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DeFi’s quest to reimagine finance must come from a community-based design

DeFi’s quest to reimagine finance must come from a community-based design

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Source: Coin Telegraph

A more inclusive DeFi lending protocol can empower the unbanked and underbanked in ways traditional finance cannot.

Crypto has seen a rise in novel uses of liquidity mining and rewards through protocols like Uniswap, Aave and Compound. More recently, a new crop of DeFi 2.0 protocols such as OlympusDAO, Alchemix and Abracadabra are exploring new ways of operating without giving up token rewards. 

For all the innovations happening with decentralized systems in crypto, they are still failing to open new pathways for economic prosperity for the most marginalized. In its current form, DeFi remains open only to people who already have access to the financial system and live in countries with strong financial markets. This is evident by the fact that the growth of DeFi has been particularly driven by crypto degens.

As DeFi 2.0 continues to grow, it needs to break free from the historical underpinnings of a financial system predicated upon exploitation and oppression. One immediate way is to reassess lending protocols that require over-collateralization and explore more community-based models for finance that empower everyday people.

Over-collateralized models do not promote financial inclusion

Over two billion people are unbanked or underbanked — disproportionately women, people in poverty and young people. In its current model, DeFi lending protocols rely on over-collateralization. This means that to take on a loan, one must deposit collateral that is of greater value than the actual loan itself.

For example, to borrow 75 Ether (ETH) worth of DAI on Aave, a borrower would need to post 100 ETH of collateral. Loan-to-value ratios across DeFi protocols can range anywhere from 20% to 90% depending on the collateral and asset being borrowed. Over-collateralization exists for three reasons:

  • Underlying collateral is volatile.
  • Borrowers must be incentivized to repay loans in a trustless environment where creditworthiness is unknown.
  • Protocols are designed for people who seek to continue holding their crypto assets while getting access to liquidity.

In response, various DeFi protocols have explored on- and off-chain methods to offer under collateralized loans. On-chain approaches include flash loans, nonfungible token (NFT) collateral, leveraged trading and crypto social scores. Off-chain methods include third-party risk assessments/approvals, connecting to off-chain credit scores, utilizing personal networks and tokenization of real-world assets.

These different approaches, however, do not help the financially excluded access DeFi lending tools. Flash loans are used for crypto trading, and NFT collateral requires owning an asset that is highly speculative (at the moment) or the tokenization of an item that may not necessarily be valuable to someone who is unbanked.

The current crop of off-chain methods offered by groups like Goldfinch, Centrifuge, Teller and ReSource are all targeted towards businesses (which helps to justify the costs of due diligence by lenders) or people who already have credit scores. Crypto credit scores offer perhaps the most potential but possess inherent challenges. First, credit scores can create the same forms of exclusion already in place by traditional credit score systems. Second, people who are limited in resources may find it difficult to build a crypto credit score when DeFi protocols remain largely inaccessible. Overall, DeFi’s over-collateralization structure does little to advance financial inclusion at the individual level — inclusion instead trickles down to already vouched-for businesses.

Related: We still have a lot of work to do on diversity, equity and inclusion

A community-based model for lending

DeFi protocols can tap into community networks and rotating savings and credit associations to better address financial exclusion. A community-based model to DeFi would utilize off-chain and real-world personal networks built on mutual trust, similar lived experiences and shared commitments. In the United States, many of these instances exist in rural parts of the country or communities of color and are led by organizations like the Mission Asset Fund, Native American community development financial institutions and the Boston Ujima Project. And outside the United States, a thriving ecosystem of community-based financing and informal lending groups are a critical source of capital for the unbanked and underbanked. This model of finance is not a new phenomenon, but rather a return to the origins of finance without intermediaries — a system predicated on shared resources and value that DeFi needs to learn from.

A community-based DeFi lending model will need to cater to affordable smaller loans including microloans. For this to be possible, protocols will need to operate on layer one or layer two chains with low gas fees and partnerships with on ramp and off ramp agents such as exchanges, merchant networks and other local businesses. Additionally, DeFi lending protocols must be mobile-friendly given the fact that smartphones are increasingly becoming the primary way in which people access financial services. Desktop-based applications with complex user interfaces are simply not the solution.

DeFi can be particularly powerful for small loans. Traditional lenders are unable to service small loans due to the high overhead costs, including underwriting, loan servicing and technical assistance. DeFi, however, can automate overhead costs away through a decentralized protocol. By focusing on affordable smaller loans, DeFi lending protocols can better leverage off-chain networks of trust.

