#39 - Adventures in De-Fi Land Part 2

Going into the deeper elements such as lending, liquidity pooling and decentralised exchanges

Hi all - This is the 39th edition of Frontier Fintech. A big thanks to my regular readers and subscribers. To those who are yet to subscribe, hit the subscribe button below and share with your colleagues and friends. 🚀

Introduction

In last week’s article I took my first steps in the De-Fi world. The premise was based on the ability to store value and the ability to move money globally at low cost. The example was laid out from my experience observing how talented Africans can lack the ability to earn money and take care of their families simply due to the vagaries of the global financial system. I settled on the Celo blockchain due to its cost and the Valora wallet which enabled me to store and move money easily. 

However, financial services expand beyond the simplicity of storing and moving value, they extend to the realm of transforming value in time and in space. This includes maturity transformation through lending as well as transforming value through exchange including currency and commodity exchange. In my view, from an African perspective this is one of the most critical elements to solve given the potential impact on economic growth. In this article, I delve into the other elements of DeFi such as liquidity pooling, borrowing and decentralised exchanges.

Financial markets in Africa are generally underdeveloped with the consequent impact of stifling economic growth. Of course this is a chicken and egg argument where the question can be asked whether economic growth leads to an improved financial system or vice versa.

Financial inclusion in Africa trails the global level. In terms of the percentage of adults with an account at a financial institution, 42.6% of Africans are financially included compared to a global average of 68.6%. In terms of lending, 22.5% of adults in the world have borrowed from a formal financial institution compared to 8.5% in Africa. There are multiple reasons for this;

1. Inefficient macroeconomic environments containing volatile currencies and high inflation that drive high interest rates. These higher interest rates act as a deterrent to lending. In Kenya for instance, prior to the rate caps, interest rates on a personal term loan could rise up to 30%. The diagrams below show the average lending rates in Kenya, Nigeria and South Africa. South Africa has had a better experience with single digit lending rates whereas rates have hit highs of 25% in Kenya and Nigeria since the turn of the millennium;

2. Poor banking infrastructure and the cost of setting up this infrastructure constrains both the access to financial services as well as the cost of financial services. Africa is big and people in most countries are dispersed across large swaths of land. Building the infrastructure to onboard these people into the financial system in terms of branches and access points is expensive. What then happens is that interest margins widen so as to accommodate the higher operational expenses;

3. I’ve written an article on the SME funding gap that goes into detail to explain the issues around SME financing in Africa. The total funding gap stands at around US$ 330 billion in Africa with the global funding gap standing at US$ 5.2 trillion. Some of the fundamental issues raised regarding the funding gap include;

   1. Informational asymmetry and adverse selection brought about by the high costs to verify operational performance and character;

   2. Poor identity infrastructure that makes it hard to map commercial relationships;

   3. Information gaps in transactional data that stem from cash heavy operations that are typically invisible;

   4. Lack of collateral that makes it hard for people to borrow, the lack of collateral extends to insurance that is often expensive and difficult to access;

These are the main issues relating to the difficulties involved in borrowing money in Africa. However, financial services extend beyond lending to higher elements such as commodity trading, capital markets and futures markets. 

In Africa, we have commodities such as tea, coffee, gold, iron and cocoa. In most instances value added in the commodity space accrues to Europe and the USA largely due to finance rather than anything else. This point was articulated by a close friend and expert in the African coffee trade. 

...I knew coffee was the second most traded commodity after oil, but I didn’t know that 70% of its production was by smallholder farmers, working under 25 acre sized farms, all based in the poor South. The second factor I discovered was that the commodity is a price taker, with farmers forced to accept the prevailing market prices. Coffee was valued on commodity exchanges in London and New York with a mechanism of exchange that enabled traders to sell the commodity into the future, and for buyers to buy into the future. These two factors created an interesting but extremely difficult reality for the farmer.

Let’s consider each of these two factors in a little more detail: Africa, although responsible for over a third of the land under coffee production, was in terms of volume, responsible for less than 7% of world trade. Farms were small. Yield and efficiency were poor...

