## Wednesday, October 10, 2018

### Invoice financing in India: TReDS and way forward

by Sudipto Banerjee and Vishal Trehan.

### Introduction

Medium, small and micro enterprises (MSMEs) operate on tight margins and need immediate settlement of invoices to avoid shortage of working capital. However, due to the poor bargaining capacity of MSMEs, their working capital often remains blocked in receivables as they work on an unfavourable credit cycle for goods and services supplied to corporate buyers. This problem is exacerbated due to the existence of a huge funding gap for MSMEs. In order to bridge the gap between invoice date and its due date, invoice discounting emerged as a financing solution for entities which are unable to access funding options such as short term credit and working capital loans. Under invoice discounting, the seller, instead of waiting for the payment to be made by the buyer, gets a certain percentage of the invoice amount from the financier in advance. The seller pays a fee to the financier for this discounting service. Once the invoice amount is received by the seller from the buyer, it repays the amount to the financier.

However, adoption of invoice discounting as a financing mechanism in India has not been as expected. This may be due to several reasons. First, the bargaining capacity is skewed in favour of corporate buyers who express reservations while accepting assignments of receivables made in favour of financiers. Second, it is difficult for financiers to establish the credit rating of MSMEs due to information asymmetry. This, coupled with the absence of pledgable collaterals increases the credit exposure of a financier. Third, the discounting landscape is still dominated by banks and there are very few specialised discounting entities. Finally, there is a lack of awareness among MSMEs about discounting services, especially in non-urban locations. For example, even though many MSMEs are exporters, they lack information about export factoring.

In 2014, the RBI observed that there is a need for institutional setup to boost discounting in India and for this purpose conceptualised an electronic exchange for invoice discounting known as trade receivable electronic discounting system or TReDS. This post looks at the TReDS platform critically in order to assess whether this fintech solution has been able to address specific issues related to invoice discounting in India. Further, we explore the developments around invoice discounting in the context of new technologies and examine whether their adoption holds any merit. It must be noted that the invoice discounting problem space is quite broad and TReDS, a technology based solution, must be seen as a solution for specific problems in the invoice discounting space in India.

Specifically, TReDS seeks to address the problem of information asymmetry and the consequent high rates offered by financiers. Also, it is envisaged to reduce the time taken for sellers to receive payments. TReDS, however, was not conceptualised to address other persistent issues related to invoice financing. For example, although TReDS operates on the concept of 'no rescourse to seller', it is not a solution to the problems arising out of the bargaining power of buyers.

### A digital platform to boost invoice discounting

In 2009, SIDBI, in collaboration with NSE set up the first e-discounting platform for MSME receivables. This was based on the lines of the Mexican NAFIN model. However, this was a closed single financier model and therefore, had limited scale of operation. To overcome these limitations, in 2014, RBI released a concept paper to set up a full fledged electronic exchange for invoice discounting. This was followed by TReDS is essentially an online electronic institutional mechanism for facilitating the financing of trade receivables of MSMEs through multiple financiers. The platform enables discounting of invoices of MSME sellers against large corporates including government departments and PSUs, through an auction mechanism, to ensure prompt realization of trade receivables at competitive market rates.

• In the TReDS ecosystem, sellers, buyers and financiers can come on board by executing a one time agreement with the platform. This reduces the documentation cost for sellers who have to execute a separate agreement everytime there is a discounting transaction with a different financier.
• After executing the agreement, once the seller provides goods or services to the buyer and after acceptance by the buyer, the invoice is uploaded on the platform. This can be uploaded either by a buyer or a seller. Once the invoice is accepted by the buyer, it is converted into a factoring unit, a nomenclature used for invoices on the platform. Subsequently, an electronic auction involving bidding for the factoring unit takes place on the platform.
• Once a bid is accepted by the seller, the amount is credited to the account of the seller either on T+1 or T+2 basis depending on the cut-off time. This financier's account is auto-debited through the National Automated Clearing House (NACH) mandate. Instructions are sent electronically by the platform to the parties. On the due date of the invoice, the bank account of the buyer is auto debited and the amount is credited to the account of the financier.

