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Supply Chain Finance Evolution in Six Steps

Introduction

Six degrees of separation is the theory that everyone and everything is six or fewer steps away, by way of introduction or connectivity, from any other person in the world, so that a chain of "a friend of a friend" statements can be made to connect any two people in a maximum of six steps. Paraphrasing this theory, this document asserts that the same applies in business and so supply chain finance (SCF) schemes will evolve—in six progressive steps (or phases)—from company-centric finance (i.e., financing the suppliers of a single “anchor” company) to supply network-centric finance (i.e., financing all the participating companies of a supply network).

The six steps of supply chain finance evolution

The SCF evolutionary journey starts with observing that the competitive strength of the physical supply chain (PSC) depends on the strength of its weakest link. From a buyer-centric perspective this link is usually represented by a supplier of a critical component or commodity that isn’t easily replaceable but strategically, or for other reasons (e.g., single-sourcing), important. This link is therefore represented by a company that supplies hardly replaceable (at least in the short term) goods, usually through intermediary tiers, to a large buyer and that could suffer from failures that result in dramatic and unforeseen interruptions of the value chain. Apart from dramatic interruptions due to natural catastrophes, the buyer-supplier chain link may break due to financial distress suffered by the weaker of the two parties. Supply chain finance programs are there to provide the necessary relief. Given the variety of financial instruments that fall under the term SCF, for the sake of simplicity and readability this paper focuses on buyer-centric structures that currently are among the more common.

The strength of a buyer-centric SCF scheme depends mainly on the financial strength of the strongest (i.e., in terms of credit rating and borrowing capacity) player, usually a large corporate buyer. Often, this balance of power is also significantly determined by the underlying trade transactions, to the point that it may be critical to focus too much on financial ratings while it would be more appropriate instead, to think about a "transaction rating” that factors in other dependencies – e.g. capital adequacy, equipment/ inventory finance, stability of commodity markets for key inputs. To the extent that cash flow/liquidity is one of the most important factors determining financial health, a SCF scheme can help a participating supplier (usually a small-medium enterprise – SME) to remain financially strong and to continue delivering goods (or services) to its buyer in the PSC. A SCF program can reduce the overall financing costs of the total/end-to-end supply chain by avoiding more external financial institutional financing at the most costly/less credit worthy/risky nodes in the chain.

The conclusion after reviewing this first round of facts is that in a buyer-supplier relationship the strength of the weakest link in the physical supply chain depends on the strength of the strongest in the supply chain finance scheme. And this also constitutes the first step of the SCF evolution: To build a strong supply chain you need a strong supply chain finance partner.

A primary influencer of the strength, costs, and risks of the physical supply chain in this context is a solid supply chain finance program. This immediately leads to the second step in the SCF evolutionary journey: To establish a SCF program.

While leading SCF providers will suggest that only a qualified subset of suppliers are to be invited to avail of the financing support, in order to limit potential threats for the value chain, a large company should consider the strength of the entire (i.e., end-to-end) physical supply chain responsible for the supply/delivery of its goods. That is, enterprises are not in a singular, linear one-to-one supply chain but in more complex supply networks in which the players create interferences. In essence, the buyer's strength is a determinant but it is the more influential the less the network of off-takers is diversified, and vice-versa.

A physical supply network is therefore a sequence of interconnected [buyer-supplier] links that exchange goods (or services) for money.

The next two phases (i.e., third and fourth) of the evolving SCF are to acknowledge that the strength of a physical supply network will be the sum of the strengths of each [buyer-supplier] pair, and that the weakest link of a large company’s supply network may be a [buyer-supplier] pair distant from the large company’s direct reach. A company’s supply network is only as strong as its weakest link and that link may be quite far from the actual center (i.e., “anchor” company—OEM) of the network.

Moreover, this [buyer-supplier] pair may be part of many large company supply networks, so it is in the interest of all to address this link.

