DeFi or Decentralized Finance is a movement that aims to democratize access to financial services so that they no longer have to depend on centralized financial institutions. For the realization of this goal, Decentralized Finance (DeFi) uses revolutionary and innovative tools such as Blockchain Technology, Cryptocurrency Tokens, and Smart Contracts. Most Defi Development projects take place on the Ethereum platform because of its robust programming language called solidity and the large number of Ethereum developers around the world that create new applications every day.
The number of Defi users has grown exponentially and many believe that Defi finally brings the possibility of having programmable forms for financing and could be one of the most important innovations of blockchain technology, capable of revolutionizing global finance. One of the key areas of opportunity for Defi could be the ability to make a significant contribution to financial inclusion in the world. In this article, we will explore the opportunities defi represents for non-banked people, as well as the challenges ahead to achieve this mission.
How can Decentralized Finance help improve financial inclusion?
To understand the impact of Decentralized Finance on financial inclusion, it is important to understand who the unbanked are and why they are not banked? According to reports by the World Bank, there are nearly 1.7 billion people in the world without access to financial and banking services. These people are part of the world’s population who do not have access to traditional financial services such as bank accounts, credit cards, or any type of formal financial services. Lack of access to formal financial services is closely linked to global poverty. The lack of access to financial services makes storing financial assets difficult and insecure.
In rural areas and informal-economy societies such as sub-Saharan Africa, people often store large sums of money under the mattress, exposing themselves to burglars and physical damage. In addition, access to credit is a huge problem for unbanked entrepreneurs who wish to grow their businesses. There are many barriers that prevent unbanked people around the world from accessing financial services. In places such as Africa, this can be as simple as the difficulty of having an identification, and the difficulty of paying the costs of traditional financial institutions. More often than not, different administrative requirements of traditional financial authorities and institutions often lack the ability to adapt to the context of poor and marginalized people in developing and underdeveloped countries. Most of the solutions proposed by cryptocurrencies for financial inclusion can also be achieved by decentralized finance, but Defi projects go far beyond what cryptocurrencies have been able to solve so far.
In general, cryptocurrencies have the flexibility to meet needs and adapt to the context of poor and marginal populations that traditional financial institutions can hardly match. Many people who do not have access to banks have access to smartphones and can use their smartphones to access digital financial services such as cryptocurrencies and Defi. In many African countries where local currencies are weak, transactions via cryptocurrencies offer the ability to store value and access global financial markets in a way that traditional financial services can hardly offer them. A cryptocurrency can be stored in a digital wallet and is considerably safer than a paper currency. Cryptocurrencies offer the possibility of being converted into international currencies that many local currencies are unable to achieve.
Traditional financial services often require complex administrative and due diligence processes that cryptocurrency transactions do not. These processes prevent unbanked individuals from accessing various financial services. The cost of cryptocurrency transactions is significantly lower for local and international transactions than what regular financial institutions offer. Beyond the advantages offered so far by cryptocurrencies, the biggest impact of Defi projects is in the areas of lending and borrowing. The ability to access credit as part of a challenge could be cheaper, easier, and faster over time than the solutions currently offered by traditional financial institutions. A significant portion of the interest charged by banks comes from their labor and operating costs. These costs are eliminated or significantly reduced under the Defi projects, with the ultimate effect of reducing loan costs.
In addition, Defi does not follow most of the regulatory rules of traditional financial institutions such as the KYC (Know Your Clients) or AML (Anti Money Laundering) laws, which automatically eliminate many individuals and small businesses to access credit. Defi’s development can be expected to be a boost for access to capital, particularly in emerging and developing countries where a significant segment of the population does not have access to credit. Although Defi opens up new opportunities for the unbanked, many challenges still need to be met to fully deliver on its promise. This is mainly due to the nascent nature of the movement.
Challenges to overcome
Decentralized finance is a relatively new phenomenon and the concept is not yet fully developed. Like many new concepts, there are many obstacles along the way that will need to be removed to enable Defi to play its full role in financial institutions. There are obvious regulatory risks associated with deploying financial tools and instruments in an open and unassigned manner. Since there is no control of any kind 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 defi’s uncontrolled nature. In addition to regulatory risks, the underlying technology is not fully developed to be accessible to the general public. Most transactions are focused on the Ethereum platform and it is not well equipped to handle large transactions.
In comparison, while Visa can process 24,000 transactions per second (GST), the Ethereum network that is primarily used for DeFi can process only 15 transactions per second (GST). The next Ethereum 2.0 is expected to increase the volume of transactions on the Ethereum platform, but in the meantime, we will have to operate with the current low level of transaction capacity. Another weakness of the Ethereum platform is the risk of intelligent contacts as it is permeable to hacking. Essentially, Defi replaces the custody risks that exist in the traditional financial system with the risks of smart contracts that can be hacked to steal sequester funds. Last but not least, there is the liquidity risk that comes from early adoption and a relatively small volume of activity to provide liquidity to a global audience. Despite impressive growth, DeFi’s market capitalization is still small (approximately $9.5 billion in September 2020) compared to the market capitalization of US$275 billion for all cryptocurrencies.
As a result, DeFi cannot withstand the higher liquidity demands of the major market players. However, this could change quickly given the explosive growth of the market. In the African context, we are comparing it with, a major challenge will also be the lack of qualified professionals. In order to implement Defi and adapt it to the general population, it is necessary to have professionals trained in the concept. At present, most academic institutions in countries like Africa have not yet adapted their programs to catch up with the blockchain and crypto revolution. The lack of trained professionals in this field is probably greater in these places than in the rest of the world. Decentralized finance is one of the major advancements in the blockchain and cryptocurrency revolution, and one that holds many promises. The potential to disrupt financing “as we know it” is significant and can open the doors of access to capital to millions of people who have been excluded from the traditional financial system.
However, it is fair to say that it will take Defi some time to fully achieve the promise of greater financial inclusion for people who are not banked. The technology is yet to be developed and some form of regulatory protection will be needed to mitigate the risks inherent in the movement. On an optimistic note, I want to believe in the ingenuity of technology and human beings to meet these challenges for the greater good of millions of unbanked people who could be freed from poverty through decentralized finance.