Global financing needs for small and medium-sized businesses
The International Finance Corporation (IFC) estimates that 65 million businesses, or 40% of formal micro, small and medium-sized enterprises (SMEs) in developing countries have unmet financing needs of US$5.2 trillion per year. There are 200 to 245 million formal and informal businesses that do not have access to credit or overdrafts but need one – also known 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 raise liquidity at affordable fees from established financial institutions and are therefore forced to turn to informal lenders at higher lending rates or sell their bills 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 from the pool against their crypto collateral and repay with interest. For more information on DeFI and liquidity pools, see this article.
The big question is how to collateralize traditional bills to borrow from the pool. Unlike crypto assets, traditional invoices are created off-chain in an enterprise environment. Therefore, there needs to be a “digital twin” of the invoices on the blockchain, meaning that the invoices’ attributes must be on-chain, preferably in smart contracts. This enables the creation of a Non-Fungible Token (NFT) representing the invoices. These invoices then become on-chain assets ready to be collateralized in crypto pools.
“Lower” borrowing costs of DeFi
Because the process of borrowing is fully automated and liquidity pools do not involve large administrative costs, the total cost of borrowing can be much lower than borrowing from traditional factoring companies and financial institutions. But that is not the case and depends on the pools. Most liquidity pools claim to offer liquidity providers a higher rate of return than traditional lending, resulting in higher fees for borrowers. Also, pools can be very 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 offers stable lending rates – see “stable borrowing APY” in the image below. It also shows lending rates for different pools in AAVE. The cheapest borrowing rate is ~3%, which is well below the borrowing rates offered by traditional financial institutions for short-term liquidity/cash needs, especially in developing countries. For a comparison of SME lending rates by country, see the OECD website. It shows that SME lending rates can range from 1% (e.g. Austria) to over 40% (e.g. Brazil).
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