Liquidity-saving mechanisms in trade credit networks: Optimising corporate liquidity

Trade credit, or the delayed payment for intermediate goods, has been reported as an important source of short-term external finance for many non-financial firms. The value of trade payables is comparable with that of outstanding corporate bonds and is about one-third of non-financial firms’ outstanding bank loans (Boissay, et al., 2020). In the United States, trade receivables represented approximately 8% of the assets of corporate balance sheets in 2022 (Federal Reserve System, 2023). 

During financial crises, as bank credit weakens, trade credit becomes a substitute source of liquidity (see Baños-Caballero, et al., 2023). According to the literature, firms able to access trade credit are better positioned to withstand financial crises. For instance, a study of over 200,000 European firms found that an increase in the availability of trade credit to a firm led to a significant decrease in the likelihood of distress (McGuinness, et al., 2018). Therefore, there is a potential benefit in supporting trade credit throughout the entire economic cycle, particularly during financial downturns. 

By extending a short-term loan to buyers, sellers of goods and services provide liquidity, facilitate the purchase of supplies by other firms, encourage long-term customer relationships, and increase demand. As firms recursively borrow from their suppliers and lend to their customers through the supply chain, trade credit networks foster economic activity. Accordingly, trade credit has been reported to be a key element in enabling economic activity and ensuring financial stability.  

However, this positive feedback loop created by trade credit networks also works in the opposite direction, with the potential to create instability in the economy. For instance, if some firms do not pay on time, others may find it difficult to pay on time, and a cascading effect of higher payment terms may ensue; furthermore, when firms cannot pay, the cascading effect may be worse. That is, in adverse scenarios, the trade credit channel that runs parallel to input-output linkages could negatively affect the liquidity and the solvency of firms, and, in turn, economic activity and stability (see Costello, 2020). 

This type of network and feedback effect is well-known in interbank markets. When banks provide liquidity to each other in the money market, the inability of a single bank to pay on time may threaten the safe and efficient functioning of the payment system and, eventually, the solvency of the financial system. Large-value payment systems have long acknowledged that interbank liquidity is a network problem that is better tackled by implementing intraday Liquidity-Saving Mechanisms (LSMs), i.e., a suite of algorithms designed to compress liquidity requirements to facilitate smoother flows of liquidity. By introducing LSMs into real-time gross settlement systems, large-value payment systems have mitigated liquidity and counterparty risk.    

We suggest a similar approach to mitigate liquidity and counterparty risks in trade credit networks. By introducing a new Financial Market Infrastructure (FMI) that runs LSMs in trade credit networks, we can reduce the outstanding exposures among firms, reduce the payment terms, and mitigate potential risks arising from undesirable network and feedback loop effects. This way, by implementing LSMs, risks and potential amplification effects from trade credit exposures are mitigated while their potential contribution to firms’ growth, supply chain resilience, and economic activity is preserved. Besides, as this implementation of LSMs requires observing the trade credit network, new data for monitoring and policy-making is available for central banks and financial authorities.