Introduction to Factoring

Many small and medium-sized enterprises (SMEs) struggle when it comes to securing finance and an especially sore spot is obtaining funds to finance their operations. This is because buyers often request around one to three months to pay for products or services once delivered. During this time, the vendors raise and send an invoice, which is noted as an account payable on the buyer’s side. On the vendor’s side, the transaction is recorded as an account receivable, and until payment is made it remains as a non-liquid asset.

To address this problem, vendors can use ‘factoring’, which enables SMEs to swap their accounts receivable for cash at a discount – usually, the cost of service includes a combination of charges and interest. Because factoring isn’t considered the same as taking out credit, it doesn’t register as a balance sheet liability. However, it can be an effective source of working capital financing. Even better, suppliers who do factoring ‘without recourse’, are able to secure credit protection. In this instance, the purchaser of the accounts receivable (factor) takes on all the associated risk if the buyer fails to make payment. Alongside this, the factor assumes responsibility for the financing, debt collection, and the bookkeeping for the liabilities.

Factoring has plenty of advantages for high-risk SMEs that need to secure funding because the credit risk assumed by the factor in based on the reliability of the buyer rather than the vendor. As such, it is easier for the SME to secure funds for their accounts receivable regardless of their credit history.

Introduction to Blockchain

Blockchain is a decentralised method of record keeping that has evolved in response to numerous modern problems in computer science.

The first digital solution to the ‘double-spend’ problem was Bitcoin, which uses an open, permissionless, peer-to-peer network. The term “open” is used to mean that there are no restrictions about who can send or receive requests from the network. ‘Permissionless’ describes the fact that any connected device is free to join and contribute computational power to the Bitcoin network. In comparison, conventional ‘permissioned’ networks generally require that computers have an authority-issued certificate to do so.

The double-spend problem is a result of the ease with which digital information can be copied. For digital currencies, this poses a problem, as currencies require the concept of memory. Bitcoin overcame this by creating a network where all peer-to-peer transactions are entered in a common ledger. Each computer storing a copy of this ledger is in competition with all other network-linked computers to add valid transactions to the ledger. When new transactions are added, they must be approved by the majority of connected computers, and each of these is incentivised to discourage other computers from cheating. As sets of transactions are added to the ledger, it becomes exponentially more difficult to tamper with it. Eventually, the ledger becomes as good as tamper-proof, and this property of transactions is termed ‘finality’.

Ethereum Blockchain

The Ethereum network was later developed as an innovation on blockchain ledgers. If we view Bitcoin as the resolution of the digital currencies’ ‘double-spend’ problem, we can view Ethereum as the answer for modelling contracts between network participants who do not require intermediaries for enforcement.

More officially, Ethereum enables users to encode any state onto the ledger, then use a set of inputs to specify a state transaction function. Every computer holding a copy of the ledger must then receive the rules for this state transaction. The reason being, each needs to be able to compute it to return a valid result if it is competing against other computers to add transactions to the ledger. Correspondingly, each party with a stake in some state transaction can then audit the rules and submit amended versions if they see fit.

Legally, because ownership can be encoded as a state, and as inputs can be delineated for a state transition, the Ethereum blockchain can act as a platform for encoding any conditional ownership transfer between parties subject to a set of inputs and rules. Collectively, these rules are termed ‘smart contracts’ as they programmatically execute the state transaction once their inputs have been satisfied.

The trend for ‘tokenising’ assets on the blockchain has arisen directly from this fact. As blockchain ledgers enable scarce digital assets to be created, and as scarcity is a feature shared by both tangible and intangible assets, blockchain ledgers are optimal places for ‘tokens’ representing rights to these assets to be generated. Similarly, blockchain ledgers are suitable places for asset ownership to be represented by token ownership, and for asset transfer to be represented by token ownership transfer (state change) according to rules specified by smart contracts.

The Ethereum public network, like the Bitcoin network, is permissionless and open. It is secure, flexible, and has a demonstrated record of being a legitimate tool for deploying regulated debt securities in major jurisdictions.

Tokenising invoices

Invoice financing entails risks that make due diligence necessary. This due diligence is amongst the more notable costs associated with financing modern supply chains. Alongside numerous other use cases, Blockchain has made it much easier to decrease the risks through invoice tokenisation, earning it an important place in the supply chain industry.

Blockchain technology successfully remedies both transparency problems and the difficulties of proving that invoices are unique. On an established blockchain network, credit providers and financial entities can instantly check decentralised databases to find invoices that have been duplicated. Connected firms can confirm the legitimacy of invoices, financial entities can verify they have not yet been financed, and none of these processes requires sharing the confidential invoice details.

Every invoice shared using the blockchain network receives a timestamp, a unique identifier, and it is cryptographically hashed so it can’t be financed more than once. The hashing function encrypts data, so confidential details are unreadable.

Once the tokenisation of these invoices is complete, tokens can be sold at a discount to factoring companies or used to guarantee smart contracts deployed on the Ethereum blockchain. The tokenised short-term debt can be traded in the secondary market.

Blockchain smart contracts are ideal to model debt security contracts as they encode their conditional logic. Because the logic encoded in smart contracts is enforced by the algorithms supporting the entire Ethereum public network, smart contracts execute programmatically. There is no longer a need for third parties as transaction clearing, registration, and other functions can be executed by technology. This results in heightened data quality, transparency, price discovery, and decreases information asymmetries. Each of these, correspondingly, adds to the market’s efficiency.

About Capexmove

Capexmove’s goal is to help companies and individuals to fulfil their potential with better access to capital. Capexmove is a platform to issue and tokenise debt that uses blockchain technology and smart contracts. We allow individuals and corporates to pledge their digital-assets as collateral to borrow fiat currency.