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

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

We have exchanges for stock, bonds, currencies, coffee, pork bellies and oil. We have exchanges for made-up stuff, like options, futures, swaps and crypto. So why don’t we have an exchange for something as common as accounts receivable[1]?

It’s not because there isn’t enough demand. Companies are always looking for faster, cheaper ways to monetize receivables, which account for about 40% of their balance sheet assets, on average. The need to convert receivables to cash quickly is particularly acute among small and medium-sized entities (“SMEs”), which have significantly more trouble obtaining financing than larger, better-capitalized companies. 

It’s not because there isn’t enough volume. In 2023, business investment (which we will use as a rough approximation of the total volume of accounts receivable) represented about 15% of the total US gross domestic product, or approximately $4 trillion; by comparison, the total amount of US commercial paper outstanding at the end of that year was approximately $1.18 trillion.

And it’s not because there isn’t enough investor interest. There’s been a lot of talk over the years about the benefits of receivables as an asset class: they are short-term, self-liquidating, and uncorrelated with the stock market.

To be fair, trade receivables have not been overlooked by the financial industry. Many specialty products have been created to finance receivables (such as factoring and reverse factoring, forfaiting, receivables purchase and securitization programs, paying agency programs, supply chain finance programs,  single invoice discounting programs and so on) and trade receivables serve as the primary source of support for traditional asset-based and other secured lending. But these financial products fall short in three respects:

1. They rely on a slow, labor-intensive and expensive process. Due diligence and document negotiations can take weeks and cost thousands of dollars. And transaction closings are just the beginning – agreements typically contain compliance and reporting requirements that can take up significant staff time and restrictions that can interfere with a company’s growth and operations.
    
2. They exclude large pools of capital from trade financing. Because of their labor-intensive nature, these financial products require large underwriting and compliance monitoring staff, making trade finance inaccessible to institutional investors that do not have the necessary expertise and dedicated personnel, such as asset managers, insurance companies and pension funds.
    
3. They make it difficult for SMEs to obtain financing. The annual worldwide volume of rejected trade finance applications has been estimated to be between $1.4 and $1.6 trillion, most of them from SMEs.

To overcome these obstacles and provide SMEs with faster and cheaper financing options, a number of countries have encouraged and overseen the development of electronic marketplaces for trade receivables:

• Mexico. Nacional Financiera (“NAFINSA”), Mexico’s national development bank, launched Cadenas Productivas (Productive Chains), an electronic platform that facilitates payables financing, in 2001. The platform enables banks and other financial institutions to finance early payment by participating buyers of goods and services (generally large, creditworthy companies) of approved invoices from suppliers the buyers have invited to participate in the program. 
   
• Argentina. The Bank for Investment and Foreign Trade (“BICE”), Argentina’s national bank for foreign trade, launched e-Factoring, an electronic platform similar to Productive Chains, in 2018. Like Mexico’s platform, e-Factoring enables financial institutions to provide reverse factoring services to qualified buyers and to suppliers invited by the buyers to participate in the program.
   
• India. The Reserve Bank of India (“RBI”), India’s central bank, took a different approach. Instead of building an electronic platform to facilitate the financing of trade receivables, it has set the regulatory framework and established guidelines for the buildout and operation of such platforms (which it called Trade Receivables Discounting Systems or “TReDS”), it has licensed providers to build and operate the platforms and it monitors the platforms for compliance with its rules and guidelines. Like the reverse factoring programs established by NAFINSA and BICE, TReDS only allows the financing of invoices that have been approved by the buyer, but unlike them it requires participating financiers to bid on them. That is a big step towards establishing a true marketplace for receivables and is credited by buyers and suppliers that participate in the program with reducing financing rates by one to two percent.
   
• China. The People’s Bank of China (“PBOC”), China’s central bank, has developed an online platform named Zhongzheng Receivables Financing Service Platform (“RFSP”), which allows suppliers to post accounts receivable information and request financing from participating investors once that information has been confirmed by the buyer. Due diligence and negotiations for the purchase of posted receivables are conducted by the relevant supplier and interested investors offline. While the RFSP was not built to accommodate bidding or facilitate payments, it does serve three important functions:
  • it provides access to a wealth of valuable historical transaction data that allows investors to make informed decisions about buyers and suppliers before committing to purchase receivables;
  • it allows investors to access buyers’ ERP systems to confirm the authenticity of accounts receivable and their payment status; and
  • it allows investors to register receivables transfers with the central registry (which is also operated by PBOC), and to notify the relevant buyers of the transfer, through the platform.

All of these initiatives owe their success to government involvement. The Mexican, Argentinian and Chinese platforms were built and are operated by governmental institutions. TReDS platforms were built on blueprints created by the central bank and are operated by licensees of the central bank under the close supervision of the central bank. 

That, of course, is not the American way. The question is, can private enterprise build and operate a successful electronic auction marketplace for receivables without relying on the government for financial support or mandates?

