Nov 26, 2018 published knowledge @ Wharton. University of Pennsylvania
An interdisciplinary team from MIT, Wharton and Boston College has created a new blockchain-based system that has the potential to disrupt the global supply chain. Called ‘b_verify,’ the system is designed to help small and medium-size enterprises — especially those in developing nations — get financing from lenders at potentially better terms while mitigating warehouse deposit fraud. The system brings greater transparency to a key part of the supply chain, which can have a big impact on global trade financing. B_verify introduces a series of blockchain technology innovations tailored to facilitate supply chain finance and operations management.
“The potential benefits are vast and global in scale,” said Gerry Tsoukalas, Wharton professor of operations, information and decisions, who was part of the team. Small and medium-size enterprises, he said, represent the backbone of many economies in the world, and they account for more than half of the jobs as well as a third of global GDP. But despite their scope and impact, these companies have a harder time getting financing than larger established firms. He said the World Bank estimates their global financing shortfall to be $2.6 trillion.
Small and medium-sized firms also find it difficult to get financing on terms as favorable as the ones big companies get because they usually lack the latter’s track record and reputation. Banks typically would charge higher interest rates or put more restrictions on loans to smaller enterprises because they are less certain of repayment. Add to the mix the propensity for fraud, especially in the developing world, and smaller firms get the worse end of the proverbial stick. “Obtaining loans at reasonable rates can be very challenging for small firms,” Tsoukalas said.
Enter b_verify. “The use of blockchain platforms [like b_verify] has the potential to redefine global supply chain operations by democratizing operational transparency,” said Nikolaos Trichakis, MIT professor of operations management, who was part of the team. The team, which includes computer scientists Henry Aspegren (MIT and Tsinghua University) and Mark Weber (IBM and MIT), worked with the Mexican government and Ukrainian entrepreneurs, and even conducted field visits, on the road to inventing a new system that incorporated elements of both public and private blockchains. Importantly, b_verify can be accessed inexpensively through smartphones and tablets without the need of advanced technologies. The creators also are giving away the open-source software for free.
What Is b_verify?
When a bank or other lender is making a decision whether or not to give a company a loan, it will assess the firm’s creditworthiness, or ability to repay. Generally, the stronger the business, the better the ability to pay back the loan and so it will get more favorable loan terms. With small and medium-size firms, it can be tougher to assess the true state of their business because not as much information is readily available. As such, loans to them are seen as riskier; lenders compensate for the risk by charging higher interest rates or giving stricter loan terms.
“The potential benefits are vast and global in scale.” –Gerry Tsoukalas
What if the lender can accurately check how well a business is really doing? Smaller firms will benefit more than large firms because they can qualify for better financing terms than they would otherwise get, since there will be reduced risk to the lender. The team developed b_verify to accomplish just that, as detailed in the research paper, “Blockchain and the Value of Operational Transparency for Supply Chain Finance.” The authors are Tsoukalas, Jiri Chod of Boston College, Trichakis, Aspegren and Weber.
Through a blockchain-powered app, b_verify lets lenders check a company’s inventory transactions easily because they don’t have to send people to monitor operations onsite or rely on records that can be easily falsified. In turn, this has two important implications: First, firm inventory can be more credibly put to use as collateral for the loan. Second, as shown in the paper, even absent any collateral, the transactions record itself opens a window of transparency into the firm’s operations.
The team believes that by observing inventory transactions, lenders will get a more accurate picture of the health of a company’s business than they could otherwise by simply observing loan requests. (Some banks look at the terms of the loan to make inferences about the health of a company. For instance, the bigger the loan amount, the better the business is growing. But a firm can more easily inflate the size of the loan requested to give this impression than order more inventory.)
How It Works
B_verify uses blockchain technology because it is a cryptographically secure, or virtually unhackable, database. (Prior hacks of the Bitcoin blockchain were done at the fringes, such as at the cryptocurrency exchange level, not the blockchain database itself.) As a distributed ledger where all participants have a copy of the records, the blockchain makes falsifying transactions nearly impossible. Also, the blockchain is a system in which members do not have to trust each other for it to work.
The team considered both public and private blockchains. The Bitcoin blockchain is an example of a public one, which anyone can join and participants are identified only by a cryptographic key. Private blockchains are those in which members are invited to join and it is typically run by one entity, such as a company. But they are not fully decentralized, have difficulties scaling to achieve adequate security guarantees and carry relatively large infrastructure costs. Public blockchains don’t have those issues, but they often do lack some things found in private blockchains, such as verifiable identification of parties, data privacy and transaction costs controlled in-network, according to their paper.
“The use of blockchain platforms [like b_verify] has the potential to redefine global supply chain operations by democratizing operational transparency.” –Nikolaos Trichakis
“To use a private blockchain means losing the properties that made blockchain famous in the first place,” Weber explained. “Bitcoin pioneered a specific type of distributed ledger technology in which a large number of nodes build consensus on successive blocks of information. Each block points to the previous one, thereby making the sequence interdependent. The larger the network of nodes and the more independent nodes are from one another, the more secure the ledger. This security comes with high energy and transaction costs.”
