Crypto, DeFi and Banking the Unbanked
What do you do with money? I’m not talking about how you spend the money, but where do you store it? What is your method of banking?
Chances are all of your money isn’t in your wallet, or locked in a safe at home. Most likely, it’s deposited in a bank account, right? You’re not alone, that’s how most people’s money is kept safe. But a vast proportion of the world doesn’t have a bank account. That vast majority is the ‘unbanked.’
Enter the unbanked
According to the World Bank, 69% of adults in the world, or 3.8 billion people had an account at a bank or mobile money provider, as of 2018. While this number may not seem like much given that on the flip side, 1.7 billion adults don’t have a bank account, it’s a growing statistic. Four years prior, in 2014, the number was 62%, and in 2011 it was 51%. In just the three years between 2014 to 2017, 515 million adults opened an account. That’s more than the population of the US, Canada, France, and Germany combined.
This begs the question, why are so many people without a bank account, or unbanked? Not just in the developing or under-developed world, but even in countries with a strong banking system, the unbanked problem persists. In the US, the number of unbanked stood at 55 million people or 22% of the population. In the UK, that number stood at 1.3 million, with a third of them having a bank account in the past.
What does this mean? For starters, the problem of the unbanked goes beyond poverty-stricken countries. But the bigger picture is, even in a country with a strong banking system, people are opting out of it. Why? Before we answer that question, let’s look at what a bank does, and why it is helpful.
Banks, what are they good for?
In one word, the purpose of the bank is trust. Why trust? Everything a bank does for us is based on the trust we give to it.
Take functions offered by banks in the traditional finance world and look for trust. When we open a bank account and deposit money, we trust that it’ll be there when we need it. We trust the bank to give us a piece of paper (cash) or a piece of plastic (credit/debit cards) to buy goods and services. When we take out a mortgage, we trust the bank not to take the house if we continue paying interest. Health insurance is predicated on trust that if we pay the periodic premiums, we can get coverage the next time we’re sick. We trust a bank to invest in products to mitigate our risk today so that we can grow wealth tomorrow. There’s so much trust we give to banks.
All these banking functions are indispensable. In our modern society, banks underpin the entire financial system. So, living without a bank account can be very difficult. You can’t store all your wealth under your bed, you can’t have all money stashed away in a locker for a rainy day, you can’t walk around with a bag of cash, you can’t expect your employer to pay you in dollar-bills, you can’t expect to make cash-payments across countries, can you? That’s why we have banks, to keep our money safe and in one place.
But how exactly do banks do this?
Trust and the bank
A quick note on what the idea of the bank is. Put simply, a bank acts as a pool where we can put all our money, and transact it in little bits. How does this work? When money is deposited into a bank, it’s marked with an accounting entry, to denote how much is put and who has put it. Once confirmed the depositor receives ‘banknotes’ from the banks which state that the depositor has deposited a certain amount. The depositor can then use the notes to buy goods and services.
Let’s understand this in the form of an example. Adam deposits $100 into a bank. The bank makes an accounting entry in its books and gives him ‘banknotes.’ He can use these banknotes (verifying that he holds $100) to buy goods or services or transfer it to someone else. Say he transfers $100 to Ron for payment of goods. How does the process go? Ron deposits the $100 into his bank account. Ron’s bank checks with Adam’s bank if the latter has the money. Once confirmed the $100 is transferred from Adam’s account to Ron’s. Simple, right?
This transfer of $100 between Adam and Ron through their bank accounts is built on trust. Adam trusts his bank to hold his money and gives him banknotes representing this holding or custody. Ron trusts Adam’s banknotes as a representative of his deposit and accepts it. In turn, Ron trusts his bank to receive the money from Adam’s bank. Here, trust is present both between Adam and Ron and between their banks.
In the picture below, see how often trust comes up.
Trust beyond the banks
The cycle of trust doesn’t end with the bank. While we outsource our trust to banks, the banks also outsource trust. In order for banks to keep our funds safe, banks insure them through two routes, insurance companies, and the government.
Firstly, insurance companies protect the supporting functions of the banks. Anything that helps a bank conduct its functions of custody and lending is insured. For instance, the buildings, the employees, the technology, are part of the ‘banking infrastructure.’ These help support the custody and lending processes but aren’t at the core of it.
