First-hand experience: developing a blockchain solution to reduce double financing risks in SME financing

In our previous blog, Friso Spinhoven and Douwe Lycklama discussed the demonstration of ‘track & trace’ of invoices statuses for improved risk management in factoring accounts receivables. This blog reports on the development of a blockchain registry to cope with double financing risks.

Factoring accounts receivables (i.e. sent invoices) is becoming a more popular[1] funding option under Dutch small and medium-sized enterprises (SMEs) to quickly unlock cash in sent invoices. This allows SMEs to optimise their working capital and to avoid late invoice payments. Factoring is costly for SMEs, as providers (e.g. banks, factors, brokers) lack appropriate information and mechanisms to manage the risks associated with factoring accounts receivables efficiently. Digital innovations in this space would contribute to a healthy and growing factoring market. In return, SMEs benefit from improved offerings.

One of the risks in factoring accounts receivables is ‘double financing’: the event that a fraudulent SME successfully extract funds from multiple financiers using the same invoice. Double financing often leads to disputes where financiers have to bear the loss. Disputes can be avoided if there was a register to check the funding status (e.g. open, secured) of receivables. Innopay was commissioned by the Dutch Logistics Top Sector program to gain experience in developing a register based on blockchain technology. Innopay developed a first prototype in collaboration with project participants, Voldaan factoring BV, FreelanceFactoring BV and Trfi BV. The next step is to create a ‘live’ version of the blockchain register. If you are interested to join this new project, please send an e-mail to Pepijn Groen

Explaining double financing complications

In order to determine the scope of a receivables register the project participants shared their encounters with double financing and their intention to discourage fraud. To clarify this issue, the double financing complications are explained through a simplified scenario in a setting of a seller, buyer and two financiers. See Figure 1 below.

Figure 1: Explanation of double financing complications

Other scenarios include collusions between seller and buyer. In any scenario, a receivables register could have prevented financiers from financing pledged receivables. Application of blockchain technology to manage double financing could be an interesting opportunity. In the next paragraph is explained why.

Use blockchain potential to create a register for financiers

A receivables register is only relevant if, for a start, all Dutch financiers that offer SME financing here in The Netherlands use it. That means that an industry of (approximately) 26 players need to rely on a secure, scalable, accessible, “no downtime” and easy to govern registry. Furthermore, it requires undisputable unique recording of financial agreements (i.e. transactions).

A blockchain solution meets fore-mentioned requirements as it allows for an immutable, decentralised, always accessible, shared ledger (i.e. register) to exist on a large network of nodes. In Figure 2 below, the five core enabling blockchain properties are explained, and a visualisation of a shared register is provided.

Figure 2: The five core blockchain properties to create a ‘trusted’ distributed registry for financiers

Blockchain was preferred over ‘traditional’ database solutions (e.g. Oracle, SQL, SyBase) because the trust model is advantageous. Blockchain technology ensures that the exact same version of the register exists on all nodes at all times. This is done without coordination by a central organisation and database. Furthermore, it is almost impossible for nodes to unilaterally control transactions in the register, so the blockchain can serve as a secure and clear record of transaction ownership. This means trust and governance should be operated cost-effective for the whole ecosystem.

In the next paragraph the essentials of the receivables register prototype are further explained.

Setting-up a blockchain register

For this project a private blockchain database structure of ‘certified’ nodes (i.e. clients) was set-up, each representing a financier holding an exact same copy of the register at all times. Based on the first scope, three preliminary protocols were developed that financiers can execute directly from their back-end system:

1. Verification notifies financiers whether a receivable is already part of a financial agreement or open is for finance;
2. Notarisation records financial agreements uniquely on a cryptographically secured register;
3. Revocation allows for the release of single receivables or release of receivables from long term agreements (e.g. overdraft facility) to be financed by another node.

Though blockchain is often promoted to deliver transparency, the project participants demanded strong customer privacy protection. This means little customer information is used to record transactions. More important, the participants wish to protect sensitive information for competitive reasons. Since each participant can query its own copy register, the private blockchain will be implemented with a group signature scheme. This means participants can only see that transactions are signed by a certified node, but not by whom.

Market responses to solve double financing with a blockchain register were rather positive and Innopay is now looking into the next steps to mature the prototype towards an industry model.

The next steps to create a ‘live’ version of the blockchain register

For now, the following activities are foreseen to create a ‘live’ version of the register:

• Engage more financiers (banks and non-banks) and other stakeholders to form a leading project group;
• Design a ‘governance’ that controls access to the blockchain, manages identities and secures rights on receivables;
• Identify more use cases and application of other blockchain instruments such as smart contracts and multi-signature wallets.

The project is open for further participation. If you are interested, please send an e-mail to Pepijn Groen

[1] Sales volume in the Dutch factoring market increased with 25%, between 2013 and 2015, rising from 54,4 bln naar 65,7 bln (source: http://www.factoringnederland.nl/cijfers-en-trends)

Originally published at innopay.com.