Sunday, July 5, 2009

An Inconvenient Essential--Part One

Among the essential numerical values that we learn in high school physics is the number that defines the speed of light. If we go on to other, non-scientific pursuits in our lives, it is likely that we’ll forget an important qualification in that definition. The number we learned represents the speed of light in a vacuum. In the presence of any source of friction, that speed cannot be reached.

In our last post we noted the desire of The Receivables Exchange to become a very large-volume platform. Growing from an initial transaction in late 2008 to a targeted $1 billion in volume in 2010 might not challenge the speed of light in literal terms but it comes close in financial terms. An essential element in its success must be the elimination of as much friction as possible.

We’ve already identified a few of the sources of friction usually encountered in purchasing individual invoices and the ways that TRE has devised to lessen their impact.

Now we need to address another major one: the issue of invoice verification. The buyer of a receivable needs to verify that the receivable is valid.

Most buyers of individual invoices will want assurances that: the Account Debtor acknowledges that it contracted to purchase the goods or services; that the goods or services have actually been provided; that they meet the criteria established in the contract; that the invoice being purchased states the correct amount due and the correct terms of payment; and, that the invoice is scheduled to be paid.

That’s a lot of friction! It’s often difficult or impossible to find anyone in a Debtor’s organization willing to sign-off on such assurances.

After the initial qualification of a client, the invoice verification process represents the major impediment to the speed of invoice purchase transactions. Given the need for TRE to minimize such impediments, it’s clear that this issue has had to be a focus of their operational design.

TRE has to have a process that provides appropriate comfort on the verification issue without causing so much friction in the system that it is impossible to meet their speed-of-growth and scale objectives.

The procedural solution is a compromise. Many of the typical elements of “full verification” are sacrificed, but the loss of those assurances is balanced by other elements of the TRE system.

What are the assurances that are sacrificed?

1) Neither TRE nor the Buyer has a direct relationship with the Account Debtor; so the Debtor does not provide either TRE or the Buyer with a direct assurance of the existence of a contract or purchase order.

2) The Debtor does not provide a direct assurance of the receipt of the goods or services.

3) The Debtor does not provide a direct assurance that the goods or services meet the requirements of the contract.

4) The Debtor does not provide a direct assurance that payment will be made.

In what ways is the sacrifice of those assurances balanced?

1) Prior to approving the invoices of a Debtor for posting on the exchange, TRE will investigate the history of transactions between the Seller and the Debtor to determine that a relationship does exist.

2) The history of the relationship between the Seller and Debtor will be examined to provide context for the analysis of invoices proposed for future sale.

3) The agreement of the Debtor to make all future payments to the TRE lock-box provides additional evidence of the validity of the relationship.

4) TRE will independently acquire contact information allowing it to access appropriate individuals within the Debtor organization who can verify that an invoice is “in the system for payment”.

5) TRE employs experienced fraud investigators to help it to detect any potentially fraudulent relationships or transactions.

The only piece of directly-sourced information regarding a specific invoice is that it is “in the Debtor’s accounts payable system”. That might seem to provide much less security than typically required by single-invoice buyers.

However, by the time a TRE Buyer sees that invoice posted for sale, the invoice will have been analyzed within the context of a great deal of previously-verified information about the relationship and the historical transactions between the Seller and the Debtor.

It’s certainly possible that, from time to time, specific invoices will prove problematic; and it is possible that the TRE verification process will have failed to uncover those problems in advance.

On the other hand, if such a problem occurs:

a) Within a verified pattern of transactions between the Seller and the Debtor,
b) In the presence of a continuing payment-direction agreement,
c) In the context of a security system that provides meaningful recourse, and
d) In an environment of a robust fraud-detection effort,

it is likely that a solution to an isolated problem can be found.

There is no guarantee that no losses will occur, but losses can occur when buyers obtain ALL of the typical assurances. Stuff happens!

There is a good argument to be made, I think, that the sacrifices made in the TRE verification system, for the sake of reducing friction and accommodating scale, are reasonable and that the apparent additional risks are balanced within the operational system of the exchange.

An important question remains, however, that will be addressed in our next post.

TRE itself, with its very aggressive growth goals, acts as its own verification agent. The question of potential conflict between growth goals and transaction quality goals has to be addressed.


  1. An on-target analysis, and the proposed mitigators have solid footing. I would also propose that the science & art of portfolio modeling and predictive metrics, or predictive analytics, can be leveraged in a large way to mitigate the risks. Most practitioners also have now accepted the additional religion of stress-testing as being an absolute.

  2. Excellent and helpful observations.

    I'd make one point: portfolio modeling, analytics and stress testing will work once a certain critical scale has been reached.

    TRE, itself, can do such modeling and analysis now at the level of the entire exchange activity. And it will be able to do it much more effectively once volume has scaled further.

    However, from the point of view of the individual buyer, "portfolio" level analysis will depend on that buyer's having sufficiently large and diversified holdings to allow such high-level analysis.

    Exchange-level analytics can comfort the individual risk-taker only to the extent that his holdings mirror the characteristics of the entire exchange.

    But please disagree if you see it differently!

  3. I certainly do not, but being prepared for "what's next" is an important part of business management...

  4. This issue is exactly why TRE's partnership with and integration to Ariba is so important. Essentially, the Approved invoice for the Ariba community of suppliers will come directly from their Buyer's ERP into the Ariba Network as approved to pay, then will be uploaded directly to TRE with no opportunity for the supplier/seller to alter the invoice in any way. Thus this should add a strong level of surety in the validity of the approved invoice and its terms.