What is Decentralised Finance?
What would be the interesting use cases in Africa?
Decentralised Finance;
2020 was a breakthrough year for Decentralised Finance “DeFi” with increasing global interest. This was largely driven by the skyrocketing prices of Bitcoin and Ethereum. The De-Fi movement as it currently exists is largely driven by technologists and hobbyists with the terminology being strange and unfamiliar to most. Typically in most industries a lexicon develops that tends to distinguish between outsiders and insiders. The main goal of this newsletter is to Learn out Loud about Fintech. I found it useful to get into the rabbit hole that is Decentralised Finance to understand what it is, what it isn’t and what value it would have for Africa.
De-Fi can generally be described or thought of as an ecosystem of decentralised applications that run on top of a distributed ledger and are geared towards the facilitation of permissionless access to financial services such as borrowing, lending, insurance and investing. The main building blocks of the De-Fi movement are blockchain technology, distributed ledgers, smart contracts and crypto-currency. It is then useful to understand the building blocks of each concept in detail prior to digging deeper into De-Fi.
However first, as always with this newsletter, it is critical to understand the context in which innovation works. Sometimes you can try and replicate an innovation where the context doesn’t apply.
Context
The growth and interest in De-Fi maps the growth and interest in blockchain and cryptocurrencies such as Bitcoin. Bitcoin was first launched in 2009 after Satoshi Nakamoto released his white paper on a new peer to peer permissionless cryptocurrency that worked on a distributed ledger. Around this time, the Global Financial system was falling apart due to poor decision making on the part of larger banks and financial institutions in the Go-Go days of the early 2000s. The anatomy of the financial crisis was driven by the following core issues;
Poor regulatory oversight of the derivative products being marketed by banks particularly the toxic Collateralised Debt Obligations (CDOs) issued by banks and underpinned by sub-prime mortgages - the poor regulation was linked to a cosy relationship between the banks and the regulators.
The auditors and ratings agencies that were trusted to provide oversight to the banks and society in general were also complicit. It was often and still is the case that “he who pays the piper calls the tune”.
When things went belly-up, the big banks, given the concentration of power and influence were termed as being “too big to fail” and that their failure was a systemic risk to society. Governments across the rich world thus bailed them out using taxpayer funds.
One underlying thread that connects all the above issues together is the concept of centralisation. Financial power was centralised within banks, the ability to regulate was centralised within one or two powerful institutions and oversight and audit were centralised within the big four accounting firms and a couple of credit ratings agencies. At the same time, a number of people globally started wondering whether we could have a more robust financial system underpinned by decentralisation which would in theory drive fairer outcomes.
The societal fall-out particularly in the rich world from the GFC is still being felt today. The growth of the far-right, Trumpism, Brexit and even the recent “Gamestop” saga are just but themes birthed by the GFC. A lot of energy is driving the rethink of many big picture issues such as politics, societal design, economics and finance. The De-Fi movement owes a lot of its energy to this as well. The African context largely revolves around an emerging class that wants to take part in the global economy despite geographical restrictions. “I am not my passport” if you will.
De-Fi Building Blocks
Blockchain
The main building blocks of the blockchain are;
Distributed ledgers;
Cryptography;
Consensus Mechanisms;
Distributed Ledger;
Ledgers are tools to store records, in most cases accounting records, ownership records and transaction records. In the past, we used physical ledger books and maintained records in hand-written form. Updates to these records were done manually by a pre-approved person who had to append their signatures to the transactions. With time, record-keeping moved towards centralised computer-based records held in relational databases. This is the existing record keeping system for most modern financial service providers. In most cases though, physical record keeping is done in concert with centralised record keeping. Think mobile money where you have to sign on a physical ledger upon depositing or withdrawing cash at an agent.
In the blockchain, the concept of a distributed ledger is utilised. In a distributed ledger, instead of having a central server, you have numerous distributed computers that often operate on a peer to peer basis that store and update the records. The main benefit of having this distributed system is that there is no single point of failure within the network.
Asymmetric Cryptography;
The idea of having a public distributed ledger that is run on a peer to peer network obviously raises the question of security. The blockchain utilises the concept of asymmetric cryptography to secure data and information shared between participants. I find the video below very useful to understand asymmetric cryptography at a high-level.
Consensus Mechanisms
So you have a distributed ledger with in-built security protocols. However, how do we decide if changes to the records within the ledgers are valid or not. In centralised systems, we often have maker-checker approval processes where a central institution has in-built protocols for deciding who gets to change records. We then trust an institution e.g. bank or insurance company to maintain accurate records and update them properly.
Within a distributed system such as the blockchain, we need to have a consensus framework for deciding on how to update records. There are two main consensus frameworks. Proof of Work and Proof of Stake. In the proof of work frameworks, the blockchain requests that all independent computers (miners) run complex algorithms that “approve” transactions and thus update the ledger.
