On the Financing Benefits of Supply Chain Transparency and Blockchain Adoption Jiri Chod, Nikolaos Trichakis, Gerry Tsoukalas Henry Aspegren, Mark Weber July 1, 2019 Management Scienceforthcoming Abstract We develop a theory that shows signaling a firms fundamental quality (e.g., its operational capabilities) to lenders through inventory transactions to be more ecientit leads to less costly operational distortionsthan signaling through loan requests, and we characterize how the eciency 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 blockchain technology could enable it more eciently 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 eective way. The paper identifies an important benefit of blockchain adoptionby opening a window of transparency into a firms 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. Chod (chodjbc.edu): Carroll School of Management, Boston College; Trichakis (ntrichakismit.edu): MIT Operations Research Center and Sloan School of Management; Tsoukalas (gtsoukwharton.upenn.edu): The Whar- ton School, University of Pennsylvania; Aspegren (): MIT Media Lab Weber (): IBM Research 2) disintermediation, e.g., the ability to provide trust in the absence of a trusted party; 4 3) record integrity, by providing a chain of audit which reduces fraud opportunities; 4) automation, so that tasks such as making loan payments can be automated (Babich and Hilary 2018). In brief, these features can be leveraged to address many of the aforementioned shortcomings including the paper trail ineciencies, the need for costly intermediaries, and issues of fraud. There are, however, some potential obstacles that may inhibit the use of blockchain technology in supply chains, or may make it too expensive to deploy. First, it is not obvious to what extent and how exactly blockchains can be successfully ported to provide verifiability of physical goods transactions, such as procuring inventory. In particular, physical transactions involve a certain amount of human intervention and, therefore, are more susceptible to mistakes or deliberate mis- representation. The ensuing “garbage-in-garbage-out” problem could completely negate the main purpose of blockchain adoption in providing transparency. Second, even if transaction verifiability can be successfully ported, it is not clear whether blockchain can be deployed in a way that keeps implementation and operating costs low enough to make it relevant to SMEs in developing economies. To this point, there are substantial dierences to consider between private and public blockchain implementations, each having their own advan- (fbi.gov/scams-and-safety/common-fraud-schemes/letter-of-credit-fraud). 2 Perhaps the most infamous example of falsifying warehouse receipts in asset-based lending is the De Angelis salad oil swindle, which nearly crippled the New York Stock Exchange (Taylor Nov 23, 2013). 3 Blockchains were originally designed to solve the infamous double spending problem for digital currency, i.e., to ensure that a digital asset transmitted from one party to another has not already been spent elsewhere. 4 In the Bitcoin blockchain, for instance, the task of recording transactions is assigned to individual miners who compete through a proof of work mechanism at every round, to append blocks to the existing chain, in exchange for compensation (composed of transaction fees, and new currency issuance). 4 tages and disadvantages in the context of supply chains. On the one hand, private blockchains have some desirable properties in terms of privacy but 1) are usually not fully decentralized and do not fully eliminate intermediation, 2) have diculties scaling to achieve adequate security guarantees, and 3) have (relatively speaking) large infrastructure costs. On the other hand, public blockchains, such as the one backing the Bitcoin network, do not suer from these issues, but they do lack some of the desired properties that are important to supply chains, such as identification of verified parties, privacy of data, and transaction costs that are controlled in-network. To demonstrate how these technological and cost issues can be overcome in practice, we devel- oped an open-source software protocol termed b verify. The protocol uses the Bitcoin network to ensure recorded data cannot be retroactively modified or altered. At a high level, the protocol is designed to leverage the infrastructure benefits of public blockchains, while taking advantage of several innovations that mitigate some of the aforementioned privacy, identification and transaction cost issues. Unlike previous systems, b verify was designed so that it can provide data integrity at scale and at low cost; it is capable of processing thousands of transactions per second at a fraction of a cent each. More details about the protocol and its key innovations are included in Section 3. In this paper we consider a specific use case in agricultural supply chains, demonstrating how the protocol facilitates transaction verifiability in the context of warehouse inventory. Warehouses often play a central role in supply chains, being frequented by suppliers who deposit inventory, buyers who procure inputs, and banks who utilize warehousing receipts and transactions to process loans (Trichakis, Tsoukalas and Moloney 2015). An enterprise-grade implementation of b verify at this nexus of stakeholder interaction can securely provide, depending on the need, relevant supply chain transanctional information to stakeholders, along with a cryptographic proof that the records are authentic and that no record has been omitted. According to our theory, this in turn should enable high-quality firms to use inventory as a credible signaling device and thereby unlock access to favorable financing terms with smaller operational distortions. 1.1 Related Literature Signaling models The literature on signaling goes back to the seminal paper by Spence (1973). Whereas Spence (1973) considers only one signaling mechanism (education), herein we allow the informed players to choose between two alternative signaling mechanisms, and study which one prevails in a least-cost separating equilibrium. As we shall see, inventory signaling incurs higher unit signaling costs than cash signaling. While casual intuition could suggest that signaling through the costlier mechanism is automatically more ecient, a deeper analysis within the classical frame- 5 work laid out by Spence (1973) reveals that this may or may not be the case. Using a generic game, we formally show that if two signaling mechanisms are available that dier only in the unit signaling costs, the high type can prefer the costlier or the cheaper mechanism, depending on the circumstances. In particular, our analysis brings to light the following tradeo. Because the costlier mechanism allows the high type to separate with a smaller distortion, the choice of signaling mech- anism trades o the lower per unit signaling cost of one mechanism against a smaller distortion required to separate with the other. In the context of Spences education signaling, if, say, liberal arts education is costlier than engineering