The Perfect Illusion
Deep-tier Supply Chain Finance (DTSCF) is often sighted as a magic spell that could transform the funding landscape for SMEs. Unfortunately, much like the world of Cinderella, this magic isn’t real—at least, not yet.
The core principle of Supply Chain Finance (SCF) is to reduce credit risk by leveraging financial stability of the Anchor, typically a large corporate buyer. This works well for Tier 1 Suppliers (T1), who deal directly with the Anchor. These high-quality receivables can be easily discounted or purchased by the financier. The idea of DTSCF is to extend this risk mitigation due to Anchor’s presence further down the chain to Tier 2 (T2) and even Tier 3 suppliers.
On paper, this sounds like a noble concept. Smaller suppliers often struggle to get timely access to credit due to higher collateral requirements, information asymmetry, and inadequate documentation. According to IFC, the unmet demand for credit among MSMEs is an estimated $5.7 trillion annually. DTSCF can be a potential game-changer here. It can help meet the working capital needs of these smaller suppliers in real-time, with easier assessment and without collateral.
A few popular stories further fuel our imagination of it’s transformative magical powers.
Standard Chartered Bank, in collaboration with Linklogis in China, offers deep-tier financing by tracking payments and receivables across multiple tiers using the “WeQChain” platform based on Tencent’s blockchain technology. Beyond financiers, Samsung has a partners program offering no cost finance to their T1 to ensure timely payment to lower tiers. There are more such corporate or financier initiatives, but details about their success remain sketchy.
My own assessment of some of the lending Fintechs excitedly offering DTSCF was a bit of a downer. Most turn out to be downstream SCF or small add-on being positioned as DTSCF. In reality, there are more panel discussions than actual case studies on DTSCF.
In essence, while the concept has caught attention, scaling DTSCF is proving to be difficult. As you scratch the surface, several challenges become evident.
The Slipper doesn’t fit!
In a traditional SCF setup, once the receivables are assigned, the credit risk on Tier 1 (T1) supplier transforms to payment risk on Anchor. There is also a comfort of direct and well-established trade relationship between T1 and Anchor. As you copy-paste this to a Tier 2 supplier, the situation changes significantly, giving rise to two key issues
Complexity of Anchor Involvement
For T2, the debtor is a relatively smaller entity (T1) and the Anchor is no longer directly involved. To leverage the lower payment risk at T2 level, you need to find a way to involve the Anchor. Here are a few scenarios of how this can work in DTSCF
○ If T1 fails to pay T2, the Anchor deducts payments from T1’s payables. In this case, the Anchor isn’t directly involved in the T1-T2 transaction but acts more like a guarantor.
○ Another option is to route the Anchor payables to T1 through an escrow or collection account, ensuring that any due or overdue payments to T2 are settled before T1 receives the remaining funds.
○ Alternatively, there could be a pre-agreed split ratio where every time a payment is made by Anchor to T1, it proportionately secures downstream finance for T2. This would require tri-partite agreement between all 3. (I explore this split option in more detail a little later)
Mismatch in Payment Cycles and Lead Time
Consider a timeline where on Day 0, T2 supplies steel to T1, an auto-ancillary unit for a large automotive Anchor. For simplicity the credit period for both, T2—T1 and T1—Anchor, are set to 30 days. However, T1 ships the goods after a lead time on Day 15. Thus, T1 will receive from Anchor on Day 45 from the Anchor. However, T2 should have got the payment on Day 30 itself. So, there is a cycle misalignment. For DTSCF to function based on supply chain cash flows, you have two options:
○ Extend T2’s credit terms to 45 days, which means the financier would provide DTSCF for this period, with someone in the chain absorbing the cost of an additional 15 days of working capital.
○ Alternatively, T2 continues with a Day 30 arrangement, which the financier funds. If T1 defaults, the financier has to wait for 15 days for an Anchor-driven payment mechanism to trigger and settle overdue.
All the scenarios add operational complexity and require Anchor’s engagement with multiple T2 vendors. The fundamental question is: why should the Anchor engage? Theorists may tout ‘supply chain resilience’ as a reason, but I’m not so sure if its sufficient motivation for large scale adoption especially considering the value added reduces as you go down the tiers.
Managing these intricacies make implementing DTSCF more challenging than it initially appears. And complexities don’t end here.
