Should Nigerian banks be worried about decentralised finance?

If you take a quick look through “Naija twitter”, you are sure to find a couple of users with the .eth tag added to their usernames. This growing clique of Twitter users gives you an anecdotal sense of the number of people with considerable interest in ETH, Ethereum’s native currency. 
 

But you see, it is not just ETH; Nigerians have a soft spot for all things crypto. In August 2021, Binance, the largest cryptocurrency exchange by trading volumes, published a report that identified Nigeria as the leading country for cryptocurrency adoption. According to the report, 32% of Nigerians surveyed had owned or used crypto at some point; this was almost 1,000 basis points higher than the following country—Vietnam. Another recent publication by Finder.com, which surveys individuals in 26 countries to understand cryptocurrency adoption, found that approximately 27% of Nigerians hold crypto. The second country globally after India.

Historical trading data from Binance gives some credence to the findings of both reports. The chart below shows that in July 2022, the value of trades executed on the USDT/NGN pair was nearly ₦2 billion. And even though this has fallen from a high of ₦13.5 billion in March 2021, the trend looks to be picking up. Clearly, Nigerians have strong bullish sentiments when it concerns crypto.

This increased adoption has made Nigeria a fertile ground for other blockchain applications such as Non-fungible Tokens (NFTs), blockchain gaming and Decentralised Finance (DeFi). DeFi, in particular, is interesting because of its significant growth and the attention it is receiving from investors globally. Between 31 December 2019 and 31 December 2021, the total value locked (TVL) in DeFi protocols increased by more than 400%, from $607 million to over $250 billion by 31 December 2021. Even though TVL has fallen to approximately $90 billion, this amount is still significant and worth paying attention to. For context, TVL is a fancy way of referring to the total amount of crypto assets (valued in USD) that individuals and institutions have deposited and “invested” in various DeFi projects to support services like staking, lending, and reserve creation.

DeFi has grown to cover several aspects of orthodox finance such as savings, investment, payments, insurance and even complex use cases such as options and derivatives. To paraphrase Marc Andreessen, DeFi plans to eat up orthodox finance. One area of orthodox finance that DeFi has its eye set on is lending. Lending accounts for the second largest TVL in DeFi—more than $18 billion.

It makes sense why lending is growing; credit is the lifeblood of an economy, making it possible for businesses to invest and for consumption to take place. This working paper from the IMF shows that credit growth significantly impacts economic growth, especially in emerging markets. The mechanism is pretty straightforward; increased consumer credit allows individuals to purchase products and services they would typically have saved for or abandoned without credit. This increased consumption then incentivises businesses to ramp up investment, also made possible through business credit. Businesses can create more jobs and pay more, resulting in higher incomes and more consumption, and as this virtuous cycle continues, the economy grows.

Since DeFi plans to disrupt traditional finance and Nigerians are increasingly getting comfortable with all things crypto, it is essential to look at how this may affect the commercial banks, a key component of Nigeria’s financial system. And an excellent place to start is with lending, as this is an essential function of banks.

But before we delve into this, let us attempt to understand the DeFi concept and how it works.

How Does DeFi work?

In introductory finance, you are taught about “financial intermediation”—the process where an institution serves as a middle-man between two parties in a financial transaction like investments, purchase of assets, credit provision etc. 

In the case of lending, when you deposit funds in the bank, the bank takes those funds and provides them to individuals or companies that need a loan to carry out economic activities. The borrower then pays interest on the loan to the bank, and the bank gives you a small cut of this interest for providing your funds. Essentially the bank acts as a financial intermediary.

In DeFi, this whole process is replaced by software and code written on the blockchain. Using the example of lending above, let’s say you got a bonus check of $100 and did not want to spend it. You could convert it to crypto and stake it in a DeFi lending pool. On the other side of the transaction, someone else takes it as a loan, and the interest flows directly to you.

This explanation is thoroughly simplified, but it gives a good picture of what goes on, how this differs from orthodox finance, and why people flock to it. By removing the need for financial intermediaries, DeFi removes the associated bureaucracy, increases efficiency and ensures that the providers of funds have a higher return as opposed to the classic case of taking whatever the banks offer in interest payments.

We now have one piece of the puzzle—a working understanding of DeFi. But to conclude whether the banks should be worried, we can look at the state of bank lending in Nigeria.

Lending a helping hand…or not

One of the major roles of banks is to provide credit, mainly because deposit-taking banks such as commercial banks have access to a large pool of low-cost funds, i.e. customer deposits. 

But it seems Nigeria’s commercial banks approach this from a different perspective. Despite 45% of Nigerians using products from formal bank institutions and 27% with a savings account as of 2020, only 3% of Nigerians said they had a loan with a bank, according to the most recent survey results from EFInA.

This is reflected in the loan-to-deposit ratio (LDR) of commercial banks, which measures the percentage of deposits with commercial banks that have been disbursed as loans. The chart below shows that the LDR has fallen over time to 59%. You would notice some quarter-on-quarter improvements between Q1 and Q3 2021, but Q4 results are returning to previous levels. 

The current figure is below the CBN’s requirement of 65% and lags behind regional peers such as South Africa (91%), Kenya (76%) and global peers including Brazil (70%) and India (75%). This reluctance by the banks to lend to businesses and consumers is not unconnected to the broader state of the economy. Stears has highlighted some of these factors driving banks' aversion to lending. High poverty levels and persistent price controls result in banks viewing lending as risky; this is exacerbated by inadequate identity systems that make it hard for banks to differentiate between good and bad actors.

