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Abstract: We develop a theory that shows signaling a firmrsquo;s fundamental quality (e.g., itsoperational capabilities) to lenders through inventory transactions to be more efficient—itleads to less costly operational distortions—than signaling through loan requests, and we characterize how the efficiency gains depend on firm operational characteristics, such as operating costs, market size, and inventory salvage value. Signaling through inventory being only tenable when inventory transactions are verifiable at low enough cost, we then turn our attention to how this verifiability can be achieved in practice and argue that block-chain technology could enable it more efficiently than traditional monitoring mechanisms.To demonstrate, we develop b_verify, an open-source blockchain protocol that leverages Bitcoin to provide supply chain transparency at scale and in a cost-effective way.The paper identifies an important benefit of blockchain adoption—by opening a window of transparency into a firmrsquo;s supply chain, blockchain technology furnishes the ability to secure favorable financing terms at lower signaling costs. Furthermore, the analysis of the preferred signaling mode sheds light on what types of firms or supply chains would stand to benefit the most from this use of blockchain technology.
Keywords: blockchain ,supply chain financing ,supply chain transparency, information asymmetry,signaling
1 Introduction
Firms seeking the capital needed to efficiently run their operations are often impeded by the vexing problem of information asymmetry. Unable to readily ascertain their fundamental operational capabilities and gauge their risk, prospective lenders frequently command prohibitively high financing rates, which lead to operational distortions. Information asymmetry can be especially problematic for small- and medium-sized enterprises(SMEs)and startups,which are likely to be engaged in innovative operations and lack track record and reputation, particularly in developing economies plagued by trust and fraud issues. To overcome this problem, extant literature argues that firms can credibly signal private information to their lenders by distorting loan requests. For instance, a cash-strapped entrepreneur with an innovative prototype can try to signal good demand prospects by seeking restrictive covenants or shorter maturities, or requesting a larger loan. Alternatively, firms can also signal through their inventory transactions—for example, by sourcing high-quality materials from established suppliers, or distorting inventory trading quantities.
In this paper, we first develop a theory that shows that signaling a firmrsquo;s fundamental quality (e.g., its operational capabilities) to lenders through inventory transactions to be more efficient—it leads to less costly operational distortions—than signaling through loan requests. Of course, signaling through inventory is only tenable when a firmrsquo;s supply chain is transparent to its lenders—that is, its inventory transactions are verifiable by lenders at low enough monitoring costs. The paperrsquo;s second goal is to argue that blockchain technology has the potential to enable supply chain transparency more efficiently than traditional monitoring mechanisms. To this end, we introduce b_verify, an open-source software protocol we developed to demonstrate how this technology can be implemented in a way that is accessible to SMEs in developing economies. In particular, b_verify, which uses the Bitcoin network, can secure supply chain transactions at large scale (thousands per second) and at very low cost per transaction (fractions of a cent).Taken together, our paper identifies an important benefit of blockchain adoption—by opening a window of transparency into a firmrsquo;s supply chain, blockchain technology furnishes the ability to secure favorable financing terms at lower signaling costs.
1.1. Signaling Operational Capabilities:Cash vs. Inventory
In the presence of information asymmetry between firms and their lenders regarding firmsrsquo; creditworthiness, high-quality firms have an incentive to signal their operational capabilities to obtain more favorable credit terms. Among the potential signaling mechanisms that have been studied, the majority involve distorting loan terms(Ross1977,Besanko and Thakor 1987, Milde and Riley 1988).Indeed,signaling through loan requests, which we refer to here as cash signaling,is the de facto mechanism as lenders observe loan requests directly without incurring monitoring costs.Firms can also signal by distorting an actual physical investment—for example, an inventory transaction.What we refer to as inventory signaling has been studied primarily in the context of signaling to equity investors, who observe delayed and audited financial reports (Bebchuk and Stole 1993, Lai et al. 2012, Lai and Xiao 2018), and suppliers (Cachon and Lariviere2001,Ozer and Wei 2006, Chod et al. 2019a). Because lenders s
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