education, a first degree in the former while a postgrad- uate degree in the latter could be required for the high type to separate. We demonstrate that in general, the equilibrium choice of the signaling mechanism by the high type depends the relation between the cost premia of the costlier mechanism for the two types. Within our specific context, we find that the inventory/cash signaling cost premia are such that inventory signaling dominates. Signaling to financiers/suppliers Signaling through loan requests to financiers has been well studied in the finance literature, going back to Ross (1977) who shows that high-quality firms, concerned with short-term valuation, can signal to investors by requesting larger loans. In Besanko and Thakor (1987), lenders screen borrowers using a credit policy consisting of interest rate, loan amount, collateral, and the credit granting probability, and high-quality firms signal by borrowing more in equilibrium than they would under full information. Milde and Riley (1988) model a game, in which banks screen borrowers by oering higher loans at higher interest rate, and depending on project characteristics, high-quality borrowers may signal by choosing larger or smaller loans in equilibrium. Duan and Yoon (1993) show that when borrowers choose between spot market borrowing and a loan commitment, high-quality borrowers signal by using larger loan commitments. Signaling through inventory has been studied primarily in the operations management literature in the context of signaling to suppliers and signaling to equity investors. Inventory signaling to suppliers is the subject of Cachon and Lariviere (2001) and Ozer and Wei (2006), both of whom examine how a privately informed manufacturer can credibly share demand forecast with a supplier, which then uses this forecast to build capacity. Taking the perspective of the manufacturer and that of the supplier, respectively, Cachon and Lariviere (2001) and Ozer and Wei (2006) show that the manufacturer can signal by overordering. Chod, Trichakis and Tsoukalas (2018) study supplier diversification in a model that features inventory signaling to suppliers who are also trade creditors. The literature on inventory signaling to equity investors draws upon Bebchuk and Stole (1993), who show that when firms are concerned with the short-term valuation and investors observe the investment level, firms can signal high productivity by overinvesting. Building on the same premise 6 but in the supply chain context, Lai, Xiao and Yang (2012) show that inventory overinvestment due to signaling can be prevented using a menu of buyback contracts; Lai and Xiao (2018) find that the first-best inventory decisions can be also achieved in equilibrium when the managers short-termism is endogenous; and Schmidt et al. (2015) focus on characterizing pooling equilibria. Our paper contributes to the above literatures by contrasting signaling with loan requests and signaling with inventory, and by establishing the conditions under which the latter dominates. By studying the eect of inventory transaction observability in the context of lending, our paper is intimately related and contributes to the literature on supplier financing. Supplier financing The literature on supplier financing is vast and we only review papers here that are closest to ours. Burkart and Ellingsen (2004) show that observability of the input trans- action by the supplier reduces the borrowers diversion opportunities. Considering multiple inputs, Fabbri and Menichini (2016) and Chod (2016) show that transaction observability also reduces the asset substitution problem. Although these papers focus on moral hazard, our work focuses on information asymmetry, where it aords new insights. In particular, the insights in these papers are less relevant in settings in which opportunistic behavior can be alleviated through other means, such as debt covenants, strong legal institutions, and so forth (Iancu, Trichakis and Tsoukalas 2016). Our theory holds irrespective of buyer opportunism. Closer to our work, within information asymmetry models, Burkart and Ellingsen state that “there is no obvious distinction between lending cash and lending inputs” (p. 571). Our work demonstrates that such a distinction does exist: it characterizes the conditions under which an input transaction (inventory signaling) transmits private information about the borrower quality more eciently than a cash transaction (cash signaling). The explanation oered by our model is distinct from, and possibly more robust than, existing explanations that rationalize supplier financing based on the assumption that suppliers have an aprioriinformational advantage over banks (Emery 1984, Biais and Gollier 1997, Jain 2001). Albeit certainly the case in some instances, it is unlikely that financial institutions specialized in developing lending relationships and assessing creditworthiness are systematically disadvantaged relative to suppliers. Our proposed explanation is immune to this criticism because our model assumes a level playing field between banks and suppliers, and identifies a monitoring advantage of supplier financing that emerges endogenously from the very nature of the transaction and the supply chain transparency it provides. Our theory, although robust to the foregoing criticisms, admits its own limitation, namely, that it is relevant only in the presence of information asymmetry between buyers (borrowers) and lenders regarding the formers creditworthiness. 7 Blockchain literature Most existing literature on blockchains is in computer science, starting with the original white paper by Nakamoto (2008). Given that blockchain technology is very new and still being actively developed, the management literature on the topic is scarce. Babich and Hilary (2018) provide a qualitative discussion of the technologys potential to improve production and distribution networks and implications for operations management researchers. Several papers examine the economics of mining and/or optimal design of blockchain systems, e.g., Biais et al. (2017), Huberman, Leshno and Moallemi (2017), Budish (2018), Cong, He and Li (2019), Hinzen, John and Saleh (2019), Saleh (2019) and references therein. To the best of our knowledge, ours is the first research paper to explore both practical and theoretical implications of blockchains for supply chain finance and operations management. A few recent papers, however, have started exploring the impact of blockchain in other areas. For instance, Yermack (2017) examines implications of blockchains for corporate governance, arguing that the transparency of ownership oered by blockchains may upend the balance of power in traditional governance structures. Catalini and Gans (2017) study how blockchain technology could shape innovation by reducing transaction verifiability costs and bypassing intermediaries. Chod and Lyandres (2018), Gan, Netessine and Tsoukalas (2019) and Chod, Trichakis and Yang (2019) study financing of entrepreneurial ventures by issuing crypto-tokens (ICOs) on existing blockchain platforms. Falk and Tsoukalas (