Finding the Right Approach to Decentralization for DeFi in Emerging Markets
The twelve years since the Bitcoin genesis block can be broadly delineated into three epochs. The first was the era of cryptocurrencies - digital assets of value secured by a blockchain. During this era, Bitcoin spawned many forks and copies, some of which remain to this day.
Video from our partnersThe Dangers Of Sitting In Idle CashSyfe - Digital Wealth Manager The second epoch began when Ethereum launched its smart contract platform in 2015. In the years that followed, we saw a boom in tokenization and adoption that spurred the last big bull run in 2017.
The third one marks the era of decentralized finance, also known as DeFi. It started with a gradual build-up but has been undergoing phenomenal growth over the last twelve months, hitting $45 billion in total assets locked during late February 2021. While the expansion is impressive, the nature of DeFi means that in its current format, it is limited to a small group of niche traders and investors and will continue to be dwarfed by traditional finance for some time to come – unless something changes.
Challenges Inherent to DeFi
So what exactly is hampering DeFi’s growth? Firstly, a lack of regulatory oversight means that it often draws the same “wild west” analogies as cryptocurrencies did in their early days. Traders can and do engage in unethical market practices such as manipulation and front-running.
There are a plethora of DeFi lending applications, but because there’s no way to identify borrowers, lenders assume a high degree of risk. Therefore, over-collateralization of loans is a prerequisite, which effectively limits the lending service’s value to the market of potential borrowers.
Furthermore, the focus so far has been on developing the underlying smart contracts that support the technology, with little focus on user experience. As such, technical barriers are relatively high, creating a further barrier to adoption.
Finally, there is no bridge between DeFi and traditional finance. Users must onramp to cryptocurrency via a centralized exchange before entering the DeFi ecosystem, which is an unacceptable amount of friction for many users.
Blocking Out the Biggest Potential Market
While DeFi has vast potential to disrupt traditional finance, there’s a market opportunity that is currently untapped. According to the World Bank, there are 1.7 billion people without a bank account worldwide, the vast majority of whom live in emerging economies. Accenture estimates that there’s a $380 billion opportunity to close the gap between the unbanked and the existing financial system. Furthermore, the SME Finance Forum estimates that there’s a $5 trillion gap to meet the financing needs for micro, small, and medium-sized businesses in emerging economies.
These markets offer far more attractive conditions for DeFi adoption than the established capital markets, where there’s likely to be less of an impetus to transfer value from fiat to cryptocurrencies. With the right packaging and user interfaces, people and businesses in emerging economies could represent a significant opportunity for DeFi, assuming it can overcome the challenges outlined previously.
Furthermore, several cases illustrate that there’s an appetite for digital money solutions in emerging markets. Kenya’s M-Pesa mobile money network has achieved 72% penetration since it launched less than two decades ago. China’s WePay and Alipay have over 1.4 billion users between them.
Building a Bridge From DeFi to Emerging Economies
When considering how to bridge the gap between DeFi and people in emerging economies, the biggest issue is over-collateralization. The traditional markets have ways of assessing credit risk that enable someone to take out a loan without having to stake more than they plan to borrow in collateral. Therefore, this is the barrier that DeFi innovators need to break to tap into the opportunity of reaching the unbanked.
A semi-decentralized solution provides the ideal compromise. Consider that there are three aspects to the financing process that can be either centralized or decentralized. Decision-making involves deciding who gets loans. In DeFi, anyone can get a loan as long as they have enough collateral and the protocol determines interest rates based on algorithms. In contrast, centralized lenders decide who gets a loan and how much, based on credit history. Means of repayment and interest rates are determined based on various factors.
Risk-taking is the second aspect. In centralized systems, banks bear the risk if borrowers default and will attempt to claim repayment through legal means. Whereas in DeFi, the risk is mitigated through over-collateralization. Any risk borne by lenders is distributed across all participants in any particular pool.
Finally, record-keeping in DeFi is reflected in the transaction history on the blockchain. In centralized systems, the banks keep records.
How a Hybrid System Works
In a semi-decentralized system, credit reports from off-chain partners can form the basis of decision-making, allowing users to take out unsecured loans from a decentralized lending pool. Participating lenders determine the interest rates through consensus. If a borrower defaults, the traditional legal process will apply, and any shortfall in repayments is distributed across the lenders in the pool. As the lending pool is decentralized on the blockchain, all records can also be stored on-chain.
Such a hybrid solution taps into the many benefits of socialized lending pools, which encourage community participation through the opportunity to earn interest on savings. Decentralized record-keeping also offers transparency. However, centralizing the least efficient parts of the financing process makes it more efficient and invites broader participation.
If DeFi is to bridge the gap to emerging economies and tap into all the opportunities that exist there, it will involve adopting a mindset that doesn’t foster decentralization for its own sake. Instead, innovators must figure out the best solutions to fit the use case, pulling the best from centralized and decentralized solutions.
About the author
Kor Kiang Sean, Co-Founder of Centaur, has five years of technical experience in the blockchain industry ranging from mining rig configuration to smart contract and blockchain development. He first started with hexa-GPU mining rigs for Litecoin and gradually delved into the software side of distributed ledger technologies, working on smart contract development, consensus algorithm design and business use cases for DLTs. Sean has since worked on multiple blockchain projects and provided support with the digital transformation of traditional firms.