...The second factor, coffee as a commodity on the exchange, meant that coffee went through a whole range of valuation that did not recognize the effort of the farmer. So, a farmer could have a fantastic quality year and crop, but if in the wrong cycle, would lose more than most. Furthermore, this fact advantaged those who could collateralize and afforded them greater power in the industry. Collateralization is a term that refers to the ability to go to a bank and say, “I have 100 bags of coffee in my warehouse, please lend me 90% of the value!”. The principle is simple, but in reality, the ability to get bank comfort and even access to skills and financial institutions able to trade futures, means this is very much a game only the northern hemisphere can play.

Unlike a smallholder farmer unable to collateralize, a coffee trader benefits enormously from the system. A trader able to buy several 1000 tons of coffee, store it in a warehouse, and do almost nothing else but wait, could become very wealthy simply because of the workings of the exchange; simply because the commodity price working revaluation and yield was higher than prime commercial rate for borrowing. A very strange phenomena indeed! I will not go into the detail of this, suffice to point out that the top traders and roasters were able to grow several billion dollars of capital in coffee alone, purely on the comfort of their trading systems to banks, and with insignificant equity.

In all, my first year in coffee showed me that this was the worst business in the world. As a farmer, you could not influence your buyer, performance did little to change your economics, and the middle man could do nothing more than buy and store your coffee, and yet make as much if not more than you. Of course, middle men do a lot in delivery of logistics, crop finance, quality selection, blending and other trade added value, but the point remains: They can do nothing and still make money.

The above is a very important passage when discussing the future of finance, structural factors beyond the control of commodity producers in Africa create structural poverty. The ability to access a modern financial system in the Northern Hemisphere enables someone in Europe to access 97-98% of the value of a cup of coffee, whereas Africa remains poor. When discussing De-Fi, people need to think hard about democratising such opportunities.

Decentralised Finance;

Economics and Commercial Considerations around De-Fi

Prior to talking about the different use cases, first it must be understood that De-Fi is a paradigm shift in not only the functionality of finance but the underlying commercial structure of the financial system. This article by Mark Cuban is an important read for anyone who wants to understand the commercial structure behind De-Fi. However, decentralised finance is largely economics and the economics of incentives. 

When you want to start a financial institution, you must first

• Get licensed from the relevant regulator; 

• Raise capital and give share certificates in exchange for the raised capital; 

• Set up physical and digital infrastructure including data centres or cloud deployments;

• Recruit staff, train them and deploy them;

• Go to the market to raise deposits and lend these deposits out to make money;

In De-Fi, there is no licensing and the attendant expense of licensing including the ever increasing costs of compliance. Through tokens, any project can raise money from an even wider base of investors. In principle, this is no different from issuing share certificates. Both are bearer tokens that incentivise ownership through a share of future profits. Uniswap tokens currently have a total market capitalisation of US$ 14 billion. Maker tokens have a market cap of US$ 2.2 billion.

Through validators, miners and stakers, any project can build the infrastructure to handle distributed computing with validators or miners providing the computing power and database management capabilities required to handle operations. Both miners and validators are incentivised through tokens. 

In the decentralized crypto world these 3rd parties (minors, validators, etc) provide the computing power that effectively run the platform in exchange for rewards in the token of that network.

In the case of Polygon, they have validators. These 3rd parties are willing to make this investment if they believe the network platform can grow the numbers of transactions on the network significantly. If they can, that pushes demand for the Polygon tokens they earn. That allows them to earn revenue from the sale of the tokens they earn or they can hold the token and hope it appreciates if demand exceeds supply.

Even better, platforms like Polygon will allow pretty much anyone to STAKE their Matic tokens with those Validators and share in the earnings of the Validators ! ...It’s a symbiotic relationship that also helps secure the network.

Lastly De-Fi runs on smart contracts that are “a set of promises, specified in digital form, including protocols within which the parties perform on these promises”. Additionally, Smart contracts lend themselves easily to financial applications largely because finance is concerned with the allocation of value and risk which tends to be intangible and contract based.

MakerDao which is a Decentralised Autonomous Organisation (DAO) is the perfect example of how DeFi is a shift in the business model. The profit and loss statement for the first five months of the year show that it’s total opex run at US$ 800k whereas total revenue was US$ 54.2 million making for a net margin of 98.52%. This shows the efficiency of Decentralised Finance as a business model. The profits are returned to owners of the MKR token in the form of buybacks.

