3 Questions For Decentralized Finance To Scale
By Sidney Powell on ALTCOIN MAGAZINE
A brief summary of the issues which would need to be solved for Decentralized Finance on Ethereum, and crypto lending, in particular, to achieve the product-market fit required to expand usage and financial inclusion.
The lifecycle of a basic loan is stepped through to identify gaps where projects will need to add solutions to improve usability. I then identify projects working on these issues. If you’re working on any of the issues hopefully this provides food for thought or an opportunity to collaborate. The basic questions are:
“How can I apply for a loan if I don’t own Ether?”
“How can I use the loan to pay for things?”
“How can I repay the loan?”
This article is the product of sitting down to write a proposal for a project I’m working on which aims to lower the barriers to entry into finance for microlenders. If successful, the project would enable thousands of small ‘banks’ to operate globally across many decentralized lending platforms.
The objective in writing it out was to identify gaps in my assumptions and reasoning. From that perspective, it was depressingly effective in unearthing non-trivial problems for DeFi products to overcome before they hit product-market fit and are considered better than traditional financial products.
The article’s premise is that someone outside the conventional banking system applied for a cryptocurrency business loan. It steps through application, drawdown, use, and repayment, identifying practical design questions along the way.
I have written previously about how identity verification, whether self-sovereign (SSI), trusted third-party (TTP) or otherwise, is the key issue standing in the way of the market for blockchain lending, but it is now clear from conducting this exercise that several other hurdles remain.
Our would-be borrower is Alice. Alice is from a country without a developed financial system, runs a small business and would like a loan for additional inventory and staff. The loan will be denominated in DAI, the stablecoin pegged to the value of the USD. Alice holds no Ether so she can’t take out a CDP, she does, however, have a smartphone, SIM card, and internet access. Deciding against using local loan sharks, Alice has researched decentralized finance to see if it suits her funding needs. She begins an application.
1. How Can I Apply For A Loan?
Alice has the following forms of government-issued and digital identification: Facebook, Gmail, Twitter, a drivers’ license and a smartphone for two-step authentication.
The regulation requires a prospective blockchain lender to conduct an AML-CTF/KYC check to verify Alice’s identity and that she is not on any watchlists. They could currently do this using Identity as a Service (IaaS) providers like Blockpass, Jolocom, Bloom or Colendi (which also aims to build a digital credit score). These protocols build an identity profile from a person’s online accounts, pair the profile with government-issued identification and authenticate it via email or smartphone.
Presently, no lending platforms offer unsecured crypto loans (yet) because of the vulnerability to Sybil fraud when lending to pseudonymous addresses (I could take out a loan, not repay you and then apply for another with a different alias) and the burden of KYC compliance. One means of preventing Sybil fraud requires borrower’s identities to be blacklistable and for the blacklist to be shared between lending platforms. Implementation would require lending platforms to integrate with one or more of the IaaS providers above, which has not occurred at the time of writing but there is nothing preventing this from occurring. Any lending platform using an IaaS solution would need to due diligence the verification practices and procedures to ensure they meet regulatory standards.
Lending platforms also have the alternative option of conducting their own KYC checks, though this is costly and can require significant in-house resources. I have not seen steps made in either direction, though given that multiple mobile-first IaaS products do exist, hopefully, this is just a matter of time. The table below captures the button issues above and projects tackling them.
Returning to Alice, to progress her journey we will assume that a new peer-to-peer unsecured crypto loan provider has launched their product in partnership with Bloom. Alice downloaded the Bloom app to her Android phone and populated her profile using Gmail, Facebook, Twitter. She wasn’t able to add her driver’s license because curiously Bloom hasn’t added this feature yet. Nonetheless, using her Bloom profile, she was able to obtain a P2P loan for 500 DAI and store it in the Metamask wallet app on her smartphone. Now Alice would like to know how to get the money out so she can spend it.
2. How Can I Use The Loan To Pay For Things?
This is a particular problem for microfinance lending, “banking the unbanked”, which happens to be a much-lauded application of DeFi. It is an issue because the unbanked don’t have access to the infrastructure to easily enter and exit the crypto economy — they can’t simply log in to crypto exchange and withdraw in their local currency with a bank transfer.
Alice, having received DAI, now needs to be able to convert it to her local currency in order to pay her staff and pay for inventory. She could pay her staff in DAI but this just pushes the problem downstream as they would still need to convert to fiat.
To provide a means for spending the DAI, borrowers need either:
- accessible crypto-to-fiat on and off-ramps, or
- the widespread acceptance of payment in cryptocurrency.
Option 1: On and Off-Ramps
In developed countries, DAI can be converted to fiat through centralized fiat-to-crypto exchanges like Coinbase, Kraken, Bitstamp, Gemini, and Bitfinex. Many in developing nations do not have access to these exchanges because bank accounts are required to deposit and withdraw from the exchange. The favored solution is the peer-to-peer exchange service, Localethereum, which preserves anonymity, and allows multiple for users to settle which do not require bank accounts. These include in-person cash exchange, M-PESA transfer, or Amazon/Google gift cards. Whilst clearly a valuable service, there is obvious friction in its use.