As mentioned previously, the TReDS platform aims to address certain specific aspects of MSME financing. The current invoice financing system is riddled with an asymmetric flow of credit information. Financiers are not always aware of the financial condition of MSME suppliers due to limited publicly available information. Due to this, screening costs incurred by a financier go up for discounting an invoice of a MSME supplier. TReDS ensures easier access to invoice discounting at better rates for MSME suppliers due to the following reasons:

• Financing on the TReDS platform is done on the credit rating of the corporate buyers, hence, financiers need to define the credit limit of buyers and not sellers. This reduces the due diligence cost for financiers and in turn lowers the cost of discounting for sellers.
• TReDS operates on the model of without recourse to the seller which means that the financier can recover the invoice amount only from the buyer.
• Outside TReDS, MSME sellers negotiate with individual banks and NBFCs who may not offer them competitive rates for the reasons discussed above. The average interest rate on working capital loans is 12% as compared to 8-10% on TReDS. TReDS allows multiple financiers to participate and bid for invoices - this is expected to provide better rates to MSME sellers. As described previously, the entire transaction happens digitally on the platform in an efficient and transparent manner.

Establishing the genuineness of an invoice is another challenge that TReDS addresses. Once the seller provides goods or services to the buyer and they are accepted, the invoice is uploaded on the platform. The bidding by financiers start only after the uploaded invoice is accepted by the buyer. However, the issue of double discounting of invoices was not addressed in the original implementation of TReDS. This was addressed through a blockchain implementation recently.

### Key issues

The most critical problem in the invoice financing space in India, and consequently in the TReDS setup, is related to the obligation on buyers to repay on time. TReDS too follows the requirement of the Micro, Small And Meduim Enterprises Development Act, 2006 (MSMED Act, 2006) which imposes an obligation on buyers to settle the invoice amount within 45 days. Hence, in the TReDS ecosystem, the buyer has to pay the factored invoice amount to the financier within 45 days from the date of acceptance of bid by the seller. This requirement of adhering to time bound payment, which is otherwise mostly flouted outside TReDS, can cause reluctance on the part of buyeres to sign up. Presently, MSME suppliers facing competition from other players are inclined to accept higher volumes of trade credit on less favourable collection terms.

Interactions with practitioners in the MSME financing segment revealed that at times, sellers also avoid disclosing their MSME status so that the buyer is not deterred by the applicability of MSMED Act in case of delayed payments. Therefore, it is not surprising that buyers have even instructed their vendors not to sign up on the electronic platform to avoid the time bound commitment to pay.

#### Other related challenges with TReDS

While TReDS is a technology based solution to provide an institutional platform to boost MSME financing, its performance needs to be evaluated against the market's response. The market usually adopts a particular solution for two reasons - it can either be a business need or a legal obligation. Considering that the TReDS platform came about as a result of the practice of delayed payments by buyers, it is important that we examine the incentives for buyers to come on board.