In proof of stake, there are no miners, but rather there are validators who have to stake the native cryptocurrency. The blockchain then randomly selects them to validate each block and update the blockchain. Again, the video gives a useful description.
Smart Contracts
Nick Szabo, one of the key players in the Crypto world and one who people speculate is Satoshi Nakamoto has a very good description of smart contracts. In his view Smart contracts are; “a set of promises, specified in digital form, including protocols within which the parties perform on these promises”
The set of promises could be contractual or non-contractual and further, may consist of contractual terms or rules designed to carry out business logic. Smart contracts should be able to operate electronically consisting of lines of code as well as the software that defines outcomes. One of the central tenets of smart-contracts is automated performance based on “if” statements. This then lends itself to blockchain technology, where you can have smart contracts that sit on top of the distributed ledgers, are trustless and importantly are verifiable by all participants within the system. The irrevocability of the blockchain is an added draw.
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. The combination of smart contracts and blockchain technology could have a lot of value in finance. Nonetheless some concerns arise;
Contract law traditionally has the “State” as a third-party implied within the contract for arbitration. What is the arbitration mechanism within digital smart contracts? Is it naive to think that a trust-less mechanism can oversee large commercial contracts?
How do you handle contracts written in code being arbitrated by lawyers and judges who understand contracts written in natural language?
Code can have bugs so how do you handle cases of contracts being voided due to buggy code? Here’s an interesting article that helps you think about this
A smart contract should have the following critical ingredients;
Identification of an agreement including commercial procedures, pricing and value transfer, transfer of rights and responsibilities;
Setting of Conditions e.g. pricing conditions, state conditions e.g. location and state of goods/services;
The encoding of the business logic - converting 1 and 2 above into code;
Encryption within the blockchain;
Execution and processing within the blockchain using appropriate consensus mechanisms;
Updating the blockchain;
Ethereum and The Trilemma
There are two major blockchains that currently dominate the blockchain space. Bitcoin and Ethereum. The Bitcoin blockchain was built primarily to run digital currency. Ethereum on the other hand was built to enable not only digital currency but also smart contracts and decentralised applications (DApps). Ethereum operates on a programming language called Solidity and is Turing Complete meaning it can be used to solve any computational problem in theory. What Ethereum offers in addition to the native currency Ether is the ability to build useful applications on top of the blockchain. Most De-Fi protocols in existence are built on Ethereum. The diagram below gives a quick summary of the differences.
However, one of the issues with Ethereum and all other blockchains is that they cannot achieve scalability, security and decentralisation all at once. This is what is called Vitalik’s Trilemma - named after the founder of Ethereum Vitalik Buterin. In essence when you’re building a blockchain, you have to make trade-offs.
Closing Thoughts on the Building blocks;
The 2018 Geneva Report on blockchains had this to say about how to approach the selection and utility of a blockchain.
One may assess the benefits of using a blockchain (or other distributed ledger) technology to overhaul an existing economic activity by asking:
What are the benefits to managing that activity in a distributed manner as opposed to centrally? Asked another way: What costs imposed by the trusted intermediaries in a given market – in the form of inefficiency or rent extraction, for example – can be eliminated by transitioning to a blockchain or distributed ledger? Or what security benefits may be achieved by decentralisation?
Which inefficiencies and technical limitations of distributed systems capacity constraints, governance challenges, privacy – pose particular challenges for the activity in question? Can those constraints be sufficiently addressed while preserving some of the benefits of decentralisation for this particular use case?
Finally, are the gains to be derived from moving a given process to a blockchain sufficiently large as to compensate for the switching costs (i.e., to overcome entrenched network effects)?
Ultimately, you can have varying degrees of decentralisation, security and scalability based on what goals you are trying to achieve. The current Ethereum and Bitcoin platforms offer decentralisation and security. However, you can actually build platforms at a nation-state level that offer less decentralisation but more security and scalability.
Use cases for Africa;
The question then becomes what level of decentralisation and anonymity do we want. The initial aim is to actually have useful applications of blockchain technology on mass scale that enable easier access to finance. Whether this is De-Fi or not critical.
Trade Finance - collateral, custody and escrow;
There are some interesting use cases in trade finance. The costs of trade are quite prohibitive in most countries in Africa and licensing and documentation often tend to act as a barrier to entry in most industries. The blockchain would help with verifiability of documentation, KYC as well as execute smart contracts and provide services such as escrow. Nonetheless, the path to adaptation would be difficult because the existing system works. I think the current experiment that the Chinese are doing with the digital Yuan could have some interesting long-term ramifications. If the Chinese were to build a trade blockchain - think smart contracts and confirming things like standards, location, FOB, insurance etc, then they can layer the digital Yuan as the native currency of that blockchain.
