By Lilian Teo, CFO and Toniya Sundaram, Blockchain Developer of oCap Management Pte Ltd
One interesting result from the recent Small Business Credit Survey 2019 shows that the share of applicants who sought loans, credit lines or cash advances from online lenders has grown remarkedly since 2016 from 19% to 32%, and among all reasons cited on lender choice, the top three reasons for this trend were #1) speed of decision making, #2) perceived chance of funding and #3) no collateral was required. Although this was a survey collaborated by 12 Federal Reserve Banks in U.S., it reflects the overall borrowing experiences of small businesses across the globe.
Just like large corporates, SMEs need to deal with similar issues such as managing working capital, taking care of late payment and collection and handling of international customers, yet the latter’s access to long-term or more sophisticated funding is often restricted.
Banks are traditionally the main provider of debt financing to businesses including the SMEs. Notwithstanding, adopting the relationship-based corporate banking model on small businesses for the banks is often too costly given the usual smaller loan size taking the existing labor-intensive processes into account. Being in a highly regulated industry, the banks generally require more paperwork and lengthier Know Your Customer (KYC) process amid their manual processes and unintegrated tools. The higher inherent risk of SMEs is another factor for the banks which generally have lower risk appetite to service this segment. This results to increased cost of borrowing for the SMEs plus imposing collateral requirements, which often become a bottleneck to appropriately service SMEs as they generally do not have any tangible asset for collateral.
Overview of Blockchain
Blockchain is simply “an open, distributed database that can record transactions between two parties efficiently and in a verifiable and permanent way”. It enables the building of a distributed database of transactions with a set of rules as to how the database gets appended, achieved by distributed consensus of participants in the system. It records and stores every transaction or exchange of data that occurs in the network, eliminating the need for a central authority and providing greater transparency. This technology is valuable in particular for applications where there is a need to provide a quick, secure and permanent date and time stamp of transactions.
How Blockchain creates FinTech Lending
The distinctive characteristics of SMEs and the banks’ low risk appetite created access opportunities for FinTech companies to this market segment and started a shift in paradigm towards FinTech lending.
Whilst SME borrowers are sensitive to interest rates on their loan, more often than not, they also want ease of application, transparency in the lender’s process and speed of approval, to alleviate at times temporary liquidity shortage.
Blockchain can play its role in automating and streamlining the KYC and approval processes by enabling lenders to automate information collection and processing through smart contracts. Instead of manually collating information, inputting data into a database and perform the KYC and risk assessment on the client before submitting the loan application for approval which could go up to 3 levels of approval, the whole cycle may take 2-3 months at least.
A decentralized ledger allows lenders to aggregate all data from multiple sources in a single location continually updated in real time. Instead of performing full manual credit assessment, lenders can apply credit scoring models which are data-driven and adopt semi-automated risk assessment methods on non-traditional data points. Using smart contract to update data and store in a database, and issue contract, which are now performed in real time, this improves data access and visibility and lower overall cost due to faster transactions and automated processes. Lenders can pass the cost saving to the SMEs. This also opens up an opportunity for lenders to employ dynamic pricing as more frequent risk reassessments on short-term loans like invoice financing, merchant cash advance, working capital line and trade financing, can now being performed faster and more easily.
Since the data needs to be permissioned, the lending platform can be built on a permissioned, private blockchain. Considering blockchain’s immutable nature, it is impossible to alter or manipulate the data which enables data security. A hack-proof ledger could serve the purpose for a transparent credit scoring system which is a win-win scenario for both the lender and borrower. Since FinTech lenders do not fund themselves with highly regulated depositor money, considering the idiosyncratic characteristics of blockchain, FinTech lenders could source funds by tokenising the debts and subsequently attract retail and institutional investors.
Constraints and Conclusion
Whilst blockchain helps enabling automation and streamlining the entire lending process, leading to faster turnaround times for a loan applications and lower cost for the SME borrowers, some technical limitations should be considered which include the lack of standards among the different blockchain networks which could restrict the sharing of data among the various participants in a lending scenario. Take for example, lenders’ investors and disbursement banks. As blockchain utilizes consensus-based validation technique and continuous replication could result to the growing amount of unalterable data, the expandability of a blockchain system is still untested. Beside technical constraints, FinTech lenders have to observe the regulatory changes as they are still caught within the lending regulatory regime. Blockchain makes sharing of data easier but at the same time data privacy has been more stringently implemented globally with the latest entry of the EU General Data Protection Regulation (GDPR) in May 2018 that adopts stricter privacy and data security policies.
Moving forward adopting blockchain in lending is definitely an exciting and promising way.