How Blockchain Bonds can Transform SME Financing

By Benedikt Schuppli, CEO and Co-Founder of Obligate

We’ve long heard that SMEs are the engine room of the economy. Accounting for 90 percent of businesses and more than 50 percent of employment worldwide, this is not an understatement. But what happens when this engine can no longer afford to run?

It is an unfortunate reality for many SMEs. After a tumultuous 2022 which saw soaring energy costs, workforce shortages, political instability, inflation, and supply chain disruptions, SMEs are now also faced with a financing crunch. 60 percent of SMEs are not confident they can secure finance from banks while 28 percent of companies reported restrictive behavior by banks in loan negotiations.

This is not a new phenomenon, in fact, much of this dates back to the 2008 global financial crisis that saw major lenders restrict access to credit in an effort to de-risk their balance sheets. This has led to far-reaching consequences for modern-day SMEs, particularly those in emerging markets where a discriminatory perception of credit risk has exacerbated an already difficult situation.

The State of SME Funding

In emerging markets, where SMEs create 7 out of 10 jobs, the funding gap is widening. The International Finance Corporation (IFC) estimates that 40% of formal micro, small and medium enterprises (MSMEs) in developing countries have an unmet financing need of $5.2 trillion every year, which is equivalent to 1.4 times the current level of global MSME lending. East Asia and the Pacific account for the largest share (46%) of the total global finance gap, followed by Latin America and the Caribbean (23%) and Europe and Central Asia (15%).

This alarming financial drought has caught the attention of international organizations and policymakers. The OECD has recently updated its high-level principles on SME financing to emphasize the need to strengthen SME access to traditional bank financing, while also promoting non-bank finance. While within the United Nations Sustainable Development Goal (9.3) it states the ambition to “increase the access of small-scale industrial and other enterprises, in particular in developing countries, to financial services, including affordable credit by 2030.”

In Lower Income Developing Countries, SMEs contribute significantly to broadening employment opportunities, social inclusion, and poverty reduction. Improving and providing access to financing is not only critical in promoting entrepreneurship and innovation but in advancing the state of the economy and the livelihoods of citizens.

Closing the Financing Gap with SME Bonds

With a lack of bank-backed funding channels, SMEs are already looking to source new financing channels, from P2P lenders and specialized asset finance companies to invoice or credit card financing. As the bond market has long been the preserve of institutional investors and high-net-worth individuals, few SMEs have previously considered it a viable option due to the lengthy processes and high costs associated with it, making issuances below a certain size impractical.

With the advent of blockchain technology powered by smart contracts, we are experiencing a bond renaissance of sorts. By introducing a regulated, traditional instrument on-chain, blockchain replaces countless intermediaries in the old world with transparent, decentralized, and secure technology. For example, integrated smart contracts can assume the role of the issuer and paying agent in the settlement layer of a bond issuance while the blockchain serves as both an asset register and trading venue, challenging existing financial market infrastructure. As opposed to the traditional world, this open infrastructure architecture leaves ample custody choices for investors, ranging from self-custody via blockchain-based wallets over to intermediated custody provided by regulated financial institutions.

As a result of moving bonds from a traditional to a blockchain-based infrastructure, transaction costs associated with bond issuances can be lowered – driven by automation and decentralization across the entire transaction lifecycle – all of which while adhering to regulatory requirements. With the thresholds to issue bonds lowered, SMEs in developed and emerging markets now have access to funding by obtaining liquidity directly from a pool of digital asset investors which can hold bonds in the form of a token in their wallet. Using tokenization, they can even provide collateral such as receivables or property to secure the on-chain bond issuance. This market is referred to by insiders as RWA, the acronym for real-world assets.

The Rise of Regulated DeFi

But are SMEs really ready to interact with these innovative financing tools?

Blockchain-based finance and more specifically ‘DeFi’ has ushered in a new era of financial inclusivity. For early adopters, DeFi has already changed the way they consume financial services, making lending or borrowing via automated lending pools more accessible than ever before. This has the potential to create more open, free, and fair financial markets that are accessible to all. But at the same time, DeFi has struggled with regulatory clarity which undermines investor confidence and overall market integrity. While the technology behind DeFi, as lined out above, is compelling, what’s missing is legal certainty. That’s a challenge that the most proven and standardized debt instrument, with an almost 400-year history, can solve.

Combining the efficiencies and accessibility of DeFi with the regulatory clarity and trust of TradFi, on-chain bonds have the potential to transform how companies raise funds and administer liquidity. As more investors engage with digital assets and large corporates use public blockchains, on-chain bonds may become the blockchain use case finally creating value for the real economy, resulting in far-reaching implications for local economies and a more inclusive financial system.

The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.