What would be very useful is that if a country like China issued Digital Yuan allocations to African countries based on commodity wealth. This issuance would thus be available to anyone who wanted to import from China via a portal with Chinese “approved” agencies ensuring that goods are delivered to your doorstep. All this information would be updated within a blockchain. The incentives are there as this would drive the adoption of the Yuan as a major reserve currency.
I liked this Podcast by Tim Ferriss about what blockchains and crypto can do and the macro-sovereign threats if the Digital Yuan had widespread adoption.
Insurance - Particularly Medical
If you’ve ever had to buy insurance and make claims in most countries in Africa, you begin to realise that the system is inefficient. Often phone calls have to be made to the insurer particularly for medical insurance, to verify if you have an existing cover and the balance that remains on that cover. If you therefore have to go for consultation, lab tests and buy medicine then that process is repeated at every step of the way. The costs can mount up for all parties involved and are invariably passed on to the customer. I think there could be potential for having all this on blockchain with the additional feature of having pharmacies, clinics and hospitals as nodes/validators that are rewarded for validating transactions.
The path to incremental adoption can be easier because the specific industry associations such as insurance and pharmacies can work together and have joint incentives.
Lending and Borrowing via Collateralisation
Land Registry in most countries in Africa is extremely broken and rudimentary. The blockchain offers the ability to register ownership in a more secure way and enable the registration of claims and charges on that property to be done securely and quickly. Sweden already has an advanced and modern land registry but is working on running its land registry on the blockchain. Additionally, moveable objects can be registered enabling a seamless asset debenture system.
For this to work efficiently, there would need to be company and personal identity registration on a blockchain as well. This would enable real time property and mortgage transactions thus freeing up significant capital for trade and investments. This would drive up access to borrowing to millions. The presence of such verifiable records would also reduce the fraud that takes place at our land registries.
Securitisation and Capital Markets;
There would be significant value if capital market players such as depository and custodial institutions were run on the blockchain. This would make the transfer of shares and bonds to be smooth and verifiable. The benefit of the blockchain is that it obviates the need of reconciliation which is the biggest headache in the securities and depository markets. These costs savings should then be passed on to the clients and issuers thus increasing activity in the markets. Digital KYC would then enable more people to participate in the industry.
Some Thoughts
The global De-Fi movement is still in its infancy but I think there is significant opportunity to dramatically alter the way finance works. Some thoughts below;
The SEC commissioner Hester Pierce had this to say about De-Fi “(De-Fi)...will provide a very good test for our ability to regulate with an eye toward protecting the interests of investors and markets, not incumbents...We tend to look at technological innovation in the markets with deep suspicion, and that mindset has to change.” Additionally, it is worth noting that President Biden’s nominee for SEC Chairman Gary Gensler is an expert on Crypto and Blockchain with a very popular MIT open course on Blockchain.
De-Fi needs to be seen within a spectrum rather than viewed from an absolutist perspective. There is a minimalist approach that says that De-Fi is completely useless and there’s a maximalist approach that says that the world will change forever due to De-Fi. I like to think there’s a middle ground where there will be incremental development in some areas and some will remain as they are.
The way I think about finance and De-Fi in general is that what’s required is a useful application rather than widespread understanding. Yele Bademosi of Bundle Africa gave an interesting analogy. Not everybody has to know how to drive for public transport to be motorised. In addition, very few people need to know how a car works… it just needs to work. Similarly, a killer-app just needs to be developed and very many intelligent people are working on this;
Additionally, existing finance and asset ownership practices would seem esoteric if explained to someone in 17th century Nigeria or Kenya. A title deed is a synthetic form of land ownership i.e. a document represents the land. As always, it's an exercise in imagination.
On Central Bank Digital Currencies - In a recent post on my newsletter I mentioned that I don’t know how different they will be from existing systems. Nonetheless, as it’s a learning exercise, I later came to realise that digital cash is considered legal tender and thus has to be accepted. This has serious implications. A merchant can reject a visa/m-pesa payment but cannot by law reject cash. Digital cash that runs on a blockchain can then have widespread adoption and fuel the De-Fi movement further.
De-Fi would be very useful for Africans in that it would enable you to break free of your geographical barriers. The existing global system penalises people of the global south. Decentralisation would enable you to benefit from your experience and knowledge by democratising access.
A big part of our world is already permissionless think media and entertainment. The permissionless movement is deeply embedded into the ethos of Gen Z and Millenials. This is a very useful book to understand the new permissionless way of the world.
I really like this Podcast discussion by Lex Sokolin and Pat Berarducci on the De-Fi movement. There is a very interesting story about Bernie Madoff and how DeFi could reduce the instances of such frauds.
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@gmail.com;