Hong Kong central bank, BIS explores blockchain for SME financing – Ledger Insights

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-sized enterprises (SMEs) get better financing. They intend to examine the effect on funding costs and the amount of funds available.

Numerous studies have shown that SMEs are hugely important to economies. A World Bank reports that they make up 90% of companies and account for 50% of employment. It is common knowledge that SMEs struggle with financing. The International Finance Corporation (IFC) says there is $5.2 trillion in unmet demand for financing annually. This means that the funding only covers a little over 40% of what SMEs need.

There are several reasons for this shortage, but two stand out. The first is a matter of trust.

Blockchain reduces the need to rely on SMEs

Large companies have better credit scores and lower failure rates, which represent a much lower risk for the banks. Supply chain financing was a major breakthrough because instead of a small company saying I owe $100,000, the large customer not only confirms that it owes the SME the amount, but often uses its own credit to help finance the SME’s cash flow.

Blockchain can share this approach, allowing suppliers to verify that invoices are valid, reducing the need for trust. The technology is also a potential approach to prevent fraud where the small company tries to obtain funding 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.

In addition, blockchain can be used to use funding sources other than banks. Startups such as Centrifuge, Credix, Triterras, Tradeteq and XinFin are exploring this approach. Ant’s Trusple uses blockchain for SME trade finance, but with banks.

One of the main applications for DeFi is for lending pools, matching borrowers and lenders. To date, borrowing has mainly used cryptocurrency as collateral for lending, but in some of the above cases, they use trade finance invoices instead.

Decentralized identity may not help

The interaction between identity and anti-money laundering (AML) is another cause of financing and SME transaction challenges. Some companies even struggle to open bank accounts, never mind getting financing. BIS said it is interested in exploring decentralized identity.

SMEs bear most of the unfortunate side effects of AML procedures. Never mind funding, just sending and receiving payments across borders is a huge hurdle for many SMEs, with transactions regularly blocked through compliance. Larger firms carrying out the same transactions do not face similar obstacles because they are more valued customers by the banks.

For banks, there is often a poor balance between the high costs of compliance and the low value of the SME customer to the bank. If there is any perceived AML risk, whether it is a false positive or not (as it often is), it is easier for the bank to block funds or close or deny a bank account to the SME customer. Often the problem is overly simplistic rules such as considering all transactions with certain 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 it is a move away from simplified AML rules, it could make matters worse. It can, for example, lead to a company being completely blocked on invalid grounds. For example, if they hire an external software developer in Ukraine.

This is not just an emerging market. It also happens in the developed world.

The BIS also mentioned that it was interested in the use of artificial intelligence to assess SME credit risk, innovative supply chain financing solutions and the interoperability of payment solutions such as stablecoins and central bank digital currencies.