This consideration adds one more step (i.e., the fifth) to the evolutionary SCF path: In order to secure the strength of their supply network, large companies must all ensure the strength of the weakest [buyer-supplier] pair. This goes against the common trust that such type of assurance may not come through an SCF solution, as both the buyer and the SCF lender would filter out weaker suppliers from an SCF program. It is, instead, at this very moment of discovery of a distant—and potentially disruptive—weak link that the anchor company must ensure its financial support.

Supply chain finance is a portfolio of multiple financial instruments encompassing more than only liquidity provisioning products (e.g. credit insurances, letter of credit-confirmations). Particular emphasis must then be placed on "financial instruments" in the broadest sense, including all non-bank-intermediated finance as well. The [buyer-supplier] pair or- as the case may be – the network of certain buyers and suppliers -  will have peculiar needs that only a subset of instruments of the SCF portfolio can fulfill. In most cases, one instrument will fit best, but it is likely there are cases where various or all portfolio capabilities could be applied and would be useful and solve the problem. [Buyer-supplier] pairs may also be in a different ‘industry’ than the “anchor” company (e.g., plastics, electronics, or chemicals in the supply network of an automotive OEM), with different financial dynamics.

Once the weakest [buyer-supplier] pair is strengthened, another pair becomes the weakest link. This observation leads to the sixth—and finally last—step to complete the SCF evolution: The strength of a supply network depends on multiple SCF schemes, potentially applicable to all [buyer-supplier] pairs of the network. These schemes are either financed with a company’s own cash, third-party funding providers and/or risk takers, or a mix of both. Or, they can net out since a buyer can also be a supplier somewhere within the network. This netting approach is something in the future –very similar to securities or payments netting. An example is GE Global with various subsidiaries which can net out at operating currency, or Licuos, a global business to business (B2B) payment platform where companies can compensate and pay their commercial debts.

Conclusion 

SCF programs of the future (at least 5 years from today) will evolve from current hub-and-spoke (i.e., single large “anchor” buyer – multiple small suppliers) schemes into individual and interconnected [buyer-supplier] SCF schemes, each one configured to fulfill the needs of each single pair across multiple supply networks[1].

SCF programs – depending on the flavor – are subject to the sovereign regulatory environment and compliance issues of the region where companies trade.  To cover an entire supply network of [buyer- supplier] pairs would be multi-geography in all practicality, and a single solution would not fly from a bank or from a non-bank SCF.  What has to happen is that B2B commerce networks (e.g., Basware, Ariba/SAP, Elemica, Covisint, GTNexus, GXS) will play a big role in making this process happen in a single geography, and where the [buyer- supplier] pair have accounts in multiple and different regions (e.g., US, UK, China, Eurozone, South America, Middle East). In team sports this is called a “zone” defense instead of a “point-to-point” defense.

This will take the form of an ecosystem of interconnected B2B networks that—by virtue of enabling the exchange of electronic commerce (e-commerce) transactions (e.g., purchase and sales orders, product catalogs, invoices) between [buyer-supplier] pairs—will provide the necessary visibility of how each single node in the network is behaving in terms of responsiveness, reliability, and flexibility of product and service deliveries, as well as in terms of punctuality and quality (e.g., partial payments, need to be solicited continuously) of payments.

These same B2B e-commerce networks will fill the gap of absence of data inputs from the physical supply chain transactions (e.g., sales orders, manufacturing schedules, inventory flows) into a SCF program that seriously impairs the value and effectiveness of current SCF platforms.  In other words, events that either happen or don’t happen in the PSC world may have a serious impact on the financial health of a trading pair.  If this glitch is long-lasting, then factors other than purely working capital become critical to the financial solvency of the chain.

