The Collaborative Finance side of Cosmos
At Informal Systems, we are using Cosmos tools to build payments infrastructure with positive externalities for communities, to realize the vision of Collaborative Finance.
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This FAQ unpacks the following paragraph:
CoFi begins from a most fundamental kind of credit at the heart of the real economy: trade credit. It offers a unique way to clear this credit: Multilateral Trade Credit Set-off (MTCS). This kind of clearing results in liquidity savings. MTCS has many benefits over factoring and clearing houses. It also has a drawback - it can only account for debt in cycles (turns out more debt is in cycles than you think). But we can still clear the rest of the debt with intelligent liquidity injection, informed by the structure of the graph. A highly successful MTCS system has been operated by the Slovenian government for 30 years, and the time has come for a more universal solution: Collaborative Finance.
Trade Credit, MTCS, & Liquidity Savings
MTCS vs XXX
Liquidity Injection
Market
Risk and Legal
Trade credit means many things but the simplest definition is an arrangement to buy goods and/or services without making an immediate payment.
This agreement allows one business (customer) to purchase goods or services from another (supplier) without paying cash up-front, and instead pay at a later date. The obligation to pay at a later date is the trade credit. Typically, businesses who do trade credits allow customers to pay within 30, 60, or 90 days, as specified in the invoices they send to their customer. The best part about trade credit is the lack of interest charged on the delayed payment.
Trade credit-related finance globally is estimated at 5.2 Trillion USD. In the EU trade credit is the second-most common form of credit for Small/Mid-size Enterprises (SMEs).
MTCS stands for Multilateral Trade Credit Set-off. It is sometimes referred to as “obligation clearing.” It allows debts to be cleared without using money or financial intermediaries by finding closed cycles of trade credit.
MTCS is a process whereby multiple parties (i.e. companies) share their trade credit data (i.e. obligations / Accounts Payable) with a third-party (i.e. a platform, an instance of a smart-contract, etc) tasked to analyze the trade relations (i.e. trade graph) among the participant parties. By looking at the trade graph it is possible to find cycles of debts which can be netted out (i.e. canceled), thus reducing the overall indebtedness (unpaid trade credit) of the companies participating, saving them liquidity, and avoiding payments gridlocks in the economy.
It turns out that a significant percentage of trade-credit is in cycles and can be cleared this way.
MTCS is unique in that it allows for clearing without novation
Novation is when a new financial obligation replaces an old one. Transfering or securitizing debt are classic examples of novation. MTCS allows debt-reduction without novation, which means it does not change the existing set of creditor-debtor relations, and so does not introduce or involve any financial intermediaries. It does not involve the creation of any new financial liabilities on any balance sheet, only their coordinated reduction. It emerges only from the collaboaration of participants in existing credit relationships in the real economy. Hence, Collaborative Finance.
MTCS allows businesses to improve their cashflow and reduce the cost of payments. Payment costs are a major expense, and cashflow challenges are a major source of bankruptcy.
MTCS allows a business that is part of trade-credit cycles (many are without knowing it!), to effectively pay its Accounts Payable with its Accounts Receivable, thereby reducing the size of its balance sheet and its outstanding obligations without the use of money. We call this kind of reduction a liquidity savings. The net result for firms is cost savings and reduced risk.
Liquidity-saving is the outcome of a successful MTCS execution. It is the amount of debt that does not need to be paid because it was successfully set-off due to being part of a cycle.
Liquidty-saving can be measured as the difference between the original outstanding balance of all obligations submitted and the final outstanding balance once all cycles have been found and (partially) cleared.
The amount cleared depends on the density (i.e. average invoices per company) of a trade credit network and the distribution of amounts in individual trade credits. A significant number of cycles starts to emerge at a density of 1.5 invoices per company. In a normal B2B environment in developed countries, savings around 5% of total debt can be expected. At 3 invoices per company we can expect savings of at least 15% of total debt. Beyond 4 invoices per customer the savings approach 25% of total debt. In communities where the amounts on the invoices are more similar and the economies more closed, like rural communities, villages in developing countries, or some crypto exchanges, the savings can go up to 50% or even to 80% of total debt. You can estimate the savings for a typical B2B community with our liquidity saving estimator here.
MTCS is very different from Factoring.
Factoring transforms a bilateral obligation into a tradable multilateral product, in essence a security. So it implies novation, i.e. when a new party enters the relationship. The debtor remains the same, but the original creditor is replaced by the factor who can then trade the factored invoice in the market.
Firms that decide to use factoring as a means to manage their liquidity have to deal with the relationship issues with their customers. Not all customers appreciate the securitization of their debts.
MTCS, by contrast, does not disturb the existing bilateral relationships. The multilateral nature of the service manifests itself only through the cyclic structure that emerges from the network of all bilateral obligations. All participants agree to this before submitting their obligations to the MTCS service. There is no novation (new obligation replacing an old one), no new bilateral relationships. There is only a decrease in the amounts outstanding on the existing obligations. This simplifies relationship management e.g. in supply chains.
The drawback of MTCS relative to factoring is that MTCS cannot always discharge the obligations in full, but only to the extent that they are in cycles. There are remaining outstanding amounts to deal with. In the case of factoring the creditor gets the discounted amount immediately and the problem of outstanding amounts is transferred to the factor. (“Problem” means managing the risk of getting paid by the debtor: the creditor sells the obligation to factor; the factor makes a risk assessment and offers a discounted price; now the factor has to manage the debt repayment cost within the discount, otherwise they are at a loss.)
It is possible to mitigate the problem of the partial discharge of obligations in MTCS by introducing liquidity injection.
MTCS is very different from a clearing house.