Source: Mark Rubinstein

Borrowing in De-Fi

Unlike my previous article where I actually onboarded onto De-Fi and moved money around the Ethereum and Celo blockchains, I did not actually borrow money on the De-Fi platform. As part of the thinking behind this article, I was only to use a minimum of US$ 100 and I was to remain a layman. My first and only attempt to borrow was on MakerDao but the constraint was that I didn’t have enough Ethereum to open a vault. Below was the message I got;

I needed roughly 2.8 ETH to open a DAI vault and this is roughly worth US$ 12,000 thus way above my limit. However the process of DeFi borrowing is straightforward;

1. Make sure you have crypto on your wallet, this could be Metamask or any other crypto wallet;

2. Open a borrowing platform such as Compound, Maker or Aave;

3. Select a cryptocurrency or stablecoin that you want to borrow;

4. Usually De-Fi lending is over-collateralised to cater for the variability in crypto prices. The MakerDao platform is quite useful given that DAI is a stablecoin whose value is algorithmically pegged to the US$. Borrowing DAI is essentially the same as borrowing US$;

5. You then have to set up a vault, place your cryptocurrency such as Ether or Bitcoin and then borrow DAI;

6. The DAI generates a stability fee which is functionally equivalent to an interest rate that stabilises the value of DAI to the US$. The higher the stability fee, the less the demand for the DAI token. The lower the fee, the higher the demand for DAI and thus the lower the price of the DAI token;

7. You then select the borrowing parameters including amount and repayment period;

8. The disbursement is instant;

The above shows the different parameters on MakerDao.

Liquidity Pools and Decentralised Exchanges;

In addition to borrowing, DeFi enables other functionality such as exchange of value. For instance, swapping cryptocurrencies as well as tokens. The big innovation here is the idea of liquidity pooling. A liquidity pool is a collection of funds locked in a smart contract, they are used for facilitating trading, lending and numerous other functions.

Liquidity is a major consideration in finance and particularly currency trading. The higher the liquidity usually the more efficient the market is.  In asset trading, be it stocks, commodities or currencies, one issue that occurs is slippage where the actual price at execution can differ from the price upon confirming the trade. So for instance, you decide to buy a stock at US$ 10, but upon actually executing, the price is US$ 10.5. Traditionally particularly for specific assets, centralised market makers needed to provide liquidity to a specific asset. Big firms such as JP Morgan, Goldman and others provided this through their prime brokerage divisions.

Additional services within the whole trading domain include collateralisation of assets, custody, settlement and delivery. DeFi collapses all these functions through smart contracts. The beauty of the whole idea behind collateral pools is that revenue accrues to liquidity providers for all the trades that occur within those crypto pairs. 

The diagram above shows for instance where I supply Celo USD into the Celo USD/Celo liquidity pool. If I supply the equivalent of 70.3 cUSD I account for 0.23% of the liquidity pool and thus receive 0.23% of the revenue generated within this pool. 

The idea of liquidity pooling and DAO’s could have a major impact on a number of financial services.

Thoughts, Risks and Challenges;

Lending and Borrowing

Collateralised lending in DeFi is a barrier to widespread adoption of De-Fi based lending. Most people in the global south don’t have collateral to begin with thus onboarding into DeFi. Currently, De-Fi seems to be used as a wealth tool. Across the world, wealthy people borrow strategically. By pledging your assets as collateral you are able to access liquidity whilst preserving your wealth and current DeFi lending markets seem to be working in the same manner. Nonetheless, SME’s and businesses in Africa also borrow on collateral. In many markets in Africa, businessmen struggle to acquire property so as to be able to grow their business and access finance. Maybe consideration should be made where instead of buying property in markets where property laws are tenuous, businesses could buy Crypto as an asset and use this for accessing “cheaper finance”. Firms like Centrifuge are also bringing real world assets into DeFI.

One issue that may arise is the actual cost of borrowing, DeFi is essentially a dollarised space where everything is pegged or priced in US$. A businessman trading in Africa will earn in local currency which when you consider annual depreciation rates of 10%, would take the effective rate of borrowing in DeFi to ranges of 20-30% over a long period. This would be far from an improvement in outcomes.

To deal with the issue of collateral, protocols such as Goldfinch have emerged which operate without collateral requirements. The beauty of a platform such as Goldfinch is that local MFIs can raise liquidity from the platform and do onward lending to their clients. Companies such as Tugende Microfinance, Aspire, Payjoy and Quickcheck have already raised funds on the Goldfinch platform.