1. Restriction on raising disputes: It must be noted that presently TReDS is an optional system. Assuming there is a corporate buyer X dealing with several vendors, under TReDS, X has to execute an agreement where it accepts the invoice of the seller (its vendors) and only after such acceptance, an invoice is made available for auction on the exchange. The TReDS Guidelines specifically require that X cannot dispute the goods or services received from the seller at a later stage. This is a major disincentive for buyers. Outside TReDS, X usually does not give acceptance to suppliers but merely records the event that it has received supplies - thereby keeping an option to dispute them in the event of any deficiency.
2. No recourse to seller: In the non-TReDS setup, if X defaults in paying the financier on the due date, the seller becomes a debtor vis-&agrave-vis the financier for recovery purpose. However, as discussed above, on the TReDS platform discounting is done without recourse to the seller. This means that if X fails to pay the invoice amount on the due date, the financier would have no recourse to the seller. Instead, the financier will have to pursue the buyer. While this mechanism may reduce the financier's risk, it may not attract buyers as they would now have to deal with an institutional lender who replaces the MSMEs.
3. Enhanced transparency: In case of default or any delay in payment by the buyer to the financier on TReDS, the delay/default gets duly recorded and can feed into the credit rating of the buyer. Outside TReDS, instances of such delay or default are not recorded, unless the MSME seller chooses to pursue action under MSMED Act at the cost of its future business relationship with the buyer. Therefore, the decision of a buyer to join TReDS would most likely depend on a cost-benefit analysis of aspects such as reduced flexibility in cash flow management, more transparency, etc.
4. Existing arrangements: Experts in the MSME financing area have pointed out during interactions that many big corporate houses have their own discounting business and their suppliers/vendors are required to avail discounting services from their group entities. For instance, Reliance Capital, Mahindra Finance, Tata Capital, Bajaj Finance, Aditya Birla Capital, etc are full fledged NBFCs and have dedicated invoice discounting divisions. Companies not having such an in-house discounting facility usually have pre-existing arrangements with banks or NBFCs. Moreover, these big houses usually consolidate their vendor payments into select groups not falling within the category of MSME who in turn buy products from MSMEs. This may be another reason for big houses to not come on board TReDS.
5. Cost of integration: Another barrier, especially from the buying corporates, is their reluctance to invest in the cost of integrating into a system like TReDS. Since the buyer bears the costs but the benefits accrue only to vendors, this
may prove to be a disincentive for the buyers.
6. Poor awareness: Lastly, the level of awareness about any new solution determines its success. Based on inputs from several stakeholders such as discounting entities and banks, the overall level of awareness about TReDS does not appear to be encouraging. Further, in smaller towns and semi urban setups, banks are the predominant option available to suppliers for their financing needs. These sellers do not easily switch banks with whom they share an established relationship, unless the buyer takes the initiative to migrate their dealings onto TReDS.

In order to ensure that the TReDS platform achieves its objectives, broader issues related to invoice financing in India as well as TReDS specific concerns need to be addressed. Extending the timeline of 45 days for settlement of invoice, which presently could be the prime reason for buyers not coming onto the TReDS platform, may be considered. To begin with, the platform should be enabled to give an extension to buyers on a case by case basis. While balancing the conflicting interests of suppliers, buyers and vendors is a challenging task, a middle path can be arrived at by ensuring constant interactions between the regulator and the stakeholders, especially the buyers. Further, it is essential that RBI invests resources to increase the overall level of awareness about TReDS. As discussed previously, the focus of such an awareness programme should be smaller towns and semi-urban setups.

Alternatively, a light-touch approach to regulating the behavior of large buyers could involve doing away with the 45 day payment period for TReDS so as to incentivise big buyers to get onto the TReDS platform. Instead, buyers may be asked to disclose their payment practices. Such reporting is mandatory in the UK where firms are required to disclose payment practices as per the Small Business, Enterprise and Employment Act, 2015. Removing the time-line of 45 days and mandating disclosure of payment practices would require amendment of the MSMED Act, 2006. The disclosures, which can be made public on TReDS, should also form a part of the notes to accounts of financial statements of such firms so that they can be cross verified by statutory auditors. This would require amendment to Schedule III of the Companies Act, 2013.

Further, there could be a mix of other regulatory tools like:

• A code similar to the Prompt Payment Code in UK can be created and large buyers may be encouraged to sign on to this code. Such a voluntary code can in turn set a maximum payment term.
• A system for blacklisting companies which violate payment terms repeatedly may also be created based on the payment practices data.
• The role of MSME associations is important in this context to ensure that big buyers do not abuse market power. As is generally the case, a single MSME will be reluctant to file a complaint against a buyer for fear of losing business as well as the costs involved. Instead, MSME associations can give MSMEs the requisite support and can help MSMEs collectively protest against a buyer to enforce a change in behaviour.