What is at the core of the banking process is what you deposit in a bank and take from it, money. Money, cash, banknotes, fiat currency, all mean the same thing. It is a piece of paper that you use to buy goods and services. This piece of paper, as we’ve seen above, can be deposited into the bank withdrawn from it, or transferred between people. This is the core of the bank.
Insurance of trust
Secondly, the government insures the bank’s core, the money we deposit and take as loans. The bank outsources ‘money trust’ to the government. In the United States, every dollar, up to a certain limit, we put into a bank is insured by the Federal government. If there’s a run on the bank, the government will step in and protect deposits.
What does this mean? Run-on the bank? For starters, ‘run on the bank’ isn’t a bank robbery. Like in the movies, where a guy with a ski-mask, points a gun at a cashier and yells “Put the money in the bag,” and then hops into his get-away car and is off. No.
Run-on the bank is everyone who deposited money into the bank withdraw it at once. This happens when banks or the banking system lose people’s trust. They would rather hold on to their cash, instead of keeping it in a bank account. Why is this a problem? If banks lose their deposits, they don’t have money to provide loans. If loans aren’t disbursed, individuals and companies can’t finance operations. All forms of economic operations are ceased. This leads to the halt of the economic engine as we know it.
In order to prevent this the government insures the money in the bank. So, if the bank is unable to cough-up the money, the government makes you whole. This prevents you from losing trust in the bank, and banks run smoothly, keeping the economic engine running.
By now you can see how deeply trust is embedded within the banking system. Right from individual deposits, withdrawal, and transfers, all the way to insurance companies and the government. Connecting this chain of trust is the bank. Now, let’s look at the functions of a bank.
When people like Adam deposit their money into the bank, and they don’t pull it out or transfer it to someone else immediately, what does the bank do with all the money deposited? What happens to the money between the time it’s deposited, and withdrawn? For starters, it isn’t just sitting there in the account, it’s put to use.
Banks loan out the deposited money to people and companies who need it. These loans, whether corporate loans or various individual loans, for homes, cars, consumption, education, etc. have a certain interest attached to them. This interest is calculated based on the nature of the borrower and borrowing, credit history, loan amount, pre-payment, and other market factors. The important thing to remember is from the borrowers the banks are earning interest. To the lenders i.e. people like Adam who’ve deposited money, banks are paying interest. Based on the nature of the account, and the lock-up period, a certain interest rate is charged. What banks earn is the difference between what they pay and what they receive.
Unbanked and fees
But what about fees? Does this mean that depositors don’t pay any fees at all? No. Even those who give banks money to loan out pay fees, and that’s where the problem of the unbanked comes in.
In order to open and operate a bank account, depositors pay fees. This can be a simple maintenance fee i.e. a fee paid if a minimum account balance is not maintained. It can be a transaction fee i.e. fees paid for certain transactions, higher for those across borders. Or other fees like for deposits, withdrawals, and overdraft facilities. There are tons of fees when it comes to banks.
Let’s be clear, this isn’t banks being intentionally evil or anything. Banks, like any other institution, offer a service at a cost. However, their service is far more essential, universal, and constant. Because of these three factors, everyone needs a bank. They make our lives easier by keeping our money safe and giving us credit. But since banks need to pay for the offices, administration, staff, technology, etc., all these services come at a cost.
Most of us don’t notice the fees, because they are few and far between. But over time, it eats up. If we had a smaller amount of deposits, every little bit taken away counts. For someone making a few hundred dollars per month, they simply can’t afford to pay a $100 overdraft fee. Those making less than $1,000 a month, can’t afford to pay $20 monthly because they cannot maintain a $1,500 minimum balance. Those operating cash-heavy businesses can’t afford to pay fees on deposits and withdrawals every month eating into their tiny profit margins. If you’re living from penny to penny, such fees can be the difference between having a bank account and not.
Back to cash
If opening and operating a bank account is doing you more harm than good, what do you do? The obvious and economical thing would be to ditch the bank account, right? If so, no money is ‘deposited into an account.’ It’s just held in cash. Let’s see how this plays out.
