Profitably serving small and medium-sized enterprises has been a challenge for traditional finance players. An ecosystem approach may be the key to tapping this vast market.
In my previous article, I explained how the recent share acquisition of NPEX fits into our plan to create an ecosystem for the financial markets of today and tomorrow. Our research suggests that SMEs stand to benefit the most from an ecosystem approach, and there are various signals that such an ecosystem will leverage the unique benefits of blockchain.
To list a few: The European Central Bank is preparing to issue a digital euro. In particular, the European Commission is seeking advice for a public sector blockchain. These are just two out of many signals of Europe’s ambition to leverage the unique benefits of blockchain. This makes our goal of a digital financial ecosystem utilizing ledger technology a conscious one.
...we should be prepared to issue a digital euro... - Christine Lagarde, President of the ECB
To more thoroughly understand why ecosystems are expected to play such a powerful role, it is important to acknowledge the trends that are currently shaping the SME market.
Signal #1: Traditional actors aren’t sufficiently serving SMEs.
Access to finance is essential, however, at all stages of development small businesses struggle more than large enterprises to get finance. While the SME sector boasted a size of €36B in 2019, they were facing a substantial funding gap of €20-35 billion, with banks being their major source of funding (90%).
It is especially troublesome that the traditional financiers, such as banks, are actively moving out of the space because the credit assessment of SMEs requires complex models and specialization, making it difficult to manage the costs to serve this market. This exodus reduces access to capital for those small and medium-sized businesses who rely on it most.
Signal #2: The process of investing in SMEs is outdated.
For institutional investors, getting SME exposure is rarely economically viable. They can either invest via other funds (which means paying twice for due diligence and asset management) or acquire holdings through OTC (over-the-counter) markets or primary issuances (which are often encumbered with high transaction fees and cumbersome portfolio management).
In blunt terms, the fund structure is outdated and increasingly avoided due to the friction these intermediaries cause. For SMEs to become attractive to institutional investors, the current system needs to be modernized.
Signal #3: Liquidity is scarce.
The capital markets are hyper liquid by design but assets considered ‘alternative investments’ are typically illiquid. In the case of secondary private markets for SMEs, they are largely composed of disconnected OTC desks, resulting in an illiquid market with little transferability.
With the absence of effective ecosystems tailored to the needs of SMEs trust is implemented through expensive intermediaries. Yet, this often fails to result in active trading due to disproportionate cost and risk. For now, the transition to hyper liquidity is unlikely to happen in the SME space. However, reducing the cost of trust, reducing spreads, and raising liquidity overall would already be a huge (and financially beneficial) improvement.
Signal #4: Alternative finance is set to grow, but become less diverse.
The investment platforms for alternative finance are maturing in the same way as traditional finance has in the past: with regulatory harmonization gradually increasing between countries, alongside harmonization between major platforms in the space.
This maturing is crucial to scalability. Without it, alternative finance platforms cannot follow in the footsteps of traditional large stock exchanges. However, the capital and knowledge required to operate on these platforms automatically excludes most of the SMEs. This is how growth in a maturing market can also lead to a potentially less diverse market.
Signal #5: There is momentum to create a single digital market in Europe.
When it comes to the rise of digital financial services, the writing is on the wall and Europe is accommodating. The ability for investments and savings to flow across the union is increasing, along with unlocking funds for SMEs and reducing listing requirements for public markets.
Additionally, regulatory frameworks are being developed to strengthen alternative finance, including token-based finance. Digitization and sustainability of assets & infrastructure are key pillars in this future vision. And to make no doubt about which way the EU sees the wind blowing: legacy incumbents are increasingly forced to reduce their intermediary and switching costs.
Trends Meet Challenges; Challenges Need Solutions.
While not exhaustive, these signals indicate a move towards (and a need for) a new European SME financial ecosystem. One allowing plentiful room for innovative solutions to serve a multi-billion dollar market. Using technology to increase liquidity, reduce the cost of trust, and harmonize the European Capital Market Union. All the while ensuring a level of entry that doesn’t alienate the intended SME audiences.
When summarizing these signals and observing the picture they paint, it becomes clear that there are a few contradictions and challenges arising from these trends. Challenges that seem impossible to combat with traditional solutions. In my subsequent article, I will lay out these challenges, the ways in which traditional players have failed to effectively meet them, and outline the solutions.
My aim is to show how decentralized technology, specifically purpose-built technology like Dusk Network, is arguably the only viable solution to the challenge of building the type of financial ecosystem the market is trending towards; one which effectively serves the multi-billion-dollar needs of hundreds of thousands of companies and investors in an innovative way.
Business director Dusk Network