### Additional measures for boosting TReDS

RBI may take additional measures after taking stock of bottlenecks currently faced by the TReDS platform to ensure that the platform achieves its intended objectives. These include:

1. Presently, only banks and NBFCs are allowed to participate on TReDS. These entities lend as per the minimum credit lending rate. TReDS Guidelines do not allow any other entity to participate on this platform as a financier. Considering that the objective of TReDS is to boost MSME financing, RBI may consider lifting this restriction after doing a cost-benefit analysis. More participants such as urban cooperative banks, regional rural banks, high net worth individuals (HNIs), mutual funds, pension funds, etc. may be allowed to ensure the best rates for MSME suppliers. Such participation is allowed in other jurisdictions. For example, UK based MarketInvoice connects businesses with investors, including HNIs through its peer-to-peer invoice finance platform.
2. On the supplier side, the option of allowing non-MSME entities can also be explored. For example, a corporate buyer on board TReDS presently would have to maintain an additional payment mechanism for non-MSME segment. This leads to operational inefficiencies for the buyer. Allowing both segments on TReDS may ease their way of doing business.
3. Several MSMEs lack reliable information systems which can generate invoice suitable for discounting. To address this problem, in the Union Budget 2018-19, it was declared that TReDS would be linked to the Goods and Service Tax Network (GSTN). Further, as discussed previously in the post, financing in the TReDS environment is done on the credit worthiness of buyers on 'without recourse to seller' basis. This can potentially create disincentives for buyers to come onboard. If financiers are allowed to access the transactional data of MSME sellers available on GSTN, subject to certain safeguards like privacy of data, this can reduce their information asymmetry in terms of assessing the credit history of sellers. In other words, this measure can enable financiers to discount invoices based on the credit worthiness of sellers.

### Technology solutions to address challenges

Some technological solutions are also being explored to address specific challenges with TReDS. The three licensed TReDS exchanges recently got together with MonetaGo, a US based startup, to implement a blockchain based solution for a specific problem - the problem of double invoicing and associated fraud. This permissioned blockchain solution, with each of the exchanges acting as a node, went live recently. This solution has enabled the three exchanges to work together to eliminate instances of double discounting while protecting confidential information of their clients. The system generates a hash which is used by the exchanges for validating whether an invoice has already been discounted or not.

In other parts of the world too, blockchain is being considered to develop end-to-end solutions for invoice financing. Several early implementations already exist - examples being Populous in the UK and the Hive Project in Slovenia. More specifically, blockchain is being used to:

• Ascertain the legitimacy of an invoice
• Find out whether the invoice has already been discounted
• Make available immutable contract information securely to all stakeholders, thus ensuring transparency
• Create incentives for quicker payments
• Reduce costs related to the invoice financing process

### Need for a cautious approach

In view of the decision by the three exchanges to move the fraud-detection module of the TReDS platform onto a blockchain, going forward, authorities and other stakeholders must follow a cautious approach when considering a blockchain solution for other modules of the invoice discounting process of TReDS. A blockchain based solution is envisaged to reduce costs associated with invoice financing and also incentivise quicker payments by bringing in transparency of transactions through a distributed immutable ledger. However, certain considerations need to be made to come up with the most appropriate design approach in the Indian context:

1. Will a blockchain solution incentivise buyers? Considering the reluctance of buyers to come onboard TReDS due to
the lack of a dispute resolution mechanism, it is critical for any future blockchain implementation to tackle this issue. Buyers may want a transparent mechanism on the blockchain which allows them to flag the quality of goods/services sold to them even after accepting the invoice.
2. Is a blockchain the best design choice?
Various design choices, including centralised and distributed databases, must be considered and a cost benefit analysis must be done to choose the most efficient solution.
3. Will the solution help achieve RBI's objectives?
Depending on RBI's objectives and factors such as trust among stakeholders, a permissioned or permissionless blockchain solution might be more suitable in case a blockchain solution is found to be the right choice.
4. Issues of security, scalability and governance: Blockchain solutions with public facing data and handling a large number of transactions have been known to struggle with issues of throughput capacity and security. Further, complex questions such as who controls the blockchain, who are the nodes in case of a permissioned blockchain with multiple stakeholders and what is the consensus mechanism need to be answered.
5. How will the solution respond to a complex and dynamic environment?: A blockchain based 'smart contract' solution for invoice financing should be able to quickly adapt to complex and fast-changing real world environments - for example, changes in the regulatory framework.