Source: Goldfinch

Liquidity Pooling, DAO’s and Decentralised Exchanges

This is a very interesting area. I started the article by talking about the value derived from the financialisation of commodity trading where European trading houses leverage their ability to raise low cost funds and speculate on the price of coffee. It would be interesting if a forward thinking country in Africa say Rwanda incentivised decentralised exchanging whilst providing warehousing and custody of African commodities such as coffee, iron, gold and cocoa. Anyone can then be a liquidity provider with the revenue from these liquidity pools being shared with the farmers or miners (in the traditional sense) who provided the commodities. 

DAO’s and liquidity providers also offer a very interesting take on remittance. This point was made by the ever Mercurial Michael Kimani in the thread below;

Kioneki @pesa_africa

So an African DAO is essentially an online community of migrants of regularly send money back home to Africa and choose to stake their USD/GBP remittance on a UniSwap style DEX to support liquidity for cross border remittance transfer and get to earn 7% APY on their stake

His argument is simple yet compelling, Fintechs can become DAO’s and users can be liquidity providers who receive rewards for providing liquidity on specific currency pairs. For instance, US$ - KES and these can be in the form of stablecoins. This can significantly reduce the cost of remittance whilst potentially creating a low cost bank. The same logic can be extended to lending and trading.

Other Thoughts;

1. DeFi is still hampered by a number of issues. Cryptocurrencies are very volatile and thus they don’t lend themselves to some of the use cases. For instance, borrowing on your Bitcoin holdings over the long term can be unsustainable particularly if prices swing in the range of 40-50% in either direction;

2. Cyber-security risks abound in crypto. Earlier this year, hackers stole around US$ 600 million from the Poly network. Given that these operations are decentralised then there’s no recourse to insurance or government led enforcement measures to either recover your funds or pursue the perpetrators. It’s difficult to build trust with such vulnerabilities;

3. Macro-instability - MakerDao in early 2020 lost its peg to the Dollar due to a crash in Ether prices. Given that pricing and incentives are based on smart contracts, in the event of a black swan event, then a crisis can be exacerbated due to the smart contracts. The flash crash of 2010 is a perfect example where algorithms can multiply adverse outcomes. Traditionally some of these issues are resolved by institutions such as the Central Bank which acts as a lender of last resort;

4. UX - DeFi is still user unfriendly and intimidating. In traditional finance, a customer doesn’t need to understand ALCO, liquidity matching, value at risk, projected NPLs etc, he just trusts that all these are managed well and that he can access finance as and where needed;

5. Can traditional finance adapt in time? Ultimately some of the core concepts behind DeFi can be done using modern technology by traditional organisations. For instance, a token is an ownership document, therefore can a Bill of Lading or Title Deed be tokenised so as to improve liquidity and visibility? Technologically the answer is yes. Nonetheless this asks a lot of existing governments which will have to be at the vanguard of such a transformation. Usually such transformation is too painful for incumbents and thus DeFi just has to continue building without waiting for TradFi to adapt;

6. Real world enforcement is still an issue. Ultimately we live in the real world. As Dave Chappelle says “Twitter is not a real place” and similarly the Metaverse is also not a real place. Real world enforceability is still an issue for DeFi;

7. Ultimately DeFi is dollarisation and in my view this is one of the reasons China has cracked down on cryptocurrencies whilst building its own centralised CBDC with a view of in the long-term achieving the long-term benefits of DeFi whilst remaining in control. As DeFi adoption spreads, it will come up against the formidable barrier of a government’s instincts to survive.

All that said, talent and funding is flowing into web3 at an unprecedented rate. When you look at the world from a holistic perspective, the long term trends are towards a fairer and more just world and this is embedded into web3 economics. It will be interesting to see how this evolves but after dipping my toes into DeFi, I’m a big fan. Of course there are major obstacles to widespread adoption but the functionality is so rich and intuitive and the economics are built into the protocols thus creating a new economic paradigm. This paradigm is underpinned by universal access which was excluded from the industrial revolution by design

As always thanks for reading and drop the comments below and let’s drive this conversation.

If you want a more detailed conversation on the above, kindly get in touch on samora.kariuki@frontierfintech.io or samora.kariuki@gmail.com