Deep-tier supply chain finance (DTSCF) allows companies further down the supply chain to benefit from a tier-one supplier’s financing at more favourable rates. It holds the potential to reshape trade by fostering resilience, transparency and ESG-aligned relationships. However, DTSCF lacks the necessary legal, technological and operational frameworks to scale effectively and is often misunderstood. A whitepaper released by Baft, Simmons & Simmons and the Asian Development Bank aims to clarify DTSCF and encourage banks to explore its potential. Isaac Hanson reports.
Interviewees:
- Steven Beck, director of trade and supply chain finance division, Asian Development Bank (ADB)
- Carmen Maria Ramirez Ortiz, relationship manager, trade and supply chain division, ADB, co-author of DTSCF whitepaper
- Tod Burwell, president and CEO, Baft (Bankers Association for Finance and Trade)
GTR: What led Baft and the ADB to collaborate on this paper, and why now?
Burwell: It goes back to the growing trade finance gap. DTSCF appeared to be a new type of structure that could potentially get at the hardest-to-reach parts of that gap. In 2016, Baft was part of a consortium of industry bodies that made up the Global Supply Chain Finance Forum, and we put together a paper to outline definitions for supply chain finance techniques. The spirit behind this paper we did with the ADB was the same. We think DTSCF needs to be understood in definitional terms, because if you just throw the label onto a variety of structures, you lose the integrity of the asset quality.
GTR: What are the benefits to lenders for exploring DTSCF?
Burwell: The answer to me would be that you’re expanding your ecosystem. In many cases, as a lender, you might not be willing to lend directly to a particular institution, and you may not even know enough about that institution to evaluate if you’re willing to lend. If they are part of the ecosystem that comes attached to your client’s supply chain, though, that potentially gives you an avenue to build a relationship.
The second thing is, as opposed to doing direct SME financing, DTSCF provides a better level of risk control for a financing agent. It gives them a greater comfort level. The transparency will also ultimately help with fraud, sustainability and other types of reporting and controls that the financing agent is concerned about.
Beck: If lenders can provide DTSCF for their large corporate anchor clients, then they’ll be helping them secure their supply chain, make it more efficient and provide it with all sorts of metrics to mitigate its risk and it more resilient. And, of course, it’ll help large clients extend payment terms to suppliers.
It also opens up the possibility for banks to bring in a whole bunch of new clients from a new market segment: the medium and smaller-sized businesses in their large corporates’ supply chains.
GTR: How does DTSCF work?
Burwell: It allows you to loop the normal payables finance process, so the tier-one supplier can present their invoice and discount it, but they can also pass down part of the proceeds to the tier-two supplier. They can then, in turn, pass down part of that to the tier-three supplier, and so on. If you look at the history of traditional supply chain finance structures, the tier-one suppliers were the ones that primarily benefited. In a deep-tier structure, this allows you to go much further down the hard-to-reach parts of the chain.
We have a relatively narrow definition of DTSCF: first, it has to be related to trade. It’s also based on an irrevocable payment obligation of the anchor buyer, and we’re only dealing with post-shipment. We did that intentionally. I spoke with some people in the market who said ‘we’ve been doing this for years; it’s just microfinance’. But microfinance has a completely different credit profile to DTSCF the way that we’ve defined it, so if you equate the two, you missed the point.
Ortez: It’s based on that irrevocable payment undertaking from the first layer and it’s then chopped into pieces and transferred down the chain. The price of the financing is linked to the credit risk of the buyer, and it has to ensure that whatever is financed is part of the supply chain of the anchor, because that reassurance will engage the anchor better. Especially in the retail or automotive sectors, for instance, the supplier will be manufacturing for multiple buyers so otherwise anchor buyers might be helping their competitors access better financing indirectly.
GTR: In the whitepaper, you say that, as far as you’re aware, no DTSCF solutions have yet been deployed for cross-border payments. Why is that the case?
