Cryptocurrencies have seen a surge in the use of liquidity mining and new rewards through protocols like Uniswap, Aave, and Compound. More recently, a host of new DeFi 2.0 protocols such as OlympusDAO, Alchemix, and Abracadabra are exploring new ways of working without sacrificing token rewards.
With all the innovations that are happening in decentralized systems in cryptocurrencies, they still fail to open up new paths to economic prosperity for the most disadvantaged. In its current form, DeFi is still only open to people who already have access to the financial system and live in countries with strong financial markets. This is evident from the development of DeFi, which is particularly driven by crypto-degens.
In the course of the further development of DeFi 2.0, it must break away from the historical foundations of a financial system based on exploitation and oppression. One immediate option is to reevaluate over-secured credit logs and explore more community-centric financial models to empower people on a daily basis.
Mortgage loan models do not encourage financial inclusion
More than two billion people have no or no bank account – disproportionately women, poor and young people. In its current model, the DeFi credit protocols are based on overcollateralization. In other words, in order to borrow money, you have to provide collateral that is worth more than the actual loan.
For example, in order to borrow DAI worth 75 Ether (ETH) on Aave, a borrower must deposit 100 ETH collateral. DeFi protocols loan-to-value ratios can range from 20% to 90% depending on the collateral and assets loaned. There are three reasons for over-indebtedness:
- The underlying collateral is volatile.
- Borrowers must be incentivized to repay loans in an unreliable environment with unknown creditworthiness.
- The logs are intended for people who want to continue holding their crypto assets and still have access to liquidity.
In response, various DeFi protocols have explored on-chain and off-chain methods of providing secured credit. Online approaches include instant loans, non-fungible token (NFT) collateral, leveraged trading, and crypto social scores. Off-chain methods include third party risk assessment / approval, connecting to off-chain credit ratings, using private networks, and encrypting real-world assets.
However, these different approaches do not help financially marginalized people access DeFi credit instruments. Instant loans used to trade cryptocurrencies and NFT collateral require owning a highly speculative asset (currently) or the cryptocurrency of a commodity does not necessarily have to be of value to non-bankers.
Existing off-chain methods offered by groups like Stieglitz, Centrifuge, Teller, and ReSource are all aimed at businesses (which eliminate the cost of lender due diligence) or those who already have credit. Cryptocurrency creditworthiness is perhaps the most promising, but there are inherent challenges. First, credit ratings can cause the same exclusions as in the traditional credit rating system. Second, those with limited resources can struggle to build crypto credit scores when DeFi protocols are inaccessible. Overall, the over-secured structure of DeFi does not contribute to accelerating the financial inclusion on an individual level – instead, the inclusion is reduced to companies that are already secured.
Related: We still have a lot to do on diversity, equity and inclusion
Community-based credit model
DeFi protocols can permeate community networks and rotate savings and credit unions to better address the problem of financial exclusion. A community-based DeFi model would leverage off-chain and real private networks based on mutual trust, similar life experiences, and shared commitments. In the United States, there are many such cases in rural areas of the country or in colored communities and are led by organizations such as the Mission Asset Fund, Financial Institutions for Native American Community Development, etc., and the Boston Ujima Project. And outside of the United States, a thriving ecosystem of crowdfunding and informal lending groups is a major source of funding for the bankless and underbanking. This financial model is not a new phenomenon, but a return to the roots of zero media financing – a system that is judged on shared resources and values that DeFi must learn.
The DeFi community-based lending model needs to take into account smaller, affordable loans, including microcredit. To be able to do this, protocols must operate on a Layer-One or Layer-2 chain with low gas charges and partnerships with on-slope and standard agents such as exchanges, networks, etc. Network of dealers and other regional companies. In addition, DeFi credit protocols need to be mobile-friendly as smartphones become the main gateway to financial services. Desktop-based applications with complex user interfaces are not a solution.
DeFi can be particularly powerful with small loans. Traditional lenders are unable to service small loans due to high overhead costs including underwriting, lending services, and technical support. However, DeFi can automate overheads through a decentralized protocol. By focusing on smaller repayable loans, the DeFi loan protocols can make better use of off-chain securitized networks.
This can be done by developers in early stage projects, voters in managing more decentralized projects, or users in general. For example, developers and voters can help create community groups in partnership with local community organizations that know the identity of the borrower. This allows members to see who has defaulted on the loan. DeFi developers, voters or users can also help with the implementation of mechanisms whereby external parties can repay and collect a payment at the backend in the event of a borrower’s default. For example, an employer could work with their employees to create a plan that automatically deducts a borrower’s wages in the event of default.
Over-indebtedness incorrectly assumes that collateral is easily accessible. Community-based DeFi models can make collateral more accessible. One immediate option is to create stablecoin-based collateral systems that require lower loan-to-value ratios. Over-indebtedness is only necessary to earn interest, as the value of the collateral is likely to remain constant.
A stablecoin-based system could then be tied to recent developments in credit approval using protocols such as Aave and Moola. Loan approval allows liquidity providers to transfer their loan to someone else who can then obtain an unsecured loan. Based on this principle, DeFi protocols can enable the bundling of credit decentralization between individuals and institutions. In this way, communities can come together to raise enough funds to create better credit approval opportunities.
Putting all of these pieces together, one possible design for a more comprehensive DeFi credit protocol could be:
- Individuals and organizations in the community deposit 110 DAI in exchange for security tokens. They then entrust this collateral to a well-known community of borrowers in their community. Agents can view the repayment history of borrowers in their community.
- The borrower (a basket weaver) borrows 100 DAI with her smartphone at an annual interest rate of 10%. With that $ 100, she pays a local vendor to buy essentials like groceries.
- In a month, the borrower sold some of her baskets. She then converts the local fiat received into DAI and pays back the $ 100 loan plus $ 0.83 ($ 10 interest divided by 12). Community delegates will be notified when the borrower has repaid their loan. If you hold the loan for more than a year, you or others in the community must provide additional collateral or liquidate the risk.
- The community credit unions receive interest based on the rate of $ 110 on the collateral they provide.
This lending process is better for citizens than banking. First, as an intermediary, a bank charges significant subscription, service and other fees. This would make the credit unsustainable for basket weavers. Second, the bank may take some time to guarantee and transfer the loan, causing the borrower to delay the purchase of essential items. Third, and perhaps most importantly, the bank is unlikely to make any significant profit due to the low volume of credit. Therefore, a bank is unlikely to provide financial services to basket weavers at all. The DeFi structure creates a system for small loans under conditions that will be very difficult …