Instead of having a bank account to receive a periodic salary or wages, the money is received in cash. And since there is no bank account, all transactions are conducted through cash. Food is purchased through cash, bills are paid in cash, savings, if any, are in cash. There is no ability to avail credit to finance education, homes, cars, businesses. No way of growing wealth by investing it. The risk of holding on to liquid cash is higher because it can be stolen and used immediately. Payments might be instant, because you don’t have to wait for the money to be deposited into your account, but are limited. You can’t make or receive payments beyond your immediate vicinity. Cash might come with some immediate advantages but is outweighed by how little you can do with it.
Imagine living in such a cash-only, bank-less vacuum. To make things worse, any loss of cash flow has a serious and long-term impact. This is the reality of the unbanked.
For the unbanked, the economic cost of the fees and friction in the traditional banking world is pushing them to use cash. As we’ve seen, living off cash is limited, and provides little avenues of savings and investment. To those who need economic mobility the most, the banking system does not work. But with the growth of decentralized currency decentralized finance or DeFi, the unbanked have a lot more options.
Crypto, DeFi, and the unbanked
A common theme in the banking world is the excess of ‘fees and friction.’ This is not necessarily a bad thing. Banks need to charge fees to keep working, and holding up the financial system. But these fees are real, and they hurt the unbanked the most. So much so, many would opt out of the banking system and switch to cash completely. However, with the growth of decentralized currencies and DeFi, the unbanked can participate in the financial economy and avoid fees and friction weighing them down.
Wallets and transfers
Let’s start simple. Say, instead of using bank accounts, the unbanked use Bitcoin. What is Bitcoin? Bitcoin is a decentralized currency, operating on blockchain technology. It’s permission-less, censorship-resistant, and universal. You can send it to anyone, anywhere, for a minimal fee.
In order to hold, receive, and send Bitcoin, you need a private wallet, accessible by a private key. They can be created for free and accessed using a computer or a mobile phone with an internet connection. Further, Bitcoin cannot be transferred from one wallet to another unless it’s actually present. This means that the sending wallet needs to actually have a certain amount of Bitcoin in order to transfer it.
Since transactions are made via accounting entries, money doesn’t have to be in an account in order to send it. It can be credited as an overdraft, or availed as credit. On the other hand, Bitcoin payments can’t be ‘over drafted’ because supply is limited, every newly created Bitcoin is recorded publicly.
Now that you receive Bitcoin in your wallets what do you do? Since Bitcoin is universal, it can be used to pay for several things. Such transfers are helpful to the unbanked for two reasons. Firstly, they are quick and cheap. Secondly, Bitcoin transactions cannot be executed if no Bitcoins are held, avoiding overdraft and other credit-fees eating into the balance.
Since Bitcoin is easy to use, trustless, and universal, it gets the ball rolling. The unbanked now have a wallet, which they use as a bank account. It receives Bitcoin as salary and sends it as payments for bills. Once the habit of such a simple system without the fees and friction of bank accounts is put into place, the unbanked can participate in other banking functions through DeFi.
DeFi and banking functions
At this point, the unbanked receive money and use it to pay the bills, using a decentralized currency, blockchain technology, and wallets. This simple system allows them to participate in the basic functions of a bank – receive the money, keep it safe, and use it. There’s a lot more than banks offer, that can be accessed through DeFi.
For starters, instead of manually making payments for necessities like rent, groceries, and electricity, it can be automated through smart contracts. Put simply, a smart contract is a computer program representing an automatically-executing contract once certain conditions are met. The unbanked can place conditions to pay bills by direct wallet transfers on a specific date, through smart contracts. This is similar to ‘standing orders’ used in bank accounts. Smart contracts, like auto-executing bank transactions, make payments easier. More importantly, it saves time to concentrate on building wealth.
Savings and investment
Building on the base of having a wallet, and saving time by auto-executing payments through smart contracts, let’s look at wealth creation. Banks allow customers to create wealth through two simple steps, save your money, and invest it. Above, two of the prerequisites to savings and investing were achieved, have an account, and have time to manage your account. Now, let’s see how wealth is created in DeFi, similar to using bank accounts.
Once the unbanked have begun using the account for receiving and sending cryptocurrencies, anything left over is ‘savings.’ These savings can be used to create wealth through investing. Investing, can be of two types. Firstly, for growth, meaning investing with the objective of increasing value over time. Secondly, for income, meaning investing with the objective of receiving income over time.
