Decentralized finance refers to a financial system that merges the services provided by traditional banks with next-generation technologies such as blockchain and cryptocurrency.
With these unique foundations, DeFi is able to serve the needs of businesses and consumers, providing them with access to lending, savings and checking accounts, trading, interest generation and more, all without the involvement of a centralized third-party.
The popularity of DeFi has grown rapidly and today it offers rival services to almost every facet of the traditional banking sector. One reason for this is that DeFi is helping people who live in remote areas to gain access to money and credit through a safe and trusted medium. It has also created new and unique opportunities for people to generate a profit that they cannot obtain elsewhere.
One of the key challenges with traditional finance is access. To open a bank account, an individual is required to show official identification. To be approved for a loan, one must have a suitable credit score, income and fulfill other requirements. That person may well have a lump sum of cash required to cover that loan, but they won’t be approved if they don’t meet the bank’s strict requirements. For anyone determined by their bank to be eligible, it means they’re out of luck.
Being Unbanked Is Uneconomical
What’s shocking is that in today’s day and age, there are billions of people around the world who’re unable to open a bank account due to the stringent rules of the traditional financial system. A 2017 report from the World Bank Index estimates that there are approximately 1.7 billion adults across the globe who do not have a bank account. While people living in under-developed nations make up the bulk of this number, there is an alarming number of unbanked people living in developed nations who also lack access to a bank account.
Admittedly not many people enjoy their dealings with the bank. They cause a fair amount of headaches and they make a lot of money from their customers, but very often not having a bank account is worse for someone’s financial health. Without a bank account, people are unable to perform financial transactions that many take for granted, such as cashing a check, saving money and taking out a loan. They’re forced to carry cash everywhere they go and endure the risk that carries, including higher fees.
In the USA for example, only 40% of adults own a passport, while just 75% possess a driving license. As a result, many people there lack the ID to open a bank account. According to data from the FDIC, around 25% of American households are either unbanked or underbanked.
This can have a devastating toll from an economic perspective. Although prepaid cards have lessened the impact of this, some 70% of payroll in the U.S. is still done using paper checks. For those unable to deposit this into a bank account, they’re forced to use a check cashier service that will charge high fees for the privilege of turning it into cash. Given that most unbanked tend to be in the lower income bracket, those fees can eat up a big chunk of their earnings.
The unbanked in the U.S. are also subject to more predatory lending practices. While someone with a bank account and a high credit score can borrow at around 3% to 6% interest, those who’re forced to rely on so-called payday loans can pay anything from 300% to 400% to borrow much-needed cash.
Meanwhile in the developing world, the ability to get out of financial strife is closely correlated with access to affordable credit. In South Africa, access to credit can have a dramatic change on someone’s economic prospects, allowing them to take out a loan to buy farmland and grow crops, buy a car to commute to work, or pay to acquire an education. But for many that’s a non-starter as they lack access. Very often, being unbanked causes financial inequality at its worst and can have a devastating impact on the quality of people’s lives.
How DeFi Can Make Finance More Accessible
The reason so many people are unbanked is primarily due to systemic issues within the traditional banking industry. Banks are profit-oriented institutions and they have a financial incentive to make their services available to anyone who can afford them. At the same time, there’s a disincentive for banks to provide their services to those without ID and credit.
With decentralized finance cutting out the middleman and relying instead on blockchain technology, it can facilitate transactions between two parties in a way that’s safe and very inexpensive. Traditional finance has considerable entry barriers, such as its costly fee structure and the requirement for ID, whereas DeFi is accessible to anyone with a smartphone. DeFi requires little infrastructure too. Whereas a bank would need to build a physical branch to make its services available in remote regions, all that’s needed to access DeFi is a basic WiFi service. Moreover, DeFi can function 24/7, unlike traditional banks that only open their doors from 9 to 5. This means transactions can be made at any time, and they’re processed much more quickly than traditional financial dealings take place. Because DeFi is automated, transactions are much cheaper too. So, while DeFi provides much of the same services as traditional finance, it’s also far superior in many aspects.
These characteristics make DeFi accessible to anyone and everyone, without the need for a bank account, KYC checks or any other kind of evidence. This, combined with its transparent rules, which are observed by smart contracts, creates new opportunities for the unbanked to tap into the world’s financial ecosystem.
Besides simply depositing money and saving it, people can use DeFi products to send money to other countries, to obtain a microloan, or participate in micro investments and create a passive income stream. What’s especially clever about DeFi is that the infrastructure carefully distributes the risk of these investments, such as providing capital for a loan, equally among multiple investors who finance it, meaning no one has to assume all of the risk.
DeFi is therefore especially appealing to an unbanked entrepreneur in a developing country, as they can utilize its services to obtain funding for their nascent business from investors located anywhere in the world.
Why Regulation Will Be The Enabler
The potential of DeFi is clear and yet it still has its shortcomings at this time. One of the biggest challenges is the lack of regulation – a problem that deters many investors from participating in DeFi ecosystems.
A lack of regulation is often correlated to a lack of security, and there has certainly been very many incidents within the emerging DeFi sector. In most of the publicized security incidents, investors lost money due to issues with smart contracts, validators or other problems. Some recent examples include the Mirror Protocol breach, which resulted in $90 million of user’s funds being lost, or the Saddle Finance smart contract exploit that led to another $11 million loss. Then there are exit scams too, such as BreedTech, where the founding team simply stole around $9.4 million of early investor’s cash. The big problem with such incidents is there’s no way for investors to recover their funds once they’ve been stolen, and there won’t be until DeFi becomes more regulated.
This is why there’s a lot of hope for projects such as Phree, a newly emerging decentralized and compliant liquidity ecosystem that has the goal of bringing regulation to the DeFi space. What Phree aims to do is bridge the gap between DeFi and the compliance found in the traditional financial space in order to make it more appealing to the massive amounts of liquidity held by institutional investors and banks.
As Phree points out, while DeFi’s growth has clearly illustrated its potential, it will only realize its ambitions to bank the unbanked if it can tap into mainstream finance. But that won’t happen so long as issues around risk, security, fraud, price manipulation and the lack of KYC and AML are not addressed.
Phree promises to solve these problems with a compliant DeFi ecosystem-as-a-service platform and licensed asset manager that can build permissionless and transparent protocols that will attract mainstream investors. It has made strong progress too, working with partners such as Parity Technologies, the company behind the Polkadot blockchain, PwC Switzerland and Mastercard in preparation for a 2023 launch of its platform, which will include its own regulated, asset-backed stablecoin.
By building a compliant DeFi platform, Phree hopes to be able to address questions around what happens when theft occurs as a result of smart contract vulnerabilities and scams, giving users greater peace of mind. At the same time, regulation will reduce the incidence of rug pulls, as non-compliant DeFi protocols will struggle to attract investment.
While many continue to argue against compliance and regulatory control in DeFi, claiming that implementing it is impossible due to its decentralized nature, the fact is there is always an entry or exit ramp to traditional finance somewhere. That’s where the opportunity lies and it’s there that companies like Phree are building solutions.
For DeFi to go mainstream some kind of regulation is both desirable and necessary. DeFi represents the single greatest hope for millions of unbanked people to get fairer access to finance and improve their financial prospects. That alone is good enough reason to do what is required to ensure DeFi achieves its potential.
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