DeFi and the Financial Inclusion Fallacy

In recent years, financial inclusion has become an all to familiar rallying call to justify a whole slew of tech driven financial services innovations. And nowhere is this promise bolder than in the rapidly growing world of decentralized finance (DeFi) – a system of peer-to-peer financial services built on public blockchains that seeks to disintermediate traditional financial institutions.

Globally, 1.7 billion people are unbanked. Many more only have access to the most basic services. DeFi promises to rewrite this wrong by providing these groups with access to financial services, easily and cheaper.

This ambition is commendable. How could it not be?

But I remain deeply skeptical that it can be realized. In fact, I would go as far as to say, I can’t see how DeFi can move the needle in any substantial way when it comes to financial inclusion.

Intermediation and exclusion

Financial exclusion is a hallmark of our current system. That’s undeniable.

There are a myriad of reasons for this, be it prohibitive costs, out-right exclusionary tactics, a lack of trust in traditional institutions and many more. But the key factor underpinning all the drivers of financial exclusion is the nature of our financial system.

It’s a system governed by centralization and dependent on intermediation. And not without reason. Financial services as we know it today didn’t emerge in a pre-planned, linear fashion. Rather the system evolved, to keep up with our own evolving needs. Intermediation stood-in for trust, allowing market participants to engage in transactions, and do so efficiently – whether that’s time, costs, or effort.

But that also meant, we needed to bolt on an ever more elaborate set of safeguards to mitigate the worst of the risks, inefficiencies, and structural inequalities that came with intermediation. Further baking in intermediation. This dependence on intermediaries – for consumers, to access financial services and for regulators, to safeguard the system – has had the unintended (or intended, depending on your stance on the dividing line) consequence of driving financial exclusion.

Intermediaries have consolidated so much power they can set high-barriers to entry for low-cost consumers. Our financial system’s incentive model has long made serving some of the most vulnerable in society unprofitable. And, regulatory safeguards, even well intentioned ones, have made it virtually impossible for some to access financial services in the first place.

DeFi: The Hero We Need

DeFi makes a simple but compelling claim: To offer the benefits of intermediation, namely trust, without the opportunity costs.

Have your cake and eat it (too)!

Lending, borrowing, securities, derivatives, and even financial use cases we’ve yet to imagine, can all be done, according to its advocates, without intermediaries. It’s a seductive ideal many have already bought into – over 10 million users have downloaded MetaMask, one of the most popular digital wallets for accessing DeFi networks.

So, how does DeFi do this? It’s technology, stupid!

Smart contracts, bits of code that run on a blockchain and are designed to be self-excited when a set of conditions are satisfied, hold the key. The use of smart contracts allows for pre-agreed execution of transactions to occur. In other words, you don’t need an intermediary to trust the other participant(s) in a transaction.

That DeFi networks run on public blockchains means no one entity has control over the network, and every participant in the network can see these transactions – transparency is baked in. No more market manipulation, unfair pricing, and whatever other forms of cheating the system you can think of.

Put that together and you have:

• Participants don’t need intermediaries to hold their assets,
• There are no intermediaries to gate access to these services,
• Power is no longer concentrated in the hands of select intermediaries, rendering them powerless to set prices,
• Intermediaries can’t charge rent on services, i.e. get paid for facilitating transactions,
• And crucially, because DeFi is natively digital, “only” requiring internet access and a device, it frees users from the arbitrary restraints of geographical location and regulators (or authoritarian governments),

And voila – DeFi enables everyone and anyone to have unfettered access to financial services, cheaply.

I call bullshit

When I consider this thread of thinking, there are several fallacies and illogical conclusion that jump out:

1. The notion that DeFi makes financial services cheaper is patently untrue as it stands. It doesn’t take a lot to prove this point either: look at the market now. DeFi networks often charge fees that are steeper than traditional lenders. At the time of writing, for example, the average transaction cost on MetaMask is nearly $4.

2. Basic services like lending can only realistically be accessed by those who have assets, a far cry from financial inclusion. I have yet to see a DeFi lender that lends without collateral, often requiring more than the amount to be borrowed. Banks, for all their faults, have robust credit risk assessment methods because they are centralized. That allows them to lend without any collateral in many instances. In a decentralized system, it’s difficult to see how this can be done, while maintaining limited risk for those staking their assets (those lending to others).

3. Probably the most egregious example of the DeFi’s pledge of boosting financial inclusion is the idea that because it requires only a device and the internet it’s inherently open to everyone. A disingenuous claim. More people in the world have access to bank accounts than the internet: around 20% of people are unbanked, while 37% of people globally don’t use the internet. Square this circle!

4. And then, there’s outrageous dismissal of the need for any semblance of protection. Before it went into bankruptcy proceedings, Celsius, one of the early leaders of the DeFi revolution, announced it was pausing all withdrawals and transfers between accounts.Leaving its users high and dry. And there are numerous examples of this, with consumers losing assets, often with heartbreaking consequences.

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1.Other characteristics of DeFi, like its open-source nature, means increased innovation and competition, among other things, which in theory further bolster financial inclusion, for example by driving prices down.