It is important that a blockchain solution is adopted only if it is addressing persistent challenges in the Indian context. Characteristics/features of the technology itself pose another set of questions when considering the solutions. Thus, a cost-benefit analysis is of paramount importance before deciding the design of the solution.

### Conclusion

Several measures have been taken over the past few years to boost invoice financing in India. Although TReDS is a good initiative, we must carefully evaluate its effectivesness to address the lacunae in the system. To this end, we have examined the existing design and performance of TReDS after considering the market's response and expectations of stakeholders. Primarily, a lack of incetives for buyers is holding up widespread adoption of TReDS. This is due to structural issues in the invoice discounting space as well as challenges with the TReDS platform. This classification of challenges is necessary since merely fixing the technology platform may not address the underlying distortions. Thus, both types of challenges - structural ones such as the bargaining power of buyers and TReDS related challenges like the absence of a dispute resolution mechanism within TReDS - need to be addressed to ensure TReDS' success.

Further, a cautious approach needs to be adopted when considering novel technology solutions for such challenges. In sum, this multi-layered problem needs a concerted effort from the authorities to uncover issues at the ground level and come up with the appropriate policy and technical solutions.

### References

Department of Economic Affairs, Industry and Infrastructure, Economic Survey 2017-18 Volume 2, 127-128.

Mohmad, K. M. Factoring Services in India: A Study, 2015.

Reserve Bank of India, Concept Paper - Trade Receivables and Credit Exchange for Financing of Micro, Small and Medium Enterprises, 2014.

Dylan Yaga et al, Blockchain technology overview, 2018.

The authors are researchers at the National Institute of Public Finance and Policy. The authors would like to thank Radhika Pandey and Anirudh Burman for useful discussions.

1. Excellent article.

An expert committee on MSMEs has been formed by RBI. They have also sought suggestions from the public. Last date Mar 28, 2019.

Details available at - https://www.rbi.org.in/Scripts/BS_PressReleaseDisplay.aspx?prid=46579

2. Thanks for the in-depth study :) (way late to come across this, but since Factoring in India is a topic
very close to me as I had carried out a 3-months long study on Factoring Market in India in 2008)

As you have rightly noted - lack of incentives for buyers is holding up widespread adoption of TReDS - TReDS brings nothing to the table! TReDS is a fintech or a mechanized solution attempt to solve a problem that is highly personalized and relationship-based!

Each Factoring contract is negotiated and based or tweaked on various variables - Average margin
retention%, Interest rates on Factoring (including service charges), Cost of Funds of the financier. In a
structured, regulated format of TReDS - flexibility around variables doesn't seem possible;

Banks and NBFCs are only FIs allowed to participate on TReDS - however, as most banks have own
Factoring divisions, banks are generally reluctant to issue NOC or Disclaimer Certificate thereby making it difficult for MSMEs to avail Factoring services;

As separate entities, these banks' Factoring divisions called Factors - are already deeply entrenched in the Indian market. For five years till 2008, GTF, SBI Factors, CanBank Factors and HSBC were leaders with majority market shares% - leaving little scope on TReDS;

All aside, MSMEs' preference for competing products of Factoring - LCs acceptable to foreign customers and vendors, reasonable interest rates (import LCs available at less than 1% interest rates);

Bill discounting available at interest rates as low as LIBOR + 1.5% (in $terms) or 9% p.a. comfort levels and relations with existing bankers; Packing Credit - very convenient to use, advance money received for the whole amount of the transaction and low interest rates - LIBOR + 0.75% (in$ terms) - all make Factoring or Invoice Financing
as a product itself - less lucrative than peer products!

In summary - FinTech (TReDS) is not always a substitute to a financial product + bundled service!

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