DeFi In El Salvador—The Challenges of Banking the Poor in Latin America
With El Salvador officially considering Bitcoin legal tender September 7, 2021, we decided to take you on a deep dive into what this means and where we’re heading as a result.
There was a time when cash was king, but it is now a diminishing payment system in developed countries. For example, debit and credit card payments constitute 55% of all point of sale payments in the US. In the UK, 53% of payments are card-based.
The current move in these regions is contactless payments, where users only tap cards or pay via their mobile wallets. Here, people only choose cash payments over convenient plastic and mobile payments due to philosophical arguments such as “credit card use locks users in a debt cycle.”
Others may choose not to use cards to trim their spending. Tap-and-go payment technology is so easy and quick that payments rarely feel tangible. Cash users, however, have to walk into a bank, make a queue and withdraw hard bills. They have to get to the bank before closing hours and perhaps fill in some forms.
For this reason, the stateless and poor, experimental, and perhaps the jaded plastic money user opts for cash payments. According to FDIC data, 95% of households in the US are banked.
Only 5.4% of the US adult population remains unbanked, a large chunk of it being earners. On the other hand, the number of UK households with savings or banking accounts is 97%.
The Unbanked in Latin America
Going cashless might feel like a trap for the financially wary in developed countries, but it is a luxury in Latin America. 70% of the adult population here is unbanked. South America has a complex relationship with the global financial system, leading to massive financial exclusion of its people. A large part of this complexity is historical.
The Latin American debt crisis of the 70s and 80s, a period referred to as La Década Perdida or the Lost Decade, led to the collapse of many of the region’s economies. By 1982, commercial bank and external debt grew and overtook the region’s gross domestic product.
Consequently, debt service surged in response to growing global interest rates, breaking the back of many Latin American economies. Deprived of liquidity, these countries’ debt levels grew by more than 1000%. As a result, their currencies lost their purchasing power leading to inflation, rampant unemployment, and negative or stagnated economic growth.
Causes of the Wide Financial Gap Between the Banked and Unbanked
The gap between the rich and poor increased dramatically, leading to an increase in political instability and social vices. Unable to rebuild their countries in ruin due to high debt payments, these countries turned to the IMF for relief.
However, IMF loans for unpaid debt led to reforms that increased government intervention, further increasing poverty and inequalities. Governments were also forced to implement austerity plans that lowered spending, shattering any remaining social structures such as banking and industrialization.
While 1/3 of commercial bank debt was written off by 1994, the scars of the lost decade still plague many of Latin America’s residents. As an illustration, the Federal Reserve recognizes that in their effort to keep banks exposed to debt from becoming insolvent, some regulators weakened their stance to large banks. Declining regulation forestalled an all-out panic in the banking system, but it weakened market discipline.
The Results of Decades of Poor Banking Systems
1. Centralized banking monopolies
A clear example of weak regulation is the conformation of a banking monopoly. Much of the region’s financial systems have been in the hands of a few players. “The region’s governments have long allowed the concentration of banking power to be in the hands of a few because of fears that the system might go haywire if the market were too free and competitive.”- Ozy.
Brazil, for instance, prohibited foreign investment in banking in the past. Foreign financial institutions could only invest in Brazil via a presidential decree. This rule, however, changed in 2019, and their central bank has taken over this task.
2. Low innovation
As a result, the old guard has grown immensely profitable but has not innovated to keep up with the industry’s technological strides in other parts of the world. According to Albo’s CEO, Angel Sahagun, these banks “have obsolete tech; they don’t care about people, and lots of features are profitable but bad for the customer.”
Customers, for instance, have to make long lines in the bank and physically approve simple banking transactions such as wire transfers. In addition, bank account holders pay hefty fees for their transactions and have little mobile or tap-as-you-go technology.
3. Low financial penetration
LatAm has historically not embraced international trade, lowering financial penetration. For this reason, most people cannot access the convenience of checks, plastic, credit, or any form of financial services. They also cannot save for their retirement or buy assets such as homes.
One other influence of weakened banking regulations is mistrust in the banking system. The region’s banking crises and bank runs have left a deep chasm between customers and banks such that most of them would rather save their money under the mattress. Lack of trust and money is the biggest reason Latin Americans do not have a formal savings account.
As an illustration, in the 2000s, the Argentinian government froze bank accounts, stopping withdrawals. This action has created such uncertainty that most Argentinians convert their peso to USD and stash it at home.
While it is quite easy to open a bank account in the UK and the US, this process is complicated in Latin America. For example, you could need proof of citizenship and a job to open an account. You will also need to fill multiple forms.
Some banks only offer account opening opportunities to the top 20% income bracket employees, excluding the general public from the banking system. As per World Bank data, poverty disproportionately affects the indigenous communities that make up 8% of LatAm’s population due to lower education levels and lower access to jobs and financial services.
