Can DeFi Enhance Financial Inclusion?

These are exciting times for investors that have bet their time, effort, and finances on decentralized finance (DeFi) protocols. On March 09, 2022, the Biden administration said that it would sign an Executive Order on the development of digital assets.

The White House statement said that the order would outline the US government’s strategy on cryptocurrencies and decentralized finance. But, first, the fact sheet cites the risks and implications of the nascent digital native assets sector.

It also states that the US government views digital assets as “an opportunity to reinforce American leadership in the global financial system and technological frontier.”

The order also requests the Secretary of the Treasury and her agencies to develop a report on digital payment systems and their implications for financial inclusion.

In her April 7, 2022, speech at the American University’s Kogod School of Business Center, Janet L. Yellen detailed Biden’s administration’s outlook on digital assets and decentralized finance.

Her digital assets regulation, innovation, and policy speech observed that digital payments had lowered access to financial products. They have created possibilities that skeptics would have branded improbable a few years ago.

In her speech, the Secretary of the Treasury notes that people can access all the financial services that they need from gadgets that fit in the palms of their hands for the first time in history. In addition, technological advances such as DeFi and stablecoins are transforming transaction processing and financial services such as lending, trading, and borrowing through smart contracts.

And while Yellen also reiterates the risks inherent in the new DeFi system, she notes that the financial system benefits the most from ‘responsible innovation .’ Inventions such as the credit card’s magnetic strip are good examples of innovations that fully disrupted the financial system.

This invention led to the discovery of the ATM, online commerce, and electronic payments. But unfortunately, these developments have created a financial system whose efficiency only favors a fraction of American citizens.

“A combination of technological factors and business incentives have produced a common frustrating experience shared by tens of millions of Americans every week: their employer sends their paycheck, but it takes up to two days for the check to hit their bank account,” she notes.

The US Secretary of the Treasury tells her audience that the financial sector’s inefficiencies disproportionately affect persons that have lower incomes. These shortcomings have pushed many citizens to predatory lenders and exposed them to expensive overdraft charges.

Yellen states that Americans spend an annual $15 billion on overdraft fees and services, a tax that equates to $100 per American adult. Shedding more light on the inefficiencies of the traditional finance system on a global scale, she notes that while citizens in G7 countries pay a 2% charge on cross border payments, workers in the developing world could pay costs as high as 10% for the same financial services. Moreover, these unfair charges eat into the earnings of close to 250 million immigrants that send a monthly average of $300 to their families back home.

However, in her speech, Yellen wonders whether DeFi can deliver on the promise of an efficient financial system that enhances financial inclusion. She says that technology has yet to overcome challenges such as technical barriers to access, high transaction cost, and low processing time.

Can DeFi Enhance Financial Inclusion

Fintechs and the “banking the unbanked” movement

The phrase “banking the unbanked” is a popular rallying call for financial services providers that leverage technology to provide financial services. Fintech has used the term for years, promising to offer inclusive financial assistance to the billions of people worldwide that live without access to banking services.

The fintech sector has now been operating for two decades and has enjoyed extraordinary growth. Larger financial institutions have made significant investments in fintech in the last seven years in their transformation and investment initiatives.

Most financial industry executives embraced fintech due to its disruptive and nimble setups that threaten the longstanding incumbents.

As per Deloitte Center for Financial Services data,  in 2015 and 2016, fintech-related banking and capital markets investment had an all-time high of $30 billion and $28 billion, respectively. But despite these heavy investments in fintech, there remains a clear and unrelenting gap between the unbanked and banked.

There are 20,000 fintech businesses today, building investing, banking, and payment network services. But, the number of the unbanked has barely changed from its 2014 highs of 2 billion. Over 1.7billion adults today are shut out from the formal financial system.

Efforts by the World Bank Group’s Universal Financial Access (UFA) by 2020 have also not done away with the unbanked problem. The IFC and World Bank Group went into partnership with 30 other partners to ensure that at least 1 billion people would open a bank transaction account by 2020. They also promoted access to electronic means of payments and deposits.

UFA2020 would help end extreme poverty and promote equity in prosperity. Financial inclusion is also vital to fulfilling 8 of the UN’s Sustainable Development Goals. However, the World Bank Group states that access to an account does not equal use.

