Invoice factoring through Blockchain: harnessing technology dividends

Blockchain technology and its application to lending, allow the African continent an opportunity to access a vast network of peer-to-peer financing while avoiding the friction of the current lending architecture.

Invoice factoring refers to the process by which companies receive immediate cash by using their business outstanding receivables. It allows companies to “sell” their invoices to a third party in exchange for immediate access to most of the total invoice balance.

The advantages for the companies include the fast access to cash without collateral or a credit check and the possibility to expand their business by solving their immediate cash-flow problems.

The current factoring process relies entirely on traditional lending actors such as banks or private entities, which provide export companies working capital solutions to overcome their cash-flow problems deriving from customers taking upwards of 60 to 90 days to pay invoices.

Banks provide cash-advance loans or lines-of-credit to allow export companies to face immediate expenses or expansion strategies. These cash-flow advance solutions are usually expensive due to interest, and their acceptance depends heavily on external factors such as the company’s history with the lending financial institution and the availability of additional collateral.

Invoice factoring companies offer access, within a few days, to almost 80% to 90% of the invoice value and, return the reserve amount once the invoice is paid by the customers minus fees (including processing fee and factor fee).

Blockchain technology in Invoice Factoring

As it allows transactions to be shared effectively, securely and transparently, Blockchain technology is reshaping the financial landscape. Blockchain will enable transactions to be completed in a peer-to-peer fashion by directly connecting potential investors and companies in an entirely transparent environment.

Invoices are “tokenized”, which means that their value is converted into digital tokens on a specific Blockchain, allowing them to be transferred and stored. This process ensures that tokens are secured from tampering and accessible to only those with required permissions. Tokens can be fungible and non-fungible depending on the type of data being tokenized. In the case of Invoice factoring, invoices are converted into Non-Fungible Tokens (NFTs), which guarantee that they are unique and immutable and securely store data such as the original creator of the invoice.

Payment of these tokens is set in a “smart contract”. Smart Contracts are digital contracts stored in a Blockchain that are programmed to behave according to predetermined conditions. Smart Contracts in Invoice Factoring can contain several data such as NFTs of the invoices and can be programmed to release the funds to the company once reached a certain threshold. Companies can then trade their invoices in an open and distributed ledger platform that record the transaction between parties.

Some platforms based on Blockchain technology connect investors and companies and propose to conduct companies due diligence on their behalf by rating them according to their creditworthiness from AAA to CC. Companies, such as Hiveterminal in Switzerland or VoloFin in India, have already developed such platforms.

Challenges

Although Blockchain allows companies to access an unlimited source of potential investors worldwide, most of the current peer-to-peer invoices factoring platforms limit their offer to a specific geographic zone.

The main reason for this limitation is the imperative need to access reliable data in order to correctly assess companies' creditworthiness in a jurisdiction where sometimes very limited data is available.

The second reason, is the risk of using the process for criminal purposes, such as Money Laundering (ML) or Terrorism Financing (TF), which are difficult to detect without a strong (Know your Customer) KYC process in place.

The third reason is the absence of a suitable legal framework in most countries when it comes to licensing, supervising, monitoring and mitigating the risks associated with Virtual Assets and Virtual Assets Services Providers (VASPs). In October 2021, the Financial Action Task Force (FATF) issued updated guidance for a Risk-Based Approach to Virtual Assets and Virtual Asset Service Providers, which assist “national authorities in understanding and developing regulatory responses to covered VA activities and VASPs”[1]

Opportunities for Africa

Despite being the backbone of most African economies, Small and Medium Size Enterprises (SMEs) have traditionally been excluded by major financing institutions that mostly require high levels of collateral and stringent credit checks.

The SME finance gap is estimated above USD 421 billion[2] in Africa. The peer-to-peer invoice financing platforms based on Blockchain offers opportunities for African SMEs to directly access financing and overcome the tedious process required by traditional lenders. Nevertheless, whoever they may be, lenders still require a certain amount of assurance to invest. There is an opportunity to develop a credit scoring system based on reliable data, which can accurately reflect companies' creditworthiness and give investors the necessary comfort to invest.

This credit scoring mechanism is essential to develop an African peer-to-peer invoice factoring powered by Blockchain technology and allows individuals, including the diaspora, to invest in intra-African Trade.

Most credit scoring systems collect information from individuals or businesses using the Fair Isaac Corporation (FICO) system. This system assesses the risk based on various factors such as payment history or credit history. The challenge for the continent is the absence, in many jurisdictions, of a national credit scoring mechanism, which could be then linked to an African credit scoring system.

It is fair at this point to acknowledge the unique role of the African Export-Import Bank (Afreximbank) in the promotion of factoring in Africa. Afreximbank, along with partners such as Factor Chain International (FCI), the Africa Capacity Building Foundation (ACBF), Making Finance Work for Africa (MFW4A) and African Development Bank (AfDB) have been supporting initiatives for factoring to thrive in Africa. These include legal and regulatory reforms based on the Model Law on factoring, financing and guarantees opportunities, advisory services, information sharing mechanism and, raising awareness through public outreach campaigns.

In addition, one of the major initiative of Afreximbank is the Mansa project, which paved the way to establishing a continental database of African entities. This repository platform gives access to Customer Due Diligence information on African entities to lower the risk perception and eventually streamline trade by enhancing transparency. The credit scoring mechanisms follow the same logic, as it requires a single source of data where potential investors can assess companies' creditworthiness.

Another major opportunity for the continent is the African Continental Free Trade Area (AfCFTA) established in March 2018 during the 18^th Ordinary Session of the African Union Assembly of Heads of States and Government. The AfCFTA aim is to eliminate the barriers to boost intra-African Trade of goods and services and build on the eight existing Regional Economic Communities.

The free trade area combined with the Pan-African Payment and Settlement System (PAPPS) developed by Afreximbank would significantly increase invoice factoring on the continent. In practice, an investor in Eastern Africa can purchase a part or the totality of an invoice issued to well credit-scored rated African SMEs located in Southern Africa through platforms based on Blockchain technology, which can be instantly processed by PAPPS and facilitated by AfCFTA.

The current international finance architecture, specifically the core lending mechanism has not fundamentally changed in the last century providing only very few possibilities to African SMEs. Blockchain technology often referred to as the future of finance, potentially overcome the tedious traditional funding process by offering SMEs access to a secure and transparent peer-to-peer lending opportunity. However, the successful development of this technology depends on how efficiently the various relevant institutions would enable the required environment for it to thrive. Blockchain could be a way to bypass some of the systemic challenges affecting the continent while unlocking its tremendous investment opportunities as long as the national, regional and continental digital strategies are in sync.