Should you access credit or debit card facilities, you will have to endure hidden charges that target the poor. For this reason, the use of inconvenient payment methods such as hard cash is the only option for most LatAm residents.
Efforts of the Latin American Governments
A game-changer has been the growth of mobile phone use and increasing internet connectivity in Latin America. As an illustration, El Salvador has a population of 6.4 million. There are over 9 million mobile phone connections in the country. In addition, 3.80 million of the population has mobile internet access. As a result, El Salvador has an internet penetration rate of 59%.
For this reason, the region is turning into a fintech hub. Fintechs are mobile and have stayed away from the cumbersome traditional banking branch-based model for efficiency. An example of this is Brazil, where there are currently more online banking applications and fintechs than physical banks. A tendency that is set to continue increasing.
They also receive a lot of foreign investment since the demand for financial services amongst the unbanked but tech proficient youth is high. Moreover, governments in Latin America are lowering regulatory barriers of entry, encouraging these agile banking sector competitors to step in and help deal with the large-scale financial inclusion problem in the region.
Neobanks have attracted many millennials who would rather not use the slow, stuffy services of traditional banks. They no longer need to endure bureaucracy where paying a simple bill translates to an everyday chore.
Their services help their users receive their wages, pay their bills, and make online purchases. They also give their users more control over their savings and open them to the global market.
The Problem with Alternative Banking Systems in LatAm
Microcredit institutions should only serve as a band-aid. The responsibility of banking the masses should not be delegated to centralized private entities. Unfortunately, most Latin American governments have barred foreign banks and embraced microcredits, further neglecting their citizens to unregulated financial systems. By 2018, over 1166 Fintechs were running in 18 LatAm countries. 24.4% of these startups’ revenues come from remittances and payments.
FINCA and Acción, for instance, have put in over three decades of work in uplifting the poor in Latin America. They have focused on raising the financial status of women by giving them soft loans, keeping them from the “loan shark” lender menace.
Besides all their efforts, most Latin Americans still live in poverty because the governments have failed to protect the welfare of their people. Moreover, microcredit institutions and Neobanks are limited by the need for trust when lending and borrowing, just as banks are.
The globalfundforwomen notes that “ (microcredits) might very well be the best model for a small village, where a microcredit institution works with a manageable cohort of the population to achieve a limited number of specific goals. But when there are hundreds of thousands (if not millions) of the impoverished living in a large town or city, one has to wonder if a much larger financial pool should be created or sustained for such amelioration.”
One other reason these new centralized institutions cannot solve the financial inclusion problem is their high-interest rates. Their loans have interest rates as high as an annual 20% charge. Others charge a 4% interest rate charge per month, translating to 50% in a year.
The poor cannot afford such high payments when they only make a few dollars a day from work. Therefore, to eliminate poverty in this setting, a borrower will need a series of affordable loans to scale their business.
LatAm’s unbanked also need better savings and investment opportunities. Neobanks and microcredits cannot provide such facilities due to a lack of clear regulation. Consequently, the Latin American region has many high-interest loan lenders but few operational savings and investment programs.
The State of Financial Inclusion in El Salvador
El Salvador’s Central Reserve Bank was established in 1934 as a private entity. It was nationalized in 1961 as the government’s sole bank of issue, maintaining the value of the Colon. Unfortunately, the Lost Decade did a number on the central bank, and it was broke by 1989.
New laws made the Central Reserve Bank autonomous in 1991. In 2001, El Salvador’s Monetary Integration Act granted legal tender status to the USD, making it a unit of account within the country. According to the IMF’s Financial Inclusion: Zooming in on Latin America paper, El Salvador has had an average economic growth rate of 2% in the past decade.
There are, therefore, high levels of poverty and emigrations of its citizens to the US. In addition, banking penetration here is so low that, as per World Bank data, only 14% of adults in El Salvador had bank accounts in 2012.
That number had risen to 35% by 2015. Only 7% of Salvadorians save with a financial institution, and 17% borrow from banks. 55% of the unbanked Salvadorians say they lack funds to open and keep in a bank account.
40% of adults feel that bank accounts are too expensive, while 21% say they do not have the KYC documents required to open a bank account.
Why DeFi Is Advantageous to El Salvador’s Unbanked Populations
Many parts of the world name the traditional banking system’s friction and high charges, and poverty as reasons for financial exclusion. The situation in El Salvador and many other parts of Latin America is more critical.
The regulators have not built trust with the citizens. On the contrary, they have proven that they cannot protect account holders and investor’s funds. For this reason, parts of Latin America could skip some of the financial phases that developed nations had to go through before they could achieve high financial inclusion.