Supply chain finance programs of the (near) future will evolve to provide to participants the following value propositions:

  • Access to the platform
  • Access to capital
  • Access to SMEs
  • Access to risk profiles
  • Access to debit/credit netting

 

What this means to SCF platform providers

A company (i.e., “anchor”) will want a SCF platform that reaches all tiers of the company’s network. Sources of funding will come from either the cash of the [buyer-supplier] pairs, from finance providers, risk takers, or from a mix of both. The SCF platform will have analytical tools to suggest the appropriate SCF scheme for each [buyer-supplier] pair or sub-network, based on parameters set by the anchor company and likely influenced by the lenders as well.

Some SCF programs will be buyer-initiated (e.g., traditional SCF buyer-centric products such as reverse factoring) and others will be supplier-initiated (e.g., dynamic discounting, traditional factoring).

 

What this means to fund providers (including banks)

Decisions to finance SCF schemes will depend on new risk models based on balancing the risk profiles of multiple [buyer-supplier] pairs. Financially healthy pairs may become funding providers themselves of the supply network they belong to. Decisions to finance SCF schemes will not be made purely on the economic analysis of risk, but will include innovative risk models that will factor in a company’s operational efficiency, its payments behavior, and the propensity to collaborate. B2B networks will support fund providers to manage individual know-your-customer (KYC) and know-your-supplier (KYS) criteria within supply network communities involving thousands of suppliers in dozens of markets. One crucial differentiator of tomorrow’s SCF programs is that the strongest overall corporation in the network will use their strength (i.e. credit rating) not only for their direct (i.e., Tier 1) pairing suppliers (as it is done today), but that this trickles down to the next levels of pairs, i.e., the suppliers of the suppliers. And, in the other direction as well i.e. the customers potentially.

All [buyer-supplier] pairs that select to participate in these kinds of SCF schemes would have to subscribe in some way to the B2B e-commerce network service, and only pay the fee for the service at the time that they need it.  If they never use the service, they never pay for the service.   Subscribing is free (or nominal) and entails setting up the accounts and establishing the connectivity, KYC/KYS/AML and overall verification.

 

  1. In reality SCF schemes will also be available for [supplier-buyer] pairs, i.e., the distributor/ receivables side of a business trade relationship. For simplicity this paper focused on the buyer-centric/ payables portion.

 

 

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Comments: (1)

Enrico Camerinelli
Enrico Camerinelli - Aite Group - Boston 16 December, 2014, 14:57Be the first to give this comment the thumbs up 0 likes

A good friend has commented this article.

The idea that SCF will need to become more broadly and deeply embedded in the Buyer’s PSC is one that seems right and inevitable. Currently the weakest link could still go without strengthening, because it is too small to justify the onboarding, but is that the right determinate from a risk perspective. Further, the anchor has limited or no visibility into the second tier buyer-supplier pair let alone the one beyond that, which is where their greatest vulnerability may lie.

Being able to assess the financial vulnerabilities of their network beyond first level suppliers should complement their PSC risk assessments across other dimensions. One could imagine anchors working with suppliers to give them the liquidity so they in turn can pass the early payments to their supplier, the anchors second tier suppliers, and so on. If the risk management is done well, it might lead to eliminating a weak partner, or finding a redundant supplier, or financially strengthening them – depending on the risk factors. So SCF become a risk mitigation tool where appropriate.

This could lead to the anchor’s SCF provider needing to onboard not just the supplier but parts of its supply chain too. I can only imagine what the legal agreements needed for pass-through funding to suppliers beneath the first tier suppliers.

One could envision integrated eInvoicing across the supplier network so that the invoices of the most distance participating supplier, would be uploaded into the supplier portal and passed up the chain, approved and purchased by the bank, anchor or other financer.

Enrico Camerinelli

Enrico Camerinelli

Supply Chain Blockchain Personal Coach

Aite Group

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This post is from a series of posts in the group:

Financial Supply Chain

In the world of international trade, the process of exchanging payments, information and documents between buyers, sellers, banks, and other involved parties is becoming increasingly important for financial institutions. This community aims at presenting views and innovative ideas related to this financial supply chain space.


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