The U.S. Needs an Electronic Marketplace for Receivables - Part Two

Part Two of a two-part exploration into a proposed U.S. marketplace for
account receivables, by Michael J. Clain, Partner. 

Read Part One

Challenges to Building a Receivables Exchange. Building a receivables exchange will encounter all the challenges typical of a startup – creating a robust platform that is easy to use and responsive to the participants’ needs, building market awareness, dealing with corporate buyers’ concerns regarding data protection and confidentiality,  educating and onboarding suppliers, convincing buyers and sellers of the benefits of an online auction marketplace over alternative financing structures, navigating the regulatory landscape, and so on. There is nothing new about these challenges. Overcoming them requires a knowledgeable and disciplined founding team and financial support of investors, but it does not require treading new ground.

We mentioned in Part 1 of this article that the financial industry had not overlooked accounts receivable and had created a number of products for monetizing them – from factoring and single invoice discounting to supply chain finance programs, securitizations and asset-based lending. A receivables exchange that attracts only institutions that have trade financing expertise would simply be offering them a new way to handle their existing business and would likely fail because the financing structures in place today work well enough and institutions are not easily convinced that they need to do things differently. The real promise of an online marketplace is the opportunity to attract pools of capital from institutional investors that do not currently participate in trade finance because they lack the necessary expertise and dedicated personnel, such as asset managers, insurance companies and pension funds. Attracting those pools of capital would require introducing two features that are novel to trade finance and are made possible by the enormous advances in the development of artificial intelligence over the last few years: receivables scoring and dynamic portfolio construction.

Let’s take a moment to understand how the receivables exchange would operate. It would have 4 different types of participants, all of whom would have to register to participate in transactions on the platform: buyers, suppliers, investors and market makers (who would play a role similar to the role played by market makers on securities exchanges). A typical transaction would work like this:

• Step 1: Participating suppliers post invoices on the platform and indicate the maximum discount rate they are willing to accept and the maximum number of days they are willing to allow the invoices to remain posted for sale.
• Step 2: The exchange scores the posted invoices based on the factors listed below.
• Step 3: Participating investors post bids on the platform, indicating (a) the amount they want to invest, (b) the weighted average receivable score they are looking for and the lowest receivable score they are willing to accept, and (c) the average time to maturity they are looking for and the longest time to maturity they are willing to accept.
• Step 4: The platform allocates receivables to bidding investors using a combinatorial auction process to satisfy the investors’ and the suppliers’ minimum requirements while maximizing returns to investors and payouts to suppliers.
• Step 5: Receivables that are not sold to an investor within the time period indicated by the suppliers that posted them are purchased by a market maker on the last day of the posting periods indicated by the relevant suppliers, at the maximum discount rates posted by the suppliers if (a) they meet the minimum score and discount rate and maximum maturities specified by the market maker when it registered with the platform or (b) the market maker posted the receivables on the platform in the first place. Otherwise, unsold receivables will be returned to the suppliers who posted them.
• Step 6: Upon receipt of payments from investors and market makers, the platform pays the suppliers.
• Step 7: Upon receipt of payments from account debtors, the platform pays the investors.
• Step 8: If any invoices sold on the platform are not paid by the account debtors thereon for any reason other than financial inability to pay, the invoices are put back to the suppliers who posted them. If any supplier fails to repurchase such an invoice and pay the repurchase price within 5 business days, the invoice is sold to a market maker for collection.

Receivables Scoring. The financial markets routinely rate or score a broad range of obligations, from corporate bonds and securitized products to consumer debt, in order to simplify underwriting and enable investors to compare returns on dissimilar instruments. In the case of a receivable posted on the exchange, the score would indicate the likelihood that the receivable will be paid in full and on time and would be based on a number of factors, such as:

• The creditworthiness of the buyer and the supplier;
• Whether the receivables have been approved for payment by the buyer;
• Whether the receivables are covered by credit insurance;
• The trade history of the buyer/supplier pair (length of relationship, trade volumes, history of disputes, credits, charge-offs, payment history);
• The buyer’s trade history with other suppliers;
• The supplier’s trading history with other buyers;
• Whether the buyer is subject to currency controls or other regulatory restrictions; and
• Whether the receivables are posted by the supplier or by a financier (such as a factor, refactor or other institutional purchaser of accounts receivable).

