How Blockchain Can Advance Blended Finance & SDG-Aligned Investing

One of the central tenets of the Sustainable Development Goals (SDGs) is to “reach first those who are furthest behind.” One challenge, therefore, for SDG-aligned investing is how to focus on emerging and frontier markets in least developed or lower middle-income countries. Currently, populations in these countries are underserved by the capital markets because of investors’ perception of risk. To advance SDG-aligned investment, public capital can be used to create more appealing investment opportunities to crowd-in private capital using blended finance. Blended finance provides strategies to de-risk investment opportunities, especially in areas that will become increasingly important to global capital markets. Unfortunately, there are key challenges to scaling and advancing blended finance - the complexity of deals, stakeholder alignment, and results transparency. This piece explores the potential of blockchain technology to mitigate some of the challenges associated with blended finance, and ultimately scale-up SDG-aligned investing.

 

Blockchain technology is an emerging technology driving innovation across enterprise strategy, finance & fintech, and even social impact. Distributive Ledger Technologies (DLTs) is a common term to refer to blockchain technologies because they serve as a decentralized database that is accessible and explorable in real-time. Today a wide spectrum of innovative finance and work is occurring around blockchains, especially with regards to the example given by Proof of Impact and other innovative approaches to validating and creating impact capital. At the same time a truly fascinating ecosystem is exploding around decentralized finance (see link for a deeper explanation). Broadly speaking, these blockchain-based applications seek to increase access to financial services by combining digital assets, fiat-currencies, and access to these applications via mobile technologies (for those interested, see the MakerDAO project on Ethereum).

There are a lot of exciting opportunities in this ecosystem. These technologies and the associated blockchain ecosystems could enable new ways to tackle blended finance’s challenges around complexity, scalability, and data.

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Blockchain Enables New Approaches to Data, Investment Vehicle Structuring, and Capital Sourcing:

Blockchain is highly compatible with the complexity of blended finance transactions. DLTs by their nature enable an open, immutable, and participatory database capable of storing more than just financial records and transactions. The real-time storage, validation, and access to data would bring significant advantages to blended finance and impact investment. There are multiple applications of blockchain to blended finance including raising & distributing capital, asset management, reporting impact outcomes and impact validation, and complex deals with a larger number of actors then deals today.

Transparency offered by these technologies could help to further onboard public-sector and other sources of concessionary capital by offering greater accountability and transparency to the impact measurement and reporting process. The open nature of public blockchain networks ensures not only that information is accessible, but also that it provides an accessible layer of user onboarding. Anyone with a mobile phone and capital can create an account on the network and purchase some digital assets to begin participating in the network. In the future this may create far greater access to financial services.

Smart Contracts & Scaling Blended Finance:

One revolutionary feature of blockchain technology is the ability to write programming and code that can then be run on blockchain networks, much like an app on your phone. Smart contract applications enable complex and decentralized organization and distribution of resources to actors in the networks in an automated and trustless nature. The below graphic provides a simple summary of the broad significance and use cases of smart contracts:

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Consider an example for impact investing. Say you wanted to start a $200M Global Fund for Climate Resiliency. You could have a crowdsourcing-style approach that would provide a total 10% ($20M) of your planned Fund from any number of participants. This money could then be locked up under specific first-loss or capital structure terms along with capital provided from your traditional investors and other sources of concessionary capital. Using smart contracts, you can ensure settlement in USD and pegged-currency tokens is distributed to appropriate stakeholders at a previously agreed-upon point throughout any period of the investment process. From here you could keep a simple capital structure or get increasingly complex. The blockchain will ensure everything is clearly tracked and laid out to all stakeholders. Private capital from your non-digital asset clients does not need to be stored on the blockchain so they are not exposed to any risk associated with sourcing capital through blockchain ecosystems.

The above is a perfect illustration of the variability and customization which smart contract applications can contribute to complex deal structuring and capital sourcing strategies. Blockchain enables this complexity through smart contracts in a way that provides the framework and tools to structure highly complex deals in a transparent and scalable manner. The accessibility of technology and financial services it can provide lowers barriers to participation and access as well. Although adoption rates of such systems are not yet high enough to truly test their feasibility, the groundwork is rapidly being laid. The outcome could be a system that can be leveraged to further catalyze capital flows into blended finance deals for SDG-aligned investment, and convert traditional capital into impact capital.

Another challenge to structuring successful blended finance deals is the uniqueness of de-risking strategies to each specific deal. Without strong data and knowledge sharing, the field is currently gaining this ability slowly. Scaling blended finance is challenging because of the time, resources, and complexity of assembling public and private stakeholders along with learning these lessons.  Currently, there is little centralization and sharing of public data for blended finance deals and outcomes. Blockchain makes these processes inherent and allows better learning and knowledge sharing.

SDG-aligned investment is a newer phenomenon and should explore strategies and solutions to scaling. Combining this with the complex and rapidly evolving ecosystem of digital assets can facilitate new opportunities in the space. Blockchain technologies are strong fit for innovative finance strategies like blended finance. The strategic combination of smart contracts with the traditional impact investment process could create innovative solutions for complex deal structuring and capital sourcing. In the not too distant future, these technologies and strategies will be ready to truly begin designing and testing at scale, in order to convert traditional capital into impact capital and catalyze SDG-aligned investing. As we strive towards sustainable development we should be carefully considering the advantages blockchain could offer in achieving SDG outcomes.

Author: Eli Emigh

eemigh@17assetmanagement.com

Grace Stone