Burwell: There are legal, operational and technological constraints. The legal constraints are the biggest issue for now. The tier-one supplier assigns the value of the discounted invoice down to another tier, so you must have a legal framework in a particular country that allows for that assignment to be done in the way that we’ve described it.
In a domestic context, there are certain countries that support that, but where it gets more difficult is if different tiers of suppliers are in different countries. Part of the challenge is getting legal frameworks in each of those countries to allow for that process to be done. We think that there’s still some room for this to develop.
Then, operationally, there is some currency risk, because if you go cross-border, you need to address this in different currencies, and there are some additional risk management and control issues that apply.
Third is the technology. There are probably half a dozen to a dozen technology solution providers that can support this, but their solutions have not been widely deployed, and the firms that are doing this are relatively small.
We think the technology piece can grow organically, but the hardest piece for us to solve will be the legal piece.
GTR: What legal solutions does the paper offer, and how do they differ from existing SCF structures?
Ortiz: What we try to define in the document is how to allow the finance to cascade down from the first tier of supplier to deeper levels. When speaking to the industry, we realised that most of the solutions that were being described as DTSCF were individual relationships between tiers. The anchor buyer buys from tier one, then becomes the buyer to the second tier; the second tier becomes the buyer to the third tier, and so on. That means the risk also deteriorates as you go deeper down, and at a point, it stops because the price-to-risk ratio no longer makes sense.
There are three key legal solutions described in the paper that we hope the market can develop. One is based on contractual rights: the assignment of receivables and passing the benefit of the irrevocable payment undertaking to all suppliers down the chain. That’s the private contract model.
The second one is based on a negotiable instrument. This is where the UN’s Model Law on Electronic Transferable Records (MLETR) kicks in, because DTSCF relies on a digital ecosystem. Unless the negotiable instruments become digital and enforceable, the model is very difficult to scale, because it will only be recognised in those countries where MLETR has been adopted.
Alternatively, the third model is based on the tokenisation of the payment undertaking to allow for transfer. This is more long-term, because a regulatory framework is required in order for tokens to be enforceable.
GTR: In the whitepaper you reference leveraging technology. What technology do you see playing a role in delivering DTSCF, and do you see blockchain forming part of that?
Burwell: Some of the technology solutions that are available use the blockchain approach, some do not, so it’s not blockchain-dependent, but there could be a solution that’s blockchain-based. There are probably eight to 10 technology firms that we’ve heard banks have worked with specifically to facilitate deep tier.
One example involved a large global bank partnering with a technology provider that specialised in deep-tier capabilities. The provider integrated these capabilities with the bank’s existing technology solutions to create more holistic combination structures, where they had deep tier on a post-shipment basis that may link to another structure on a pre-shipment basis. We think this deep-tier structure is somewhat modular in that it can be attached to other types of financing.
GTR: Could DTSCF help trade finance providers with their ESG commitments? Is it possible more banks would offer favourable financing rates based on ESG-related targets as floated in the paper?
Beck: If we can put these DTSCF systems in place, there is an opportunity for data to flow up and down the chain, enabling a lot more transparency when it comes to environmental standards. It becomes easier, more efficient and more transparent, so it becomes cheaper. That’s not to underestimate the enormity of the challenge, but DTSCF would lend itself to being able to tackle those challenges a lot more effectively.
Burwell: This is my personal opinion, and I know that there are several views from organisations in the market. I think DTSCF can help with transparency and reporting, but the big challenge with ESG is twofold.
First is validation at the source of processes – DTSCF does nothing to address whether the process of manufacturing or growing certain raw materials is done sustainably. It’s only as good as the information validated at the source. But the structure itself can allow for proper reporting and transparency that goes up and down the chain, which is helpful.
The second challenge that this doesn’t necessarily solve is that ESG is becoming much more regionalised in the taxonomy that’s being applied. The standards and taxonomy that may be outlined in, say, Europe could be quite different in another market. This is a bigger issue than just DTSCF.
