How The DApact maintains trust and liability within its underwriting system, and why this is a fundamentally new microfinance paradigm
There is a wide consensus that low-income countries showcase ideal conditions for early DApps to thrive—state failure, unreliable public records, top-heavy political structures are natural use-cases for blockchain.
We also find there is a strong case for microfinance to be the very first industry to be disrupted, given how it deals with largely unbanked populations and the lack of banking infrastructure.
Decentralized finance will rewire microcredit
Microfinance is said to be a double bottom line industry, in that it seeks to extend the conventional bottom line, that measures fiscal performance — financial profit or loss — by adding a second bottom line to measure performance in terms of positive social impact.
The problem with “double bottom lines” is they tend to create Cornelian dilemma. Seeking financial profit incentivizes MFIs to up interest rates, while a positive impact — financial inclusion — requires as low interest rate as possible.
In microfinance, the industry has slowly, naturally found a way around the double bottom line dilemma, by assigning each bottom lines to a unique industry layer. Offshore creditors (call them Microfinance Investment Vehicles or MIVs) will support the positive impact responsibility, while local, on-site lenders (Microfinance institutions or MFIs) seek to maximize profit.
Microfinance is a peculiar field in banking, characterized by a dissonance of objectives between mission-driven financiers (MIVs) and profit-driven operators (MFIs)
Mission-driven MIVs pour hundreds of millions in the microfinance industry every year. These social lenders take various forms such as crowdlending platform (e.g. Kiva has loaned no less than USD 1.2B), development agencies (e.g. USaid) and foundations (e.g. Bill & Melinda gates Foundations). While they are large, wealthy organization, all of these lenders are somehow held hostages by the local MFIs they work with.
Local MFIs are the ones able to perform the actual work on the field: they are those in direct contact with the end-borrower, and have an operating license from local financial authorities. They are the ones to sequence the goals they pursue: profits vs. social impact. As it happens, not a single large MFI can claim focusing (even slightly) on social impact. The reason is somewhat darwinian: MFIs are on a competitive market and they need profit to grow and survive. The finance guy defending the organization survival before the Board of Directors will always be right in face of the guy promoting positive social impact. Little by little, fiscal concerns take precedence over mission concerns.
At The DApact, we believe blockchain and smart contracts opens a window to change the balance of power between MIVs and MFIs. MFIs are no longer needed to disaggregate impact investment onto end-borrowers, as value can be passed onto remote, unbanked borrowers with guaranteed transparency and no financial custodian.
In this new paradigm, mission-driven MIVs don’t have to commit their funds to a specific MFI anymore: they can instead commit their funds directly to end-borrowers, then have MFIs compete to manage these funds.
Microfinance’s Airbnb moment
Microfinance hasn’t had its Airbnb moment to date. And yet MFIs are in a position very much alike short-term rental agencies’ 10 years ago.
Property owners used to address agents to short-rent an apartment, and accepted to pay a hefty markup. The markup was justified by the many services provided: keeping custody of keys, collecting rent fees, finding short lease holders, and providing various services such as insurance and maintenance. Then a platform arose that let property owners directly match with and collect rent from short term tenants. Turned out the agent’s supposed due diligence wasn’t any better than a reputation system. With the rise of Airbnb, short-rental agencies have been downgraded to concierge services like this one (the new industry calls itself “short-term rental management”). Market conditions are now being set by flat owners rather than intermediaries.
Web 2.0 — the Internet of Information — cut matchmakers out of many business. Web 3.0 — the Internet of Value — will cut financial custodians out.
Now think of how microfinance works. Today, mission-driven lenders have to commit their funds to a specific local MFI (just like a flat owner used to commit his apartment keys to a single agent). The selected MFI holds custody of funds, collects installments, finds microborrowers, and provides various services related to loans lifecycle.
So why are MFIs still well alive? Why haven’t they been disrupted like so many industries?
The big difference here is microfinance deals with largely unbanked populations. To be disrupted, the industry was in need of a solution that would let value be passed on directly to the unbanked, with tamper-proof traceability. This solution is distributed ledger technology, and the Airbnb of microfinance will be a blockchain protocol.
This is the original reasoning behind The DApact. With well designed blockchain protocol and apps, it is possible to slim down MFIs to Portfolio Management Services.
The system we build allows for direct matching of pre-screened & KYC’d microloan applicants with MIVs, as well as direct exchange of value (loan principal and installments) between them. In this new paradigm, MFIs simply provide underwriting and reporting services.
Most importantly, MFIs are put in a situation where they compete for deal management. After a MIV-borrower match occurs, all suitable MFIs have an option to manage the deal as per the conditions set by the MIV.
The DApact helps mission-driven lenders better fulfill their vision
This system is designed to give power back to mission-driven lenders, providing them with a tool to control how, when, in which purpose, at what cost and to whom their funds are disaggregated on the field.
Here we won’t roll out the loan origination process in The DApact. If you’re not familiar with it, give a shot at testing our apps on Kovan Testnet or read the tester starter kit or check out this explainer video.
A DApact debt agreement is a digital three-ways contract that bounds together:
- Lenders are offshore MVIs (crowdlending platforms, development agencies, foundations, etc.) and creditors in the debt agreement
- Underwriters are locally registered microlenders (small MFIs, pawnshops, lending NGOs) and portfolio managers in the debt agreement
- Borrowers are local individuals or microbusiness and debtors in the debt agreement
As opposed to traditional microfinance, in a DApact debt agreement, a Lender (offshore MIV) and a Borrower (local beneficiary) are contractually bound and move value in between them directly. However the loan lifecycle is managed by an Underwriter (local MFI).