Therefore, the UFA2020 financial access goal has a narrower scope than financial inclusion. The latter opens doors to affordable, useful, responsible, and sustainable financial products like insurance, credit, digital finance, savings, and payments.

Consequently, the World Bank’s 2021 Drive for Financial Inclusion lessons paper notes that UFA2020 has borne fruit. Bank account ownership has risen from 51% in 2011 to 69%. But unfortunately, most low-income earners and women cannot use these accounts due to a lack of funds. Consequently, they can’t access a wide range of financial services.

As an illustration, India’s Jan Dhan Yojana scheme led to the opening of 300 million accounts. However, by 2017, 48% of these accounts were dormant. Data by the Center for Financial Inclusion shows that while 69% of adults own bank accounts, at least 10% of these accounts are inactive.

It follows then that while Fintechs are vital to the traditional financial system’s customer acquisition, they do not support retention amongst the financially disenfranchised. One possible reason is the high costs of financial intermediation in the conventional banking industry.

Why Fintechs failed to “bank the unbanked.”

As per a World Bank study, high costs of financial intermediation in the banking system directly impact services such as credit rationing. In addition, high third-party charges affect the banking industry’s interest spread.

This research shows that countries with lower banking services costs enjoy higher financial development levels. Additionally, citizens in these countries have access to a wider range of financial services.

The international financial institution research shows that adults in the Caribbean (LAC), Latin America, and Sub-Saharan Africa (SSA) pay higher for banking services than users in developed countries.

These costs harm income levels and raise net interest margins in regions that already are lower-income countries. In addition, the World Bank research cites factors such as higher overheads, credit risk, and bank profitability arising from low competition in low-income countries as a cause of high financial intermediation costs.

One other reason Fintechs have not banked the unbanked is the strategic contradiction between finance and tech. Finance is slow-moving, while tech goes big and fast to dominate.

Marc Andreessen defines this conflict as the source of the “original sin of the internet .”Marc is the co-founder of Netscape, the first popular internet web browser. Marc, who had a front-row seat in developing various internet protocols, says that tech and finance came to a head in the early 90s over the internet acceptable use policy.

At the time, the internet was for nonprofit, individual, and educational use. There was a prohibition on all commercial activity. When the demand for commercial activity began to escalate, the government handed over the internet’s commercial and regulatory structure to the telecom companies.

Consequently, all commercial activity on the internet had an intermediary. This development has left the traditional banking industry unchanged by the internet. As a result, the internet developed without a money layer, only encouraging fintech growth rather than actual changes on the rails that they run on.

Can DeFi enhance financial inclusion?

Blockchain technology and decentralized finance support low-cost instantaneous, and easily accessible financial applications. Its financial records are transparent, secure, and censorship-resistant. DeFi is building the foundational groundwork for a free, open, and accessible financial system for the underbanked and unbanked.

DeFi proponents say that its peer-to-peer payments channels offer financial liberation to people living in regions that have insensitive and weak financial institutions or that suffer from hyperinflation.

DeFi can help free low-income earners from the clutches of predatory loan lenders and high financial intermediation costs in banks. Its auditable and transparent transaction ledgers are a powerful tool that removes intermediaries from the financial service access process.

On top of that, DeFi gives users control of their financial assets and empowers communities through its participation and governance incentive models. Moreover, decentralized finance is not bogged by the “internet’s original sin” since it runs separately from the fiat system.

Its tech-based financial system has created a new parallel finance ecosystem with a total value locked (TVL) volume of $198 billion. Rising TVL is a signifier of growing market efficiency and confidence in borrowing, lending, wallet banking, derivatives, and stablecoin protocols.

For this reason, regulators such as the US Treasury and the Biden administration are establishing strategies that will guide the establishment of digital assets payment systems. The US is not the only country prepping for increasing digital assets and decentralized finance influence on monetary and economic systems.

The Women’s Economic Security of Australia minister, Jane Hume, has affirmed that the DeFi space is here for good. Speaking in November 2021, Financial Review Super & Wealth Summit in Sydney, Hume warned that “all innovation begins as disruption and ends as a household name.”