Using existing infrastructure:
- Alice would need to convert her DAI to ETH using Uniswap or Kyberswap. She will need a small amount of ETH to pay for gas, crypto-loan providers may consider including this in the initial drawdown for stablecoin loans.
- Alice will then use Localethereum to find someone willing to pay cash for ETH and meet in person to settle the transaction. Localethereum offers an escrow service, so once Alice confirms receipt of the fiat, she can authorize the release of the ETH to the counterparty. If a dispute arises then localethereum.com acts as an independent third-party mediator.
Determined users such as Alice will use this means of converting the loan into a form they can spend in, but the high degree of friction (and implicit fees/spreads) will deter many from using crypto lending until fiat-crypto exchanges are easy to use without an existing bank account.
The way forward here may be through SIM-based financial services like M-PESA, which allows transfers and savings accounts through your mobile without a linked bank account. Alice could then receive fiat via a mobile transfer without a bank account (M-PESA does still perform KYC checks at on-boarding), making it easier to use her loan.
Option 1 thus appears preconditioned on smartphone penetration and SIM-based financial services (for fiat currency). The hockey stick trend in smartphone penetration and adoption of services like M-PESA encouragingly suggests that SIM-based banking may furnish crypto on-ramps to the unbanked.
This does beg the question, however, if centralized exchanges continue to use bank transfers as the primary channel for conversion to fiat, how can decentralized finance grow any faster than the pace at which the traditional financial system absorbs the unbanked?
Option 2: Widespread Acceptance of Digital Currencies
Interesting work in this space is being done by the team at Sempo. Sempo are trialing a pilot program in the Pacific Islands using DAI to deliver foreign aid to the local population. How it works is that the foreign aid (denominated in DAI) is placed into a reserve smart contract, from which a synthetic digital version of the local currency (using UMA Protocol) is minted and issued to the aid recipients. The synthetic local currency can be spent by the population in on-boarded stores using NFC chip-enabled cards which vendors accept payment from using smartphones as merchant terminals.
Redemptions of the synthetic local currency for the DAI reserve would only need to occur if a local vendor wanted to transact in a foreign currency and couldn’t find someone to exchange the synthetic currency for cash (which theoretically should be at parity). In the ordinary course of affairs, the DAI could remain locked and the synthetic local currency traded indefinitely in the local economy. For this to occur, the adoption of the synthetic currency needs to cross a tipping point at which it is accepted-enough to have utility as a medium of exchange.
Returning to Alice’s case, after she receives her DAI loan, she can use UMA to lock it as a reserve and mint synthetic tokens of her local currency at the prevailing exchange rate of DAI/USD and USD/local currency. The synthetic currency is held on Alice’s smartphone. When she wants to make a purchase she can transfer to a vendor’s wallet with a QR code. To pay staff Alice needs to either convert from synthetic into cash with a counterparty that can receive her digital transfer of synthetic currency and pay her cash fiat in return, or her staff need to have wallet accounts to receive the synthetic currency directly.
The widespread acceptance of stablecoin versions of existing fiat currencies and exploitation of smartphones as payment channel will be a powerful combination. The slowest part here will likely be the acceptance of synthetic digital currencies as tender within local economies.
It is worth also noting the work done by Synthetix in offering a decentralized platform which allows the minting of synthetic stablecoins of fiat currencies. Synthetic versions of the USD, GBP, EUR, JPY, CHF, AUD, and KRW are all currently available and tradeable.
3. How Do I Repay You?
Assuming that Alice was able to navigate the process of converting DAI into fiat cash, she has been able to use her business loan successfully to hire staff and expand her inventory. The move paid off and business is booming for Alice. She now needs to repay the loan and can do so by reversing the steps above.
Find a counterparty on Localethereum, pay them cash fiat and have them transfer ETH to her Metamask wallet, then swap into DAI using Uniswap and transfer DAI to close out her loan contract.
Solved Questions and Conclusion
While the three problems above highlight the hurdles still to be overcome for Decentralized Finance to extend financial inclusion and borderless banking, it is also worth taking stock of the successes to-date.
As you would expect for a financial system being incubated on the internet, the first successes have come from projects which can exist in the closed crypto ecosystem without strong interaction with the traditional financial and legal system. This includes crypto-to-crypto exchanges (Uniswap and Kyberswap), overcollateralized lending (Maker, Compound, Nuo, Dharma, and dYdX) and trading on margin (dYdX and Market protocol).
It is also worth calling out that the projects currently enjoying the most success are those which have relied on pooling (Compound, Maker, and Uniswap) rather than order matching (Dharma, RadarRelay). These products are advantaged in smaller markets where less liquidity is required for smooth operation because they do not require exactly offsetting trades for transactions to be processed. The fact that they have achieved product-market fit while volumes on platforms using matching protocols have languished, reinforces how early we still are in the space.
Reaching the next stage for Decentralized Finance will require projects to take the first tentative steps off-chain. This involves solving issues of identity verification, payment channels and will likely require a greater degree of engagement with law-makers and regulators in jurisdictions because the products will have a more visible impact on local commerce.
If you know of any other interesting projects not included in the article please feel free to reach out here or via Twitter.