a traditional line of credit, only without having to visit a bank.

In the industry, this is known as “trade credit”. But why should the working capital burden fall on suppliers? And those suppliers who are more often than not SMEs. One would expect sophisticated, likely larger suppliers to adequately account for the time value of money in their invoicing, but the many millions of smaller suppliers typically do not benefit from such resources and/or education, and in turn, are those left at a disadvantage when it comes to growing their businesses.

Layering on the impact of late payments on SME’s ability to grow and improve their own businesses, there is an obvious gap in the market for solutions which address the time between the delivery to a buyer and the payment to a supplier. Xero’s Kevin Fitzgerald conducted some research on key markets across SE Asia and found that only 56% of payments to Hong Kong SMEs and 39% to Singapore SMEs are made on time. It doesn’t take a rocket scientist to work out that this can be crippling for a small business owner.

What’s more and to really round out on this point, a report by the Asian Development Bank in 2019 showed that over 40% of trade finance applications by SMEs faced rejection. The OECD supported this claim in citing that “SMEs remain underrepresented in global trade ….” And per Standard Chartered, in emerging economies, SMEs are the largest employers and economic contributors.

FinTech to the rescue

As alluded to above, we expect to see a continued focus on innovation for small businesses over the coming years (accepting there has already been some noteworthy developments to date).

SCF innovation companies: clewbay

Payables and receivables often vary widely in terms, duration, and underlying creditworthiness. It is for this reason that those being served by SCF providers today are typically larger corporates with better creditworthiness and recurring higher-value invoices. Often, less than half of total spend is eligible for financing, with uptake around 60–70%. SMEs, as well as those with less frequent/recurring invoices, therefore struggle to access SCF.

Furthermore, given this is a space that has long struggled with fraud and organised crime, the provision of financing is already constrained to those with sufficient risk appetite and know-how. Whilst there are many existing marketplaces and solutions for invoice trading, factoring, discounting etc, finance providers remain wary of the asset class and unable to justify servicing SMEs.

And this is where FinTechs that act as intermediaries in facilitating transactions between a company and its suppliers can help. They enable both parties to improve working capital by extending payables for manufacturers and accelerating payment to suppliers. The outcome is greater liquidity and less variability in the timing of payments.

The goal is to help companies access previously inaccessible capital within supply chains to both help themselves in terms of flexibility and consciously and responsibly increase the capital available to the supplier ecosystem. In an ideal situation, FinTech can help suppliers to access funding at the large corporate buyer’s lower cost of capital.

Historically, the primary focus of digitization of the supply chain was simply to serve the buyers with things such as accounts payable automation, “procure-to-pay” (P2P) systems to help increase transparency and integrate the purchasing department with the accounts payable department. Yet as stressed above, the end product is to offer something to the supplier which is simple to use and even simpler to set up. Perhaps as simple as downloading an app. Connecting with the buyer’s system may be the golden ticket to opening up the SCF ecosystem to all SME suppliers.

Leveraging the large corporate buyer’s low cost of capital (assumed), the supplier offers the buyer a discount (offered to them by a FinTech funder). The supplier can then draw down on funds in a shorter time period than would otherwise be the case e.g. 10 days instead of 90. The supplier receives the invoice amount less the discount. Assuming the buyer’s cost of capital is 2.5%, the supplier would received the invoice amount less 80/365 times 2.5% which = 0.55%. So a $5,000 invoice would be paid after 10 days for $4,972.50. The funder would receive the full $5,000 80 days later (90 minus the 10).

Whilst the emergence of more and more FinTech platforms in this space will drive down returns in the SCF market, these firms are also able to open up untapped or unserved cohorts such as SMEs. The banks ultimately may get less spread, but they’re getting used to that by now anyway.

The solving of a trust issue

The big issue in serving SME supplies with SCF solutions is trust — the “trust-problem” that exists between the supplier and the lender, in which the lender is required to conduct lengthy and onerous due diligence and credit checks, as well as often unrealistic collateral. As things stand, this is the major reason why SCF is inaccessible for SMEs. The provision of collateral for smaller invoices is not worth the effort, nor is the cost of on boarding new customers etc etc. Given the importance and prominence of SMEs in along the supply chain in developing countries, it seems fitting to highlight one of the very reasons that FinTech has become so popular and well funded; to social aspect. Alternative finance solutions (think payday lending in the UK) are often absurdly costly and the terms and conditions far from supportive good business). New entrants must leverage existing data from ERP systems and reduce, potentially eliminate any manual provisioning or validation.

Smart contracts & blockchain

This can be sliced and diced in a number of ways, but without diving down another rabbit hole, let’s keep this high level. We’ve harped on about transparency, traceability, risk management and disruptions along the supply chain and within SCF — blockchain technology brings with it the potential to solve many, if not all of these challenges through the use of “smart contracts”. Smart contracts are digital agreements between transacting parties that are coded and deployed to the blockchain, where they will self-execute when predetermined conditions are met. The role they can play for SMEs and SCF seems quite amazing, with lenders being able to trigger payments as soon as goods are received and invoices are posted. This could further reduce the burden for lenders to access SMEs and smaller or less frequent invoices.

Ultimately, it’s all about marginal cost

As with anything, marginal cost usually plays a good part in any success story. After all, we’re confident enough that many a cost benefit analysis has been conducted to explore the potential for serving new customer cohorts. There is a reason why SMEs remain underserved; it’s not been worth it.

The Strategic Treasurer’s 2019 SCF Survey highlighted that SCF solutions are increasingly being found embedded within the banks. That is to say they are facilitating as much as they are competing. Another key takeaway was the issue of knowing customers or KYC, with 77% of respondents citing know your customer (KYC) regulations as the biggest hindrance to their SCF operations.

If there’s a high marginal cost to making a loan, market participants will naturally only make big loans with attractive ROIs. But where the real opportunity lies is with companies who can reduce the marginal cost of making loans and reduce the risks of not being repaid. This will allow banks to make more of the smaller loans over time and in turn, serve the SMEs that we believe offer a huge market potential.

Traditionally, the supply chain has been all about procurement, manufacturing and delivering/selling, but like many unsuspecting industries, FinTech is stepping in and reshaping the SCF space. With banks awash with liquidity, they are looking for ways to make money on the money they are being forced to hold. Innovation companies hold the key to unlocking a market comprised of many millions of willing participants.

So while people generally resent the intermediation of banks, in SCF we see a very socially responsible use case for financial sponsors and intermediaries. They are bridging the time gap that suppliers, particularly SME suppliers are hugely in need of. Perhaps the general consensus is that banks are too greedy and they over charge, but within SCF, we view intermediation is a real positive.

In this case, the bank/non-bank (well qualified and equipped to lend) is stepping into the shoes of the SME supplier (not qualified nor equipped to lend). And the magic of the tech, lowering the marginal cost of discounting small invoices for small suppliers which is making this socially useful intermediation happen.