The senator, therefore, asked Australians to set up frameworks that will help them reap all the benefits that DeFi presents.

There is proof that DeFi’s ability can overcome endemic barriers that hamper economic freedom. As an illustration, the cryptocurrency sector is the only financial system that scores higher participation rates amongst younger adults.

At least 15% of 18 to 34 years invest in digital assets. Only 4% of adults above 65 own digital currencies, Then, 11% of adults in the 35 to 64 age group use cryptocurrencies. In contrast, investors in the 50s and 60s bracket keep a US stocks portfolio allocation of 42%.

Cryptocurrency investing also has broken-down age-old racial structures that disenfranchise minorities. Data shows that people of all races own cryptocurrency in equal ratios. For example, 14% of Asians, 11% of blacks and whites, and 10% of Hispanics have crypto investments.

Conversely, as per Pew Research data, 61% of white adults are more likely to invest in stocks. In addition, 28% and 31% of Hispanic and Black adults invest in the stock market. The only financial inclusion barrier that DeFi is yet to break is the gender divide. Men are twice as likely to invest in digital currencies as women are.

DeFi can “unbank the banked.”

Fortunately, the DeFi sector can effortlessly eliminate the discriminatory pitfalls that deny the disenfranchised access to financial resources in the legacy finance world. For example, DeFi does not require its users to open bank accounts.

It also does not require heaps of documentation promoting personal data privacy. You can, for instance, access Uniswap’s decentralized digital assets exchange and liquidity pools in a few clicks. Moreover, Uniswap is free, open, and only charges a 0.3% transaction on crypto trades.

Alternatively, you can deposit your crypto assets in Uniswap’s liquidity pools and earn fees proportional to your stake from the pool’s transaction fees. DeFi’s stablecoins support fast, low-cost cross-border payments for low-income earners.

Additionally, DeFi can help close the $2 trillion lending gap that keeps SMBs from accessing capital. The DeFi sector is capital-inefficient, and its liquidity lies idle in its staking protocols and liquidity pools.

Unfortunately, unlike fintech apps that cater to daily use cases, DeFi is a speculative financial sector. It is a system that benefits ‘whales’ and yield chasing ‘degens’ whose main benefit is the providence of liquidity.

As per Chainalysis data, crypto investors and traders from high-income regions are the force behind its recent TVL growth spurt. Then, DeFi protocols do not provide users with easy-to-use retail financial tools that promote grassroots activity and enhance financial inclusion.

Its protocols are inaccessible, fragmented, and underutilized siloed networks. Moreover, these low composability levels between protocols create inefficiencies that offer huge returns in arbitrage and trade but keep the sector’s liquidity static and with low opportunity for use.

Then DeFi loans are overcollateralized, locking out low-income earners that, in the first place, cannot use bank accounts due to high costs of services. DeFi can “democratize” finance and create an inclusive financial system by first solving the over-collateralization challenge.

By stabilizing the markets through composable liquidity efficient protocols, capital-efficient liquidity pools, and the use of non-volatile stablecoins, DeFi can lower its dependence on over-collateralization.

Fintechs are ditching the banks and moving towards crypto and could become DeFi’s biggest ally. DeFi can enhance financial inclusion by creating on and off-ramps in collaboration with these traditional payment gateways. This effort will bring in more users to the new system.

Fintechs such as PayPal, Venmo, Visa, and Cash App now provide cryptocurrency ramps to the blockchain space. As a result, their large user bases can support easy real-world purchases using cryptocurrencies and effortless DeFi investments.

Then the blockchain sector should make faster strides toward interoperability to create efficient markets. Developers should also create dApps with easy-to-use integrated dashboards for the non-crypto user. They are abandoning the new cryptocurrency investor to fate and hackers by not doing so.

Last but not least, to enhance financial inclusion, dApps should build mobile-friendly applications. While 60% of the global population has access to the internet, at least 90% of this population accesses the digital world via the smartphone.

The best DeFi applications will be built not for the computer but the cheaper smartphone. They will also build applications that function in low bandwidth regions where most unbanked are. These developments will ensure that the DeFi sector evades the original sin that entrenched a digital divide that pits users against the third party few.