So far, there has been only one attempt to build an electronic auction marketplace for receivables in the U.S. and it has failed spectacularly. On the heels of Katrina and the 2008 recession two entrepreneurs created The Receivables Exchange (“TRE”) in New Orleans. TRE allowed registered companies to post their accounts receivable with the exchange and registered investors to bid on them. It received investments from NASDAQ and Bain Capital and grew rapidly for a few years but it ultimately failed, primarily because (a) it was unable to provide sufficient receivables volume to satisfy investor demand, mainly due to its pricing structure and (b) it failed to protect investors against most of the risks identified below, resulting in a high volume of defaulted receivables.

To be clear, there are a number of successful fintechs in the U.S. that operate electronic platforms designed to digitize and streamline the financing of trade receivables, such as Prime Revenue, LiquidX and C2FO, but they stop short of operating auction marketplaces that are broadly available to suppliers. Instead they license their platforms to banks that wish to offer receivables financing programs to their clients and to corporate buyers that wish to offer early payment programs to selected vendors in their supply chain.

Trading receivables is not as easy as trading bonds, commercial paper or other debt instruments. To determine the true value of a receivable, an interested investor would have to analyze a number of risk factors that would not be of concern to a bond investor:

1. Unlike a bond, which is an instrument issued by the entity that is obligated to pay it, an invoice offered by a supplier to an interested investor is simply a representation by the supplier that the entity to whom the invoice is addressed is in fact obligated to pay it. The investor runs the risk that the invoice is fake or past due, that it has already been paid or rejected, that the goods or services covered by the invoice were not in fact delivered or rendered, or that the underlying transaction was not in fact a sale (“Fraud Risk”).
    
2. Unlike a bond, which represents an unconditional promise to pay in accordance with the terms of the instrument, a receivable represents a promise to pay for goods or services purchased by the account debtor if, and only if, those goods or services comply with the contract or purchase order issued by it. An interested investor would have to analyze the underlying transaction to evaluate the risk of disputes that might affect the value of the receivable (“Dispute Risk”). 
    
3. The interested investor would also have to analyze the recent history of the buyer/supplier relationship, to determine whether prior transactions may have given rise to deductions, credits, allowances or adjustments that could reduce the amount of the receivable (“Dilution Risk”).
    
4. Delayed payment on a bond usually triggers an increase in interest rate, entitles the bond holder to sue the bond issuer for payment and enforce any other remedies it may have under the instrument or by operation of law, and may trigger cross-defaults to the issuer’s other debt obligations. Delayed payment on an invoice does not typically result in higher pricing, trigger cross-defaults, or entitle the supplier to take immediate enforcement action against the account debtor. Consequently, payment delays are not uncommon, particularly in certain industries, such as retail and apparel (“Maturity Risk”).
    
5. Publicly traded bonds are issued in book-entry (that is, electronic) form and registered with the Depository Trust Company (the “DTC”), which maintains records of all trades. Bond investors are protected from adverse claims either by registering the bond transfer with the DTC (if they are DTC participants) or holding the bonds through a DTC participant.
   
   There is no central registry for accounts receivable. To protect its interest in a receivable against adverse claims, the interested investor would have to file a financing statement against the selling supplier, search the public records to confirm that no one has previously filed a financing statement covering the receivable and, if someone has, obtain a lien release or subordination from them (“Title Risk”).
    
6. Receivable purchase arrangements typically require the supplier that sells the receivable to repurchase it if it is not paid for any reason other than the account debtor’s financial inability to pay. The protection offered by the repurchase obligation is only as good as the credit of the supplier (“Supplier Credit Risk”). 

All of the government-run or government-sponsored electronic marketplaces we discussed earlier eliminate Fraud Risk, Dispute Risk, Dilution Risk and Supplier Credit Risk by limiting trading to receivables that have been approved for payment by the relevant account debtors and requiring investors to handle Title Risk and Maturity Risk off the platform. They try to limit investors’ due diligence to the credit risk of the account debtor (“Buyer Credit Risk”), essentially converting receivables into short-term debt instruments. The problem with that approach is that it limits the benefits offered by the marketplace to receivables that are due from credit-rated buyers (institutional investors are not likely to dedicate the resources necessary to underwrite unrated companies) to their trusted suppliers (buyers are not likely to provide early approval of invoices from small or infrequent suppliers, the so-called long-tail of suppliers). It does not provide sufficient liquidity to SMEs, where the greatest need is today.

TRE tried to satisfy that need but failed. Lessons from TRE’s failure and the success of electronic marketplaces in other countries, and access to technologies that were not available ten years ago, may help us increase the speed and lower the cost of monetizing trade receivables. We’ll discuss possible solutions in the second part of this article.

Contact

If you would like to share thoughts about this topic, please contact Michael Clain and stay tuned for part two.

Disclaimers

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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