In DeFi, there are several protocols to achieve both forms of investing. For instance, you can simply buy a cryptocurrency and hold it with the objective of its value increasing over time. Hence, satisfying the ‘growth’ objective. Or, you can participate in an income-generating liquidity pool, by contributing cryptocurrencies, and gaining regular interest. These investment options would allow the unbanked to not just protect their wealth, but build it over time. Regular investments in growth-potential, as well as stable income-generating assets, keeps wealth safe and gives it the ability to grow. Another key banking function ticked off!
Even supporting functions of banks are available in the DeFi world. Take lending for instance. If the unbanked need funds to start a business, finance operations, or expand, they require credit-facilities.
In the DeFi world, credit can be received, through peer-to-peer lending, or lending pools, similar to how you would take a loan at a bank. Crypto is deposited as collateral, periodic interest payments are determined, and a certain loan amount is unlocked which can be used immediately. This credit is availed through a pool of contributors. The interest rate and collateral are determined by an algorithm based on demand and supply. Compare this to the centralized banking system that makes a profit on the spread between interest paid and received. Protocols like Aave, Compound, bZx, and Cream.Finance facilitate lending in the DeFi world.
Another key factor of banks is the provision of insurance. While DeFi is still working on real-world insurance solutions, smart contract insurance is already available. Why smart contract insurance? Because smart contracts are computer programs that can be hacked, and protecting its participants is necessary. A separate company does not insure these smart contracts. It is insured by the community, based on security-potential. Further, every aspect of the DeFi world, be it lending or liquidity pools, work on smart contracts. Protocols like Nexus Mutual and Opyn Protection facilitate insurance in the DeFi world.
Stability is also a key function of banks. We don’t realize it because banks operate with just one currency, the national currency. However, in the DeFi world, there are several cryptocurrencies used. For the sake of the banking comparison, we can differentiate them into two, cryptocurrencies and stablecoins.
Cryptocurrencies like ETH, BTC, LINK, are volatile, and cannot be used for regular payments. Instead, stablecoins are used. Stablecoins are cryptocurrencies whose prices are stable, tracking the price of a fiat currency. For instance, dollar-backed stablecoins’ price equals $1. Popular stablecoins are USDT, USDC, and DAI.
These stablecoins can be used to make constant payments with no fear of price change between parties. What’s more, they operate within several DeFi protocols. So, for instance, you can receive USDT as credit, and use it for trade invoicing. You can put your DAI in a liquidity pool and earn interest on it. Your premiums can be paid in USDC to insure smart contracts. Each of these financial functions can be executed without any fear of market volatility, as stablecoins always equal $1.
Banking the unbanked
With decentralized currency and DeFi, the unbanked can not just survive but financially grow. They can start by making transactions through wallets and cryptocurrencies, starting off with Bitcoin. Once attuned to this, they can switch into a smart-contract-based blockchain like Ethereum to automate transactions. If a certain amount is left as savings at the end of the day, it can be used to invest in growth and income assets. Investments can be supported by insurance and borrowings, and stablecoins can be used for regular payments.
This is how the unbanked can use cryptocurrencies and DeFi for what it was intended. While DeFi has gotten a bad rep for get-rich-quick schemes, its purpose was to give the financially weak a means to build their base. This base is one that starts with the simple bank account functions of custody and transfers. With time it provides all the necessary functions to participate in the financial economy, and without fees and friction pulling back progress.
Once again, banks aren’t the villain here. Banks provide an essential function and run the economy, but in this operation, they exclude many. The ones excluded cannot participate in the banking system. In the traditional world, the absence of a bank account prevents any upward economic mobility. Crypto and DeFi are changing that. With a crypto wallet, and decentralized currencies, accessible via a mobile phone and an internet connection, all the facilities of banks can be accessed. Further, the fees are severely reduced, and the friction is limited to understanding how decentralized currency, blockchain technology, and decentralized finance work, something that we at Interaxis are doing.
A long road
This is just the beginning. With cryptocurrencies and DeFi still in its infancy, a lot has to be done for it to truly become its own banking system. The missing element is participation, but the signs are positive. With more and more people embracing the power of crypto, blockchain, and DeFi, the financial world is opening up to everyone. Those who couldn’t participate in the traditional banking system can access decentralized finance, and build a financially secure future.
DeFi has the capabilities to create a trustless and community-driven financial world, which provides everything a bank can, but at an affordable cost. For the unbanked, what started with Bitcoin and payments is expanding into DeFi and payroll.