They may not have to walk the long road to a cashless society. Their jump will be wider, skipping several phases along the way: from cash to DeFi. Directly. They may not have to build robust basic and traditional banking institutions, credit card and digital banks, or the fintech sector. Instead, they can move directly to decentralized finance (DeFi).
El Salvador is ready to make that quick dash from failing legacy systems to DeFi. The Central American country has just become the first country to legalize bitcoin as legal tender. Their lawmakers have passed the Bitcoin Law “to regulate bitcoin as unrestricted legal tender with liberating power, unlimited in any transaction, and to any title that public or private natural or legal persons require carrying out.”
As it stands, Salvadorians can make purchases, pay their tax contributions, and show the prices of goods and services in BTC. All BTC transactions will not accrue capital tax gains. Nayib Bukele, El Salvador’s President, says, “In the short term, this will generate jobs and help provide financial inclusion to thousands outside the formal economy.”
His actions have spurred other Latin American legislators, and they are pursuing the adoption of BTC as legal tender. Cryptocurrencies will eliminate the region’s dependency on the USD, increase tech entrepreneurship and protect savings from runaway inflation.
The use of BTC as legal tender will provide Salvadorians with a fair, transparent, efficient, secure, and global open payments system that will enhance financial inclusion by building trust. Salvadorian migrants send over $6 billion home, about 23% of the country’s GDP.
According to President Bukele, a large portion of that money is lost to third parties in the legacy financial system. “By using Bitcoin, the amount received by more than a million low-income families will increase to the equivalent of billions of dollars every year,” he says.
How The Parallel Protocol and MIMO Can Support DeFi Growth in LatAm
El Salvador has already taken the first step towards universal financial inclusion. Bitcoin can help them survive the stress of a failed economic system, while DeFi can help them generate passive income and grow financially.
Bitcoin is known for its volatility and wild price swings and may not be a perfect solution for decentralized finance’s cutting-edge financial products. However, Stablecoins such as MIMO’s PAR token that tracks the value of fiat currencies will create a stable financial system for Latin American cryptocurrency users.
While most fiat-backed stablecoins are centralized and controlled by a single entity, PAR is fully decentralized. It is also the first Euro pegged stablecoin in the market. Anyone can use PAR and join its community governance protocol.
The Parallel Protocol is a stablecoin issuance system. You can create PAR stablecoins by locking your ETH, USDC, or WBTC in the project’s vaults. PAR holders can also earn much more interest in Balancer’s yield farming protocols. The Parallel Protocol is currently running on the Ethereum blockchain but will become a multichain protocol in the future. Salvadorians can use PAR and Ethereum smart contract features to save, invest, borrow and lend their BTC on the vast DeFi field.
First, cryptocurrency users will learn how to use crypto-wallets. A crypto wallet is free and is accessible via the internet. Users only need a smartphone to interact with a crypto wallet. The wallet acts like a bank account and has a private key. It receives all forms of cryptocurrencies and will support payments. The wallet, therefore, offers the unbanked a secure financial instruments storage system.
The wallet and the cryptocurrencies in it will then open users to the smart contract ecosystem. Over time, Salvadorians will learn how to leverage smart contracts’ trust-building functions to borrow, lend, and build their wealth.
In DeFi, they can generate wealth through MIMO and the PAR stablecoin, investing by holding MIMO and allowing it to increase over time. Secondly, they can deposit the BTC lying idle in their wallets into the Parallel Protocol’s vaults minting PAR that generates income in DeFi’s liquidity pools.
Like any traditional investment instruments, they will earn regular interest, protecting their wealth from inflation and watch it grow over time. PAR and MIMO will also help break the cycle of poverty in Latin American countries by supporting peer-to-peer lending.
The protocol will create large lending pools that work just like bank’s liquidity pools. Salvadorans who send massive amounts of cash back home can store their wealth in these liquidity pools and support their economic growth. In addition, their cryptocurrencies will support collateralized crypto-asset lending whose interest rates are algorithmically determined.
PAR’s stability will ensure that liquidity providers earn a constant yield that is safe from price fluctuations. PAR is also interoperable and will operate in a wide range of decentralized blockchains and networks. Since smart contracts create trust, DeFi via PAR and MIMO will onboard “hundreds of thousands (if not millions) of the impoverished living in large towns or cities” to DeFi’s large financial pools that will scale with use.
The biggest advantage that the DeFi movement has in Latin America is that many countries have a soft spot for cryptocurrencies. Cryptocurrency use will increase financial transparency, lower costs of transactions and counterparty risk. The one challenge working against a DeFi takeover in Latin America is low financial and DeFi literacy levels that may keep some users away. It is therefore important for companies building the ecosystem and infrastructure to align with Latin America’s population financial education to shorten the technological and financial inequalities among its citizens.