Building predictive models with a high degree of accuracy should not be a technical challenge. FICO, Experian, TransUnion and Equifax have provided scoring services for consumer credit for many years, Dun & Bradstreet, Experian and Equifax have been doing the same for small and midsized businesses, and S&P has been rating corporate and municipal credit since 1860, all without the benefit of the AI models that have become commercially available over the last few years. The greater challenge will be collecting the data necessary to successfully build a predictive model. Some of that data is already available from the major credit bureaus, but they use that data to ascertain the creditworthiness of the payor, which is only one component in determining the likelihood that a receivable will be paid in full and on time. To assure accuracy, one would need to supplement  that data with information from the books and records of the relevant buyers and suppliers and the databases maintained by e-invoicing companies and the factoring industry. The companies that that have that data would likely be willing to share it for receivable scoring purposes for the same reason they have been willing to share it with the credit bureaus – because they would benefit from a service that simplifies underwriting and reduces the risk of loss.

Dynamic Portfolio Construction. Receivables generally range from thousands to hundreds of thousands of dollars, falling well below the investment thresholds of the large institutional investors needed to make the marketplace work. Some institutions have solved that problem by securitizing receivables, others by selling participations in their supply chain finance programs, but building those structures is costly and time-consuming. The various electronic marketplaces discussed in Part 1 of this article generally leave it to the participating investors, buyers and suppliers to aggregate pools of receivables that meet the investors’ volume requirements.

Scoring offers a different path. Quantifying the Fraud Risk, Dispute Risk, Dilution Risk, Maturity Risk, Title Risk, Supplier Credit Risk and Buyer Credit Risk[1] associated with a receivable in one number enables investors to make financial decisions without any information regarding the buyer, the supplier or the transaction that generated the receivable. Building a portfolio that meets the weighted average score requirements of an investor from the receivables available on the platform becomes a relatively simple mathematical exercise for a computer model. Of course, when we say that this is a “relatively simple” exercise, we do not mean to minimize the complexity of building a model that can rate a portfolio of assets based on the individual ratings of those assets, but only to note that this work has been done numerous times in securitizations and it would not be breaking new ground.

Industry Disruption. A successful receivables exchange would likely have a significant impact on the factoring industry. By offering lower discount rates and reduced compliance requirements it may syphon off the higher quality receivables, making factoring riskier for financiers and costlier for suppliers.

However, factors that are willing to adapt may profit from new business models. In traditional factoring, the factor buys receivables from suppliers essentially on credit, and makes advances against them at an agreed upon advance rate. It keeps those receivables in its portfolio and borrows against them to fund operating expenses and advances to its clients. Its profits come primarily from factoring commissions and interest on the advances. If a receivables exchange was available to it, the factor could offer the receivables for sale on the exchange instead of holding them in its portfolio. It would not need to borrow against the receivables to fund advances to the client, eliminating the need for leverage and the related risks to the institution and its principals. When listing receivables for sale on the exchange, the factor would agree to repurchase the receivables if they are not paid for any reason other than the account debtor’s financial inability to pay – in essence assuming all Fraud Risk, Dispute Risk, Dilution Risk, Title Risk and Supplier Credit Risk. Having a creditworthy factor rather than an SME assume those risks should reduce the discount rate on those receivables, increasing the spread between the price offered by the factor to its client and the price received by the factor from their sale on the exchange. That spread would be the factor’s commission, paid to it as compensation for providing access to the exchange and credit enhancement.

Factors could also act as market makers on the exchange, using their balance sheets to purchase attractively-priced receivables that are not sold to investors or earning a fee for collecting unpaid invoices.

The purpose of this article is to offer for consideration the broad outlines of a receivables exchange built in the US without benefit of government involvement. Issues involving regulatory compliance, lien perfection and priority, payment mechanics, onboarding requirements and other operational or legal aspects of building such an exchange are outside the scope of this discussion.

Contact

If you would like to share thoughts about this topic, please contact Michael Clain.

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In some jurisdictions, this material may be deemed as attorney advertising. Past results do not guarantee future outcomes. Possession of this material does not constitute an attorney/client relationship. This information is provided for your convenience and does not constitute legal advice. It is prepared for the general information of our clients and other interested persons and it may include links to websites other than the Windels Marx website. This information should not be acted upon in any particular situation without first consulting with an attorney and obtaining legal advice based on your specific facts and circumstances.

Michael J. Clain
Partner
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