Clearing houses transform a network of bilateral obligations into multilateral obligations using the clearing house as a central counterparty. So it implies novation, i.e. when a new party enters the relationship. Instead of owing eachother, debtors are creditors now owe, or are owed by, the clearing house.
Firms that decide to use clearing houses as a means to manage their liquidity have to establish relationships with the clearing house, and be willing to pool their risk with other members of the clearing house. The clearing house must also be willing to take on the risk from the many firms. The clearing house will make rules as to who can participate and not. Often members will have to provide some form of collateral, or qualify based on certain restrictive criteria.
MTCS, by contrast, does not disturb the existing bilateral relationships. The multilateral nature of the service manifests itself only through the cyclic structure that emerges from the network of all bilateral obligations. All participants agree to this before submitting their obligations to the MTCS service. There is no novation (new obligation replacing an old one), no new bilateral relationships, no pooling of risk. There is only a decrease in the amounts outstanding on the existing obligations. This simplifies relationship management e.g. in supply chains.
The drawback of MTCS relative to clearing houses is that MTCS cannot always discharge the obligations in full, but only to the extent that they are in cycles. There are remaining outstanding amounts to deal with. In the case of a clearing house, the clearing house can act as a central counterparty (CCP) to ensure full discharge of all obligations provided it has enough available liquidity. The clearing house takes on management of risk of default of its members.
Clearinghouses often use more rudimentary algorithms or simple netting [*] in case of a single CCP. That said, MTCS can also be used as an optimization method for clearinghouses. The algorithm we use provides the maximum possible liquidity savings.
[*] Netting implies maximizing liquidity-saving without constraints, which can in some cases lead to reversing the direction of one or more obligations (or also to the creation of completely new obligations). Reversing the direction of an obligation implies a new contractual relationship, which is the definition of novation. Obligation-clearing, or more precisely MTCS, finds the maximum liquidity savings in a given network without requiring novation. That is, the algorithm can reduce some obligations to zero but cannot cause them to go negative.
MTCS cannot always discharge the obligations in full, but only to the extent that they are in cycles. What is not included in the cycles cannot be cleared directly. Typically, it would be cleared by participants paying their debts of out pocket, or by seeking a loan (or, for instance, by factoring), to then pay their debts. But another way to clear the remaining trade-credit is by way of targeted liquidity injection.
The remaining obligations that cannot be discharged by MTCS require some form of liquidity injection to be discharged. There are two kinds of liquidity injection: internal and external.
Internal liquidity injection involves the use of the participants’ own funds, which can be in different forms (fiat, crypto, mutual credit, etc). The amount cleared for each participant must of course be at least equal to the amount of liquidity that participant made available towards the clearing of their debts, but statistically it is usually significantly more. The maximum aggregate amount that we have observed in our empirical tests is a factor of 5 greater than the total liquidity made available by the network participants.
External liquidity injection in an obligation graph is akin to the provision of new liquidity performed by a lender like a commercial bank or a private fund. In our specific use case, the analysis of the obligations/payment graph leads to the discovery of financing gaps. These gaps, which are often small, if filled via efficient liquidity provision can produce even greater savings while increasing the overall stability of the underlying economic system.
The key effect of the liquidity injection for the community is a huge increase in obligations discharged in full. Without liquidity injection, less than 1% of community members discharge their obligations in full. With liquidity injection, this share can go above 50% even with just 1% of total debt injected as new liquidity.
For the liquidity provider, an obligation network with MTCS serves as a risk reduction mechanism and a non-performing loan recovery tool. Benefits are mutual and can only be achieved in collaboration between lenders and community members. So they can be shared as a lower cost of lending to community members and higher profitability due to decreased risk for the lenders.
For the construction of the payment graph (obligation network), the participants – i.e. the trading partners – need to be identified uniquely. There are several solutions to this. They can use public identifiers like tax identification numbers. Alternatively, they can use wallet addresses. Higher degrees of privacy can be achieved using encryption. The levels of privacy and mode of identification of trading partners must be agreed upon at the community level.
A combination of factors:
Leveraging Cosmos blockchain technology we could actually make it cost-effective to provide access to accounting, invoicing, and payment services in an interoperable and composable way, which is something current Web 2.0 services or Fintech cannot offer.
Aside from that, one could also argue that it is happening but not in a coordinated (composable, interoperable and still sovereign) manner as various initiatives both at national level or at internet scale show.
Traditionally, the only way to benefit from Multilateral Netting / Compression is by relying on a centralized party to gather data, compute over the data and provide results to the data contributors.
Blockchain offers the opportunity to strike the right balance between the need for a credibly neutral, globally available, and socially adoptable trade / financial infrastructure and the desires of all parties who come together to build it and/or build value-added services on top of it.
There are many legal definitions of set-off. MTCS utilises what is called a contractual set-off. Contractual set-off arises where a right of set-off has been created by contractual agreement. It is used when contracting parties want to extend or limit set-off rights which are available under general law. The right to contractually agree to set-off is only limited by insolvency. Most legal systems don’t allow the insolvent companies to execute set-off or they have special rules for insolvency set-off. When joining the MTCS community, companies have to agree and sign a cover contract, that all terms and conditions for debts reported are amended with the following:
Such contractual setup makes multilateral set-off legaly enforcable in the court of law. The base is a standard international obligation law. The international version that is implemented in all national versions can be found in UNIDROIT Principles of International Commercial Contracts Chapter 8.
It takes two parties to create a fraudulent obligation in an obligation network. Just this simple fact reduces the risk of fraud and fraudulent behavior. In addition to that, the negative effects of fraudulent obligations are limited to the parties directly involved. The risk is limited since the results can be easily verified for correctness both on the system and individual levels. The individual participant can simply check that the sum of set-off on account receivables matches exactly the sum of set-off on accounts payables. Since this is true for all participants, a fraudster can not harm anyone.