Credit is hard to come by for the financially disadvantaged, but the new wave of decentralized finance could expand access and inclusiveness.
By: Parker Spann
Telcoin’s mission to provide the under-banked with low cost, high quality financial services begins with affordable and fully digital remittances — but does not end there. Affordable money transfers are a key building block to global financial inclusion; equally important are lending, savings, and investment solutions. This series will explore the various technologies that will propel consumer finance in the developing world and the target markets which need it most.
Credit Invisible
Seemingly a relatively recent phenomenon, consumer credit is as old as civilization itself. Originating in 3500 BC in Sumer for agricultural purposes, it was codified for the first time in 1800 BC Babylon in the Code of Hammurabi. There is a viable argument to be made that credit is the foundation of technological progress and the high standards of living which we enjoy today: we use it to buy homes, start businesses, and finance productive assets like work trucks.
Though consumer credit was invented thousands of years ago, credit reporting was invented in the early 19th century by a group of English tailors who came together to swap information about customers who failed to settle their debts. Today, each individual is assigned a “credit score,” which is a number used by lenders as an indicator of how likely a consumer is to repay their debts and their probability of going into default.
In the modern system, getting a bank loan is no easy task. Borrowers generally need to go through a time-intensive process involving piles of paperwork and background checks. If you fail to pay your debts in a timely fashion, your credit score goes down and future loans are likely to be tagged with a higher interest rate.
If you have no credit history or collateral — an asset used to secure a loan — you are “credit invisible,” meaning you will find it extremely difficult to access capital. Even if you manage to be approved, rates will be prohibitively high. Obtaining a large loan like a home mortgage may be impossible.
According to The World Bank, about seven percent of Sub-Saharan Africans can access formal credit, versus 29 percent of Americans. Even in the United States, there are roughly 26 million credit invisible consumers, meaning they have no credit history and are much less likely to receive loans. Lacking access to mainstream credit, credit invisibles are vulnerable to high-priced credit such as payday loans, buy-here-pay-here auto loans, lease-to-own, and other ‘informal’ high-rate lending products.
In India, the average interest rate on a payday loan is between one and one-and-a-half percent per day. On an annualized basis, this works out to an astronomical 360 to 540 percent per year.
Even further, the CFPB estimates that 80 percent of payday loans are rolled over or followed by another loan within 14 days. One out of two borrowers end up taking at least 10 more loans before they are debt-free.
To summarize, good debt can drastically improve people’s lives while bad debt can absolutely destroy them. The financially under-served are in a very difficult position to obtain loans in the modern consumer credit system. They are credit invisible at alarmingly high rates which can lead to a vicious cycle of wealth destruction.
Enter DeFi
The first widespread use case of the Ethereum network was capital formation. With a few lines of code and a vision for the future, teams can programmatically raise capital from anyone in the world instantly, across borders without any need for the legacy financial system or middlemen. Around US$25 billion dollars was raised by projects across all verticals of blockchain using this method in 2017 alone.
This funding enabled the creation of a wide spectrum of applications, but none have proved quite as useful as decentralized finance (DeFI), or financial software built on the Ethereum blockchain. Imagine a global, open alternative to every financial service you use today — savings, loans, trading, insurance and more- accessible to anyone in the world with a smartphone and internet connection- that’s DeFi. This category includes peer-to-peer (P2P) lending and borrowing, insurance, asset exchange, savings, investments, derivatives contracts, and stablecoins.
Let’s dive into the lending vertical of DeFi, its advantages, how it might solve problems with the modern consumer credit system, and its drawbacks.
Structural Components of the DeFi Lending Market
DeFi-based lending systems differ quite substantially and improve on traditional banks and non blockchain-based fintech P2P lending companies in a number of important ways.
Interest rates: Unlike interest rates in the legacy financial system, which are set by layers of intermediaries including the central bank, retail banks, and more, DeFi borrowing costs are dynamic and variable based on supply & demand and your collateral ratio. The lowest 30 day average borrowing cost for a USD pegged stablecoin in DeFi currently sits at 1.32 percent APR while the average lies around 4 percent APR (Annual Percentage Rate).
Accessibility: While typical bank loans require mundane effort, highly scrutinizing processes, and verification from scores of middlemen, Ethereum-based lending protocols are entirely open and accessible to anyone with an internet connection and digital wallet. There are no credit checks, bank account verification, or employer verification. If you have the proper collateral ratio, you can simply borrow from a global pool of capital with a few clicks of a button regardless of your local financial system’s health and without permission from your local lender & credit agency. Whereas traditional P2P lending companies generally only allow institutional and accredited investors to lend capital, anyone can participate in DeFi.
Automated: Smart contracts, or self-executing contracts made up of computer code, connect borrowers and lenders directly. Smart contracts connect the lenders to borrowers, enforce the terms of the loans, and distribute the interest. And it all happens without the need to trust one another or rely on a middleman bank and its employees. And, by cutting out the middleman, lenders can earn higher returns and more clearly understand the risks thanks to the transparency blockchain provides.
Non-Custodial: With Defi lending protocols, users maintain ownership of their assets and can exit at any time.
Open Source & Secure: Code is entirely open source for anyone to verify, and all of the major protocols have been audited. You can also compare the various platforms on sites like DeFi Score, Defi Rate, and DeFi Pulse.
Global High-Interest USD Savings Accounts: According to the FDIC, the average yield of a savings account 0.06 percent APY whereas Money-Market accounts yield an average of 0.09 percent. Some countries like Japan, where the Deposit Interest Rate is -0.14 percent APY, have negative interest rates where consumers pay banks to store their deposits. At today’s rates, you can lend out USDC, an Ethereum-based USD stablecoin, at an average of 3.5 percent APY across all platforms. When you factor in global accessibility, negative interest rates, and historically rising inflation in places like South America and the Caribbean (an avg of 7.1 percent in 2019), DeFi lending platforms become extraordinarily compelling as tools for global financial inclusion.
The State of the DeFi Lending Ecosystem
According to DeFi Pulse, there is currently US$1.35B USD worth of collateral locked in ethereum for outstanding loans, up nearly 100 percent since my last blog post just 2 months ago. Collateral types range from ETH (the native cryptocurrency of Ethereum), USD-backed blockchain assets, WBTC (Bitcoin tokens collateralized on the Ethereum network), and dozens of others.
Credmark’s “The Crypto Credit Report 2019” posits there was a greater than 200 percent growth in the number of unique DeFi borrowers from 5,137 in Q1 2019 to 16,812 in Q4 2019.
While the numbers clearly indicate that the DeFi lending ecosystem is growing and maturing, the primary usage of these systems is more likely a combination of whale stakeholders contributing liquidity, margin traders seeking on chain leverage, traders deferring taxes, and yield farmers arbitraging interest rates and token inflation to seek high rates of return.
These use cases undoubtedly bring value to existing crypto users, but the people who need access to affordable credit the most — the credit invisible — still struggle to reap the benefits that DeFi promises to unlock. Telcoin’s first product, fast & affordable remittances, with a strong focus on the developing world, will position the company to offer additional digital financial products in the future — with a captive audience that will undoubtedly include many of the “credit invisible.” A future lending product captive to the Telcoin app would help ensure that DeFi becomes a true financial inclusion effort on a global scale.