This can be done by developers in early-stage projects, voters in the governance of more decentralized projects, or general users. For example, developers and voters can help create community pools in partnership with local community organizations in which borrowers’ identities are known. This way members can see who has failed to repay a loan. DeFi developers, voters or users can also help implement mechanisms in which external parties can repay and collect a payment on the back-end in case the borrower defaults. For example, an employer could work with employees to design a scheme in which a borrower’s salary is automatically deducted in case of a default.

Over-collateralization falsely assumes that collateral is easily accessible. Community-based DeFi models can make collateral more accessible. One immediate way is to create stablecoin-based collateralization systems that require a lower loan-to-value ratio. Over-collateralization is only needed to pay off interest since the value of the collateral is expected to stay the same.

A stablecoin-based system can then be tied to more recent developments in credit delegation by protocols like Aave and Moola. Credit delegation allows liquidity providers to transfer their credit to another person, who is then able to take on an under-collateralized loan. Building upon this principle, DeFi protocols could allow for credit delegation to be pooled across people and institutions. This way communities can source enough capital together to create more robust credit delegation opportunities.

Putting all of these pieces together, one possible design for a more inclusive DeFi lending protocol could be the following:

  • Individuals and institutions within a community deposit $110 of DAI in exchange for the collateral token. They then delegate this collateral to a community of known borrowers within their communities. Delegators can see the repayment history of borrowers in their community.
  • The borrower (a basket weaver) uses her smartphone to take on a $100 DAI loan with 10% annual interest. Using this $100, she makes a payment to a local merchant to purchase essential goods such as food.
  • In a month, the borrower has sold some of her baskets. She then converts the local fiat money she received to DAI and returns the $100 loan plus $0.83 ($10 of interest divided by 12). Delegators in the community are notified when the borrower has repaid her loan. If they hold the loan for longer than a year, they or others in the community would have to post more collateral or risk liquidation.
  • The credit delegators in the community receive the interest based on the proportion of the $110 of collateral that they provided.

This loan process is better than a bank’s for members of the community. First, a bank, as an intermediary, would charge significant fees for underwriting, servicing and other overhead. This would have made the loan cost-prohibitive for the basket weaver. Second, the bank would likely take some time to underwrite and deliver the loan, thereby delaying the borrower from purchasing essential goods. Third, and perhaps most importantly, the bank would likely not generate substantial profits due to the small loan size. As a result, it is unlikely that a bank would even offer financial services to the basket weaver in the first place. The DeFi structure creates a system for small loans in what would otherwise be difficult if not impossible for traditional finance.

Envisioning a better DeFi for the future

The example above is simply one possible scenario and utilizes some of the more traditional pieces of DeFi to meet current needs. Community-focused DeFi, however, can be made even more powerful. Anchor institutions or nonprofits could provide loan guarantees or add additional collateral. Additionally, a 0% interest rate is possible if the DeFi pool is limited to members of the community, similar to credit circles. Numerous other options are possible with varying levels of complexity.

It is important, however, to note that DeFi lending cannot be the ultimate source of income for the unbanked and underbanked — like microfinance before, which was once hailed as a way to escape poverty, there are significant limitations. This being said, DeFi lending can help provide critical daily tools for financial empowerment and this impact cannot be understated.

Related: DeFi can be 100 times larger than in 5 years

DeFi is currently on a quest for total value locked (TVL) in a market experiencing explosive growth. But chasing TVL only works for certain users, ones that have the capital to over-collateralize without worrying about the risks. A TVL-centered growth strategy could end up hurting marginalized users who could once again be left behind as people with wealth continue to make money on their wealth. We must evolve from our use of TVL as a metric of measuring success.

The real potential for DeFi will be serving as a transition point for a broader reimagining of finance into one that is not exploitative. This goal will require us to first and foremost understand the tried and true ways that communities manage risk and liquidity in economically low-resourced communities. Learning from them will enable us to develop new mechanisms for DeFi to serve not just the few but the many. DeFi is not the end state but a movement towards mutual credit and DAOs. This is the DeFi 2.0 we desperately need.

This article does not contain investment advice or recommendations. Every investment and trading move involves risk, and readers should conduct their own research when making a decision.

The views, thoughts and opinions expressed here are the author’s alone and do not necessarily reflect or represent the views and opinions of Cointelegraph.

Nikhil Raghuveera is a partner in strategy and innovation at the Celo Foundation where he focuses on DeFi for real-world use cases and financial inclusion. He is also a Nonresident Fellow at the Atlantic Council’s GeoTech and GeoEconomics Centers. His research at the Atlantic Council is on decentralized technology and the intersection of technology, social inequality and systems of oppression. Nikhil has previously worked in management consulting, nonprofit management and economic consulting.

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Author: Nikhil Raghuveera