Techno-legal Pumpkin
Conventional SCF can be operationalised on either side of the trade – receivables (factoring) or payables (reverse factoring). Without delving into techno-legal details, some challenges arise when you try to implement a similar mechanism in DTSCF. Here are a few more scenarios
○ From the receivables side, T1 would need to assign its debtors (receipts from Anchor) to the financier to cover its own payable obligations to T2. This means T1 cannot also avail of the SCF facility against the same debtor. Essentially, this leads to a finance shift down the chain without any increase in the amount. Its zero sum.
○ Looking from the payable side, where Anchor has confirmed its obligations to pay to T2. This obligation should then be distributed downstream. But how and on what basis would this work? One approach is to consider ‘value addition’— the value added by T2 is subsumed within the invoice of T1 to the Anchor. For example, each bill of $/₹100 raised by T1 might include $/₹20 worth of value contribution from T2. Therefore, a split mechanism could be created where 20% of the funding on $/₹100 is allocated to T2. This implies an underlying multi-party legal agreement and necessity to estimate this split. Then there are practical difficulties—purchases are not typically made on a per-unit or per-lot basis and there could be multiple products supplied in the same bill involving different Tier 2 vendors.
○ Alternatively, this could be based on estimated or average purchases, or settlements to T2 could be drawn from an Anchor to T1 payment pool rather than being tied to each specific invoice. This approach essentially shifts SCF from a precise and well-defined practices to a more approximation-based financing model.
Above all, most scenarios assume that the law of the land permits the assignment of debtors or splitting payables for a third party. In case Anchor directly or indirectly guarantees T2’s financing, would require the Anchor to recognize a contingent liability on its balance sheet, adding complexity and reason for reluctance.
The World Bank has highlighted the variability in legal and regulatory environments as a significant barrier to the widespread adoption of SCF practices globally. As you move to DTSCF, the barrier now doubles in height.
Tech is the Coachman
In DTSCF real magic lies in operationalising a four-party engagement—Anchor, T1, T2, and Financier-on a robust and secure platform. You will often hear blockchain as the holy grail. It can facilitate tamper-proof information flows and automate the process of reconciliation and settlement through Smart Contracts. There are platforms offering such tech enabled services. However, the scale change between SCF and DTSCF is possibly anywhere between 10x to 100x. It requires investments and currently seems experimental. I would hazard a hypothesis: Considering weak value proposition for the Anchors in most cases, adoption and traction are likely to be slow, making the viability of large investment a slow burn.
Still, some tricks are plausible
Despite these challenges, there are some scenarios where Deep Tier SCF can possibly fit better:
○ Critical and High-Value Add Supply Chains: Sectors like aerospace and high-end electronics supply chains have certain critical, highly engineered products that require a greater control and reliability. In such cases, there is an incentive for the Anchor to facilitate deep-tier liquidity. Anchors often mandate qualification for sources from where T1 can purchase their raw materials. Samsung’s case study shared earlier is an example for Semiconductor supply chain.
○ Sub-Contracting Arrangements: In situations where a T1 outsources production of finished goods or specific services directly to a T2 for delivery to an Anchor, DTSCF execution can be simplified. Textiles, Electronics, and Software are some potential candidates. But this would mean the Anchor having a clear sight of the real supplier, which may not be conducive to T1’s long-term interests.
○ There is one, rather plausible, solution but requires some systemic wizardry-a centralised system or protocol owned by a regulator or a central agency on the lines of TReDS. However, this would need to be built for 100x scale, with much greater emphasis on vetting, creating legal structures where payables can flow for T2’s liabilities.
Final Act
DTSCF has great potential, and I genuinely enjoy hearing about it in panels and reading occasional papers on the subject. However, to my understanding, scaling DTSCF effectively requires systemic intervention in both technology and legal frameworks. Until a coordinated effort is made, DTSCF will remain a magical concept that sounds great in theory but goes poof in practice at midnight.
References:
IFC MSME Finance Fact Sheet (ifc.org);
The right to borrow : legal and regulatory barriers that limit access to credit by small farms and businesses (World Bank);
Linklogis and Standard Chartered launch APIs to support deep tier supply trade finance (openbanking.sc.com);
Samsung Sustainability in Supply Chain (samsung.com);
Blockchain and supply chain finance: a critical literature review at the intersection of operations, finance and law (Springer)
Disclaimer: The opinions expressed here are those of the author and does not reflect the views of FrankBanker.com