The aforementioned factors play out in the correlation between non-performing loans and the LDR. As NPLs increase, banks cut back on their lending resulting in lower LDRs and vice-versa.

So we have a situation where banks are unwilling to lend due to some tailwinds—economic management and identity verification issues, leaving space for DeFi to come and take their lunch. But is this really the case?

DeFi to the rescue…or not

Before the crypto maximalists can start celebrating DeFi’s impending disruption of orthodox finance, it helps to check how DeFi deals with some of the problems that orthodox finance experiences.

If you have a working idea of how the blockchain works, you know that it gives a level of anonymity—you can see the transactions for any given wallet but can hardly identify the owner of the wallet. So while in orthodox finance, your bank has your identity details, knows where you live and, in the case of Nigeria, has access to your other bank balances through the Bank Verification Number (BVN), this is not the case in DeFi. And this is where orthodox finance trumps DeFi, access to data that can be used to screen potential borrowers.

So how then does DeFi ensure participants are incentivised to lend and their loans are secured? It solves this by requiring potential lenders to deposit collateral to access loans; this collateral comes in the form of cryptocurrency, and the rates are typically between 120% to 150% of the required loan amount. So if you need to access a loan of Ether worth $100, you may be required to put up $150 worth of a stablecoin like USDT.

For all the talk of democratising access, reducing barriers and removing gatekeepers that plague traditional economic systems, DeFi is adopting the same constraints people have historically experienced. First of all, in terms of affordability, DeFi fails the masses; the requirement to post collateral that is 120% more than the value of a loan restricts DeFi lending to the wealthiest people or those who can access loans from orthodox finance institutions; Here, orthodox finance institutions and fintech startups have even shown that they can lend to less wealthy individuals on the strength of their financial data like having a job or historical earning streams.

Secondly, DeFi also looks to be coming up short in terms of access. Putting up crypto-based assets as collateral restricts DeFi lending to more digitally savvy individuals familiar with the workings of crypto and the blockchain. I know I showed at the beginning of this article that Nigeria is a leader in crypto adoption, but remember that this survey was carried out on those who are digitally connected; a large swath of people fall outside this demography. It is why Stears has argued that the wave of Web3 and crypto won't make the world equal. This is primarily because the underlying infrastructure and companies that make Web3 and crypto possible are being built by people with access to capital, meaning that a significant portion of the returns will accrue to them, thus widening or maintaining existing inequalities and wealth gaps in true Matthew effect fashion.

Despite this, the reasons for requiring collateral are two folds. First, providing collateral mitigates information asymmetries, so the protocol does not care who you are as long as you have assets that can be liquidated in case of default—this is one of the core strategies commercial banks use when issuing loans. The other reason is more native to cryptocurrencies, i.e. the volatile nature means that collateral can quickly lose its value, like Terra ($LUNC) that fell from $87 on 5 May to less than $1 in seven days; hence a significant buffer is created between the actual loan and the value of the collateral. In the case of a price fall, there are players known as liquidators, who can liquidate the contract, so the lender does not lose their investment.

As you can see, this is not entirely DeFi’s fault; the anonymity the blockchain provides and the volatility of crypto due to speculative pressures, i.e. current features of the system, necessitate this design. So turns out we are back to square one in many ways. DeFi seems to be struggling with the same identity and risk problems that orthodox finance has spent years figuring out.

As I briefly mentioned earlier, banks even have an advantage over DeFi because they have access to traditional data points that can be utilised to make better lending decisions. The bankers on Broad street (Nigeria's version of Wall Street) can rest easy because today is not the day DeFi comes for lunch.
 

The wave of innovation

But hold on, what we have been doing so far is almost akin to comparing apples with oranges. Orthodox finance is an industry built over the ages with a set of principles and rules that have ensured its survival; DeFi, on the other hand, is a new set of economic arrangements made possible by the creation of the blockchain.

And this detail about DeFi made possible by the “blockchain” is vital to keep in mind because DeFi will ultimately adopt features made possible by the underlying technology. For example, the speed of settlement of transactions on the blockchain means that DeFi brings more efficiency to economic transactions.

In the same vein, another feature of the blockchain that has the potential to revolutionise DeFi is the ability to represent real-world assets as tokens on the blockchain. In the same way, NFTs are being used to represent unique works of art on the blockchain, they can also serve to tokenise economic assets such as real estate or business shares on the blockchain and use this to tap into funds to finance actual economic activity. This is particularly relevant for individuals who have businesses or investments that may be viewed as risky or complex by orthodox banks but can use this to tap into a pool of global capital through DeFi—it can solve the problem of access discussed above.

This stood out in a conversation with Dr Abel Owotemu, an infrastructure development and finance expert. His company, Greenage, is using public-private models to develop sustainable student housing solutions for tertiary institutions in Nigeria but has found it challenging to access capital from banks and other financial institutions; To mitigate this, he is working with DeFi service providers and integrating his project with the blockchain to tokenise his assets and access capital.

The tale of caution here is that banks need to pay attention to the coming wave of innovation, as the same conservatism that has kept them safe may leave them open to potential disruption by DeFi. It is no wonder that Goldman Sachs, the global investment bank, is already investing in blockchain technology and has its eye set on leveraging NFTs to tokenise financial instruments.

The wisdom here is that when innovation comes calling, only those who heed the call do not get drowned by its waves.