“Bitcoin’s network has become so secure, we refer to its ledger as (virtually) immutable,” Weber continued. “But this property is lost if you use a smaller, closed network controlled by an intermediary or group, which is what so-called private blockchains do,” he added. “There’s nothing wrong with delegating trust to an intermediary, but in that case, it makes little sense to use a blockchain system architecture, except to capitalize on the hype.”
The problem confronting the team is that they needed elements of both public and private blockchains for their purposes. That’s why they decided to create a hybrid: b_verify. “At a high level, public blockchains such as bitcoin lack in privacy, which is essential in supply chains. Private blockchains lack in scale, and therefore security,” Aspegren said. “B_verify uses unique innovations to bridge these gaps. That is, it is designed as a ‘thin’ protocol utilizing (not replacing) the existing infrastructure of Bitcoin or any secure, public blockchain, while ensuring privacy.”
On the ground, this is how b_verify would work: A farmer bringing crops to the warehouse would place the goods in a digital scale linked to the internet. The amount of goods would be weighed and recorded. A warehouse employee would manually confirm the weight. If all three agree, they would have to sign off with their private digital keys. Then the inventory would be sent to a server running the b_verify protocol for processing and recorded into the public blockchain. Lenders can access these records to verify inventory as collateral, and the history of transactions. If all is well, the loan is approved.
Practical Uses and Limitations
As part of their research, Trichakis and Tsoukalas have been studying how firms should finance their operations. In 2015, they visited a warehouse in Italy that stored parmesan cheese, which was used as loan collateral. (The bank owned the warehouse and had essentially taken on a critical role in the cheese supply chain, giving it deep operational expertise and a superior ability to issue profitable loans.) The two later joined forces with Chod, a supply-chain finance expert from Boston College, and Aspegren and Weber at MIT, who were developing a new blockchain-based solution to deal with warehouse deposit fraud and also were interested in the agricultural industry of developing economies.
“Because these systems are regulated by governments, adoption is more of a top-down project.” –Mark Weber
“Aspegren and Weber had an idea for how to design a system to facilitate trade in those economies” to overcome issues such as fraud, Trichakis said. “People would bring grain to a warehouse, deposit it and get a loan. But sometimes there’s no grain — it’s difficult for banks to check that it’s actually there.” But Aspegren and Weber needed help on the supply chain finance side, which was where Trichakis, Tsoukalas and Chod came in. “We helped them design a system that is effective for the financing aspect,” Tsoukalas said. After about three years of development, b_verify was created. The next step is on-the-ground deployment.
Weber said Mexico and Ukraine are interested in b_verify because they face a big problem with warehouse fraud. “They are countries that use warehouse deposits a lot,” he said. These governments have identified a strategic need to improve the accuracy of their warehouse deposits and loans. Also, in the agricultural sector, transaction records are often required to be made public by law — 49 of the 62 agriculture-based economies have warehouse receipts legislation, and 13 of those have specified laws for electronic warehouse receipts, Weber noted.
“Because these systems are regulated by governments, adoption is more of a top-down project,” Weber continued. For example, the government of Mexico has mandated protocols for certified warehouses and warehouse receipts, including the requirement to upload warehouse receipts to a public registry called RUCAM. “This is the target market for a more secure protocol like b_verify, which would help all stakeholders,” he said.
Weber clarified that b_verify is a proposed protocol or standard, not a startup or company. “If governments and industry stakeholders decide they want to use this standard, we expect companies and startups to compete on servicing that standard,” he said. “B_verify requires a third party server [such as IBM] to play a coordination role in the system, though the cryptography is constructed such that stakeholders need not trust this coordinator.” The cost is about $1 per transaction.
“Public blockchains such as bitcoin lack in privacy, which is essential in supply chains. Private blockchains lack in scale, and therefore security.” –Henry Aspegren
To be sure, b_verify can’t weed out all fraud. Warehouse receipts can contain errors or participants bent on cheating could falsely attest to the inventory before it is recorded in the blockchain. The authors acknowledged that their solution is not fail-safe, but they argue that b_verify will make cheating harder. Indeed, the verification by multiple parties and immutability of the blockchain “may not always suffice to fully alleviate fraudulent behavior, but they do mitigate it compared to the status quo,” the paper said.
“Opening a small window of transparency into a firm’s operations, in particular, its input transactions [like inventory orders], could go a long way to alleviate the difficulty of financing operations, which is a systemic problem for small and mid-size enterprises that is all the more severe in developing economies,” Tsoukalas concluded. “Blockchain technology could provide an efficient way to accomplish this by furnishing input transaction verifiability in supply chains in a way that is accessible to small and mid-size companies. We believe this is a novel use case for blockchain technology that has hardly been researched.”
The team is currently working with the Inter-American Development Bank to pilot b_verify in Latin America, after which it will be evaluated. “If successful, we hope this work will motivate warehouse modernization projects throughout the region to the benefit of farmers as well as the economic health and food security of those nations,” Weber said.