Defi aims to democratise financial systems

DeFi or Decentralized Finance is a movement that aims at democratizing financial systems so that they can be open source, permissionless, and ultimately no longer rely on centralized Financial Institutions.

To achieve that goal, decentralized finance uses innovative tools such as Blockchain, cryptocurrency, and Smart contracts.

Most Defi Projects are happening in the Ethereum Platform due to its robust programming language called solidity, and the large pool of Ethereum developers around the world building new applications every day.

The number of Defi users has been growing exponentially and many believe that Defi finally means the potential of programmable money and proves to possibly be one of the most important innovations of blockchain technology capable of disrupting financial services in a way that hasn’t been achieved for decades.

One of the key areas of opportunity for Defi could be the ability to significantly contribute to Financial Inclusion around the world.

We will explore in this paper the opportunities Defi represents for the unbanked, as well as the challenges ahead to achieve that mission.

How Defi can help improve Financial Inclusion?

To understand the impact of Defi in Financial inclusion it is important to understand who are the unbanked and why are they unbanked?

According to the World Bank, There are about 1.7 billion unbanked people in the world that is the world population that does not have access to mainstream financial services such as Banking accounts but also credit cards or any type of formal financial services.

The lack of access to formal financial services is very linked to poverty around the World. Without access to financial services, storing financial assets is difficult and insecure.

In rural areas and in informal economy societies of the Developing world, people will often store important sums of money under the mattress exposing themselves to burglars and physical harm.

Besides, access to credit is a huge issue for unbanked entrepreneurs who are willing to grow their businesses.
There are many barriers in the way of unbanked people around the world to access financial services.

In the developing world, it can be as simple as the difficulty to have an Identification, the difficulty to afford the cost of fees of mainstream financial institutions, or the different administrative and onboarding requirements of traditional financial institutions that often lack the agility to adapt to the context of poor and marginalized people.

Besides, financial inclusion is not just an issue of the Developing World. A relatively smaller but significant number of people also lack full access to traditional financial services in developed countries.

According to the American Federal Deposit and Insurance Corporation (FDIC), it is estimated that 55 million adult Americans were unbanked or underbanked in 2018, which accounts for 22 percent of U.S. households.

Most solutions offered by cryptocurrencies for financial inclusion can also be achieved by Decentralized Finance but Defi projects go well beyond what Cryptocurrencies have been capable of solving so far.

In a broad sense, cryptocurrencies have the agility to meet the needs and adapt to the context of poor and margin populations that traditional financial institutions can hardly match.

Many people who don’t have access to banks do have access to smartphones and they can use their smartphones to access digital financial services such as Cryptocurrencies and Defi.

In countries where local currencies are weak, transacting through cryptocurrencies offers an opportunity to store value and access global financial markets in a way that traditional financial services can hardly offer to them. A cryptocurrency can be stored in a digital wallet and it is considerably more secure than a paper currency.

Cryptocurrencies offer a possibility to be converted into international currencies that many local currencies are not capable to achieve.

Transacting in cryptocurrencies does not require the often complex administrative and due diligence processes that mainstream financial services require and that prevent unbanked people from accessing them.

The cost of transacting in cryptocurrencies is significantly lower for local and international transactions to what regular financial Institutions propose.

Beyond the advantages that cryptocurrencies have been offering so far, the biggest impact of Defi projects is in the areas of Lending and borrowing.

The ability to access credit under a defi could be over time cheaper, easier, and faster than solutions currently offered by traditional finance institutions.

A significant portion of interests charged by banks come from their labor and operational costs. These costs are eliminated or significantly reduced under Defi projects with the ultimate effect of lowering the borrowing costs of loans.

Besides, Defi doesn’t follow many of the regulatory rules of traditional Financial Institutions such as KYC (Know Your Customers) or AML (Anti Money Laundering) Laws that automatically eliminate many individuals and small businesses to access credit.

We can expect the development of Defi will be a boost for the access to capital, particularly in Emerging and developing countries where an important segment of the population cannot access credit.

Although Defi opens new perspectives to the unbanked, many challenges still need to be addressed to fully fulfill its promise. This is mainly due to the nascent nature of the movement.

Challenges ahead

Decentralized Finance is a relatively new phenomenon and the concept is not yet fully developed. Like many new concepts, there are many obstacles in the road that will need to be lifted up to allow Defi to fully play its role in the financial Institutions.

There are obvious regulatory risks in deploying financial tools and instruments in a way that is open and permissionless.

Since there is no control of any sort of KYC and AML there are many risks of scams and money Laundering associated with Defi. Millions of Dollars have already been lost by individuals due to the uncontrolled nature of Defi.

Besides the regulatory risks, the technology behind is not fully developed to be available to the greater public. Most transactions are concentrated in the Ethereum platform, and it is not well equipped to process large transactions.

In comparison, While Visa can process 24,000 transactions per second (TPS), the Ethereum network that is predominately used for DeFi can process just 15 transactions per second (TPS).

The upcoming Ethereum 2.0 is expected to increase the volume of transactions on the Ethereum platform but in the meantime, we will need to function with the current low level of transaction capability.

Another weakness of the Ethereum platform is the smart contract risk as it is permeable to hacking. Essentially, Defi replaces custodial risks that exist in the traditional financial system with smart contract risks which can be hacked to steal escrowed funds in smart contracts.

Last but not the least, there is the liquidity risk that comes from the early adoption and relatively low volume of activity to provide liquidity for a world audience.

Despite impressive growth, the market cap of DeFi is still small (roughly $9.5 billion as of September 2020) when compared to the US$275 billion market cap for all cryptocurrencies.

As a result, DeFi cannot support the higher liquidity demands of larger market participants. However, this could change quickly given the market’s explosive growth.

Decentralized Finance is a major step in the Blockchain and Cryptocurrency revolution. The potential to disrupt Finance “as we know it” is significant and it can open the doors to access to capital for millions of people who have been left out of the mainstream financial system.

However, it is fair to say it will take some time for Defi to fully reach the promise of greater financial inclusion for the unbanked.

The technology still needs to be developed and some form of regulatory protection will be required to mitigate the risks inherent to the movement.

On an optimistic note, I want to believe in the ingenuity of technology and human beings to fix these challenges for the greater good of millions of unbanked who could be freed from poverty thanks to Decentralized Finance.

Prepared by Patrick O’Brien.

Author:

Charles Awanda, Certified Blockchain Expert, Chief Knowledge Broker Songhai Labs.

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