The whole problem to solve now is:
How do you entrust Underwriters with managing funds they are not liable for?
Indeed, as Underwriters do not stake the loan principal, how to make sure they work in the interest of the lender? There are two main threats to such a system:
- Sybil attack: a malicious Underwriter would deliberately approve accomplices’ applications with no intention to ever pay off the loans
- Portfolio desertion: an Underwriter would withdraw from the system for x reason
The DApact uses two mechanisms to secure Underwriters’ perenniality: Minimum capital commitment and Incentivized peer takeover.
Minimum capital commitment
The #1 incentive an Underwriter to join The DApact is access to low-cost capital for his lending business in economies characterized by capital drought and SME financing gap. The DApact is designed to let Underwriter grow a loan portfolio while maintaining liquidity. From an Underwriter’s perspective, a DApact loan disbursement is a cash-to-token OTC transaction — his cash position remains neutral.
However, An Underwriter’s wallet freezes 10% of portfolio amount in his DApact address (currently in Dai stable coin). In other words, an Underwriters has a minimum 10% capital deposit (Dai reserve) at any point in time. While it still means a 10x leverage for him, this capital deposit ratio serves as a trigger for The DApact protocol’s portfolio safeguard mechanisms.
Whenever an installment is overdue, this Dai reserve is used to make up for it and process the installment to the Lender nonetheless.
If the Underwriter’s Dai reserve falls below 10% of his overall portfolio, then all the commissions he gets from all the installments he collects are used to make up for this deficit until the overdue loans are back on track again (given a commission of x% on each installment, this improves the security margin by x additional percentage points).
Loss aversion behaviors make commission diversion a sound incentive to keep high quality portfolio (and conservative underwriting scoring). But if commissions become insufficient and the Underwriter’s Dai reserves fall below 5% of his overall portfolio, the peer takeover mechanism is triggered.
Incentivized peer takeover
Lenders are the effective owners of their loans in The DApact — a debt agreement is represented by a unique non-fungible token on the Ethereum blockchain (ERC721), owned by the Lender. This provides him with specific control over the debt agreement (e.g. rescheduling) as well as liquidity as NFTs can be exchanged on secondary markets. Most importantly, this token is programmed to dynamically update the trusted Underwriter’s address.
Indeed, as a lender approves and funds any one loan, he implicitly awards the loan management to the Underwriter who initially introduced and screened the project. In doing so, he entitles this Underwriter to process all transactions related to that loan, and to get a commission on every installment collected. As long as the Underwriter keeps > 95% success rate in getting timely repayments in his overall portfolio (over 5% Dai reserve), his Ethereum wallet keeps being the trusted address to process payments (and get commissions) on this loan.
If an Underwriter fails to collect > 5% of installments on time (NPL30 — Non-performing loans over 30 days), his wallet address ceases to be the trusted address registered in the smart contract for an arbitrary equivalent portion of his portfolio’s performing loans. Instead, any relevant Underwriter can claim these loan management contracts and further gets the attached commissions. Claiming a loan management contract is essentially a profitable operation as the bulk of the job — underwriting the applicant — is already done and the claiming Underwriter is only fetching performing loans to his portfolio — therefore default risk is very low.
Every month, the chatbot sends the trusted Underwriter’s contact info to the Borrower alongside a prompts to signal his installment either as a cash payment or a mobile money payment. The proof of installment is provided either by producing the QR code to the Underwriter (cash payment at the shop) or uploading a receipt ticket to the chatbot (remote mobile money payment).
The Trusted Underwriter address in a debt agreement is therefore essentially ephemeral, with the commission scheme in The DApact designed to incentivize loan management contracts takeover.
Why are the potentialities of The DApact microfinance model?
Operating efficiency: The DApact is designed to serve micro- and small lending business in low income countries. In Cambodia — the pilot country — Underwriters are family business pawnshops with no overhead costs and a deep rooting in their territory: within the system they provide loans for a mere ~9% effective interest rate, 300% cheaper than standard MFIs. Our apps drive down operating costs even further as they automate the two most time-intensive processes in microfinance: customer acquisition and loan application.
Financial costs: From a Lenders’ AUD bank account in Australia, to Khmer Riel notes in the Borrower’s hands in Cambodia, moving the funds end-to-end draws off 0.25% of the loan principal amount — that’s not even the cost of a local mobile money transfers. The DApact currently buys back Dais from Underwriters in-house and the potential costs of this activity is not accounted for yet. Other costs include Ethereum gas for Smart Contract calls — but gas is set to become virtually free under the combined effect of Ethereum 1x improvements throughout 2019 and Ethereum 2.0 kick off in 2020.
Scalability: The DApact can scale in the fashion of a SaaS company as the protocol lies atop pre-existing, authorized lending agents in target countries. The protocol is “permissioned” as Underwriters need a local financial services license to join; however, registering is a rather straight forward process that merely includes accepting terms of service. The Underwriter base can grow quickly and significantly given the strong presence of independent lending agents in low income countries. In Cambodia alone, there are ~500 pawnshops, roughly 1 for every 30,000 inhabitants.
Flexibility: A network of Underwriters can be built from scratch extremely quickly and money can reach out microloans beneficiaries directly with full transparency and traceability. It makes it a powerful tool for mission-driven lenders willing to answer the needs of precarious populations such as urban refugees, or serve disaster areas or post-conflict zone.