Global Small and Medium Sized Business Financing Need

The International Finance Corporation (IFC) estimates that 65 Million firms, or 40% of formal micro, small and medium enterprises (SMEs) in developing countries, have an unmet financing need of USD 5.2 Trillion every year. There are 200 to 245 Million formal and informal enterprises that do not have access to loans or overdrafts, but are in need of one—also referred to as the unserved sector. Due to many factors, including unclear financial regulations, high registration fees, and volatile economic conditions, many SMEs find it difficult to source liquidity at affordable fees from well-established financial institutions and hence must resort to informal lenders at higher borrowing rates or sell their invoices at lower face value.

Decentralized Finance and Crypto Liquidity Pools

Decentralized Finance, or DeFi is the new buzzword in finance with potential benefits for SMEs. DeFI uses a pair of crypto assets to form liquidity pools. Individuals can borrow against their crypto collateral to borrow from the pool and pay back with interest. For more information about DeFI and liquidity pools, please refer to this article.

The big question is how to collateralize traditional invoices to borrow from the pool. Unlike crypto assets, traditional invoices are created off-chain in an enterprise environment. Hence, there must be a “digital twin” of the invoices on blockchain, meaning the attributes of the invoices must be on the chain, preferably in smart contracts. This allows the creation of a Non-Fungible Token (NFT) that represents the invoices. These invoices then become on-chain assets ready to be collateralized in crypto pools.

“Lower” Borrowing Cost of DeFi

Because the borrowing process is completely automated and liquidity pools do not have much administrative cost, the overall cost of borrowing may be much lower than borrowing from traditional factoring companies and financial institutions. However, that is not given and depends on the pools. Most liquidity pools tout themselves as providing higher yield for liquidity providers than traditional lending, which translates to higher fees to borrowers. Also, pools can be highly volatile due to the volatility of the underlying crypto assets used to create them. Most pools are variable. AAVE is one of the unique decentralized exchanges (DEX) that provide stable borrowing rates – please refer to “stable borrowing APY” in the image below. It also shows borrowing rates for different pools in AAVE. The cheapest borrowing rate is ~3%, which is significantly lower than borrowing rates offered by traditional financial institutions for short-term liquidity/cash requirements, especially in developing countries. For comparison of borrowing rates to SMEs by countries, please refer to the OECD’s website. It shows that borrowing rates can range from 1% (e.g., Austria) to over 40% (e.g., Brazil) for SMEs.