On-chain lending in developing countries

Crypto financing for the underserved and underbanked 📈

Over the past week, I've been reflecting on the future of small business finances in developing countries. Having seen friends and family struggle to run their daily business operations due to a lack of funds, I know how hard it is to raise money in developing countries where interest rates are high, liquidity is low, and revenues are cyclical. Businesses need working capital to refill their inventory, pay labor fees, account for supply-chain disturbance, etc. In some circumstances, merchants or wholesalers allow 0% interest credit for a few weeks if both parties included in the transaction, wholesaler, and retailer, for example, have an established working relationship for years. However, many business owners need to borrow money at a high-interest rate to sustain their businesses, which can stifle business growth and hinder economic development in these regions.

Current financing options for small businesses

Small Finance Banks

Small businesses with no established line of credit with private sector banks have increasingly turned to Small Finance Banks to get the working capital they need to run their businesses. In India, these small finance banks mainly serve customers who are in rural areas or people who have traditionally been underbanked. While small finance banks only have a 1.14% market share in India, their growth in new deposits has been encouraging, underscoring the demand from the traditionally underbanked population. However, while growth in this banking sector is encouraging, it falls short when it comes to the speed and execution of evaluating and approving loan applications. Business owners need to visit these banks repeatedly, meet with bank officers, and go through the lengthy process of loan application — a luxury of time that many of these businesses do not have.

Source: Cedar Edge Ratings

Raising money from individual lenders

Borrowing money from private creditors is widespread amongst small businesses, especially in tier-2 and tier-3 cities in developing countries. These lenders collect astronomically high interest rates, burdening entrepreneurs to run their businesses successfully. Generally, a borrower puts in collateral, like a motorcycle, gold, or property, to get the money from the lender. Suppose the collateral is not a viable option. In that case, the lender demands that the borrower find a guarantor who can take responsibility for paying back the loan if the original borrower can’t repay it. The guarantor is generally a third party familiar with both the borrower and the lender.

While this solution may look good on paper, it comes with significant social costs. For example, taking your car or gold to the lender’s office or house puts societal pressure on the borrower. These collateral items are generally shared among the family members, leading to a lack of discretion in borrowing money and a feeling of shame due to societal interference. Additionally, the interest charged on the borrowed money can be as high as 80% APY, leading to business failures, liquidations, and even suicides in some cases.

Instant personal loans

Business owners also rely on instant personal loans in a pinch to run their businesses. While this works for business owners who have established a good credit score, underbanked businesses who have mostly done their transactions through cash or offline face challenges in getting their loans approved. As a result, getting instant personal loans for many businesses is out of pocket.

Enter DeFi lending 🚀

What if we could solve pressing issues faced by small business borrowers? What if users do not have to wait for days to get their loan requests evaluated? What if users don’t have to pay ~80% APY to private creditors to run their businesses? What if there was a financial solution that would not put the underbanked at a disadvantage?

I believe that crypto has a huge opportunity to address most of the concerns mentioned above and provide financial freedom to small businesses in developing countries. Jump Crypto wrote a great article covering on-chain credit, outlining different lending mechanisms available to users. The underlying message of the article is that while we are still early in on-chain lending, new innovations in the DeFi protocol designs would be able to capture a full array of financial services to drive economic growth.

While DeFi comes with obvious risks, including vulnerability, smart contract flaws, higher complexity, etc., it can solve many current financing challenges that small businesses face, especially in developing countries.

Highlights of DeFi lending 🎆

On-chain lending is fast, removing the need for business owners to go to banks and repeatedly submit documents to get their working capital. DeFi lending shifts the power from centralized banks and institutions to the consumers, as the lender and borrower are part of the same peer network on any given DeFi protocol. On-chain lending promotes transparency by executing loan contracts on a decentralized protocol to which all parties involved - lenders, borrowers, auditors - can have complete visibility. This enforces accountability, leading to a reduction in fraud and delinquencies. Lastly, on-chain lending looks past the credit score. It evaluates a borrower's creditworthiness through alternative data sources, such as transaction history and revenue of the business, unlocking credit to businesses that do not have an account of debt repayment or credit. Lots of exciting startups in this space, and I expect that more Traditional Finance (TradFi) and DeFi will form partnerships to bring DeFi lending to the general population.

Jia is a decentralized lending protocol that allows businesses in developing countries to take out crypto-backed loans while providing a consistent yield to investors deploying their money in Jia’s lending pools. What I find interesting is that Jia supports unsecured lending - without requiring collateral from borrowers. I think that this is a considerable step toward unlocking loans for small businesses. According to Jia’s Litepaper, it enables unsecured lending by examining business transaction data such as revenue, inventory, repayment records, etc., on chain. This data-driven risk model unlocks financing for the underbanked population while enabling investors to earn a yield on real-world business financing.

Goldfinch is a decentralized lending protocol that allows borrowers to get financing from Goldfinch without putting crypto as collateral. Borrower pools are fully collateralized by off-chain real-world assets and income streams, removing unsecured lending risk. This design allows lenders to earn a sustained yield on their crypto holdings. Additionally, Goldfinch trusts the collective assessment of lenders instead of trusting an individual lender’s evaluation, which further alleviates the lending risk.

Atlendis is another decentralized protocol that was founded in 2021. Lenders can select which borrower pools they want to put their crypto holding in and earn the interest rate they set. With its one-time loan offering and revolving line of credits, Atlendis makes it easier to close the gap between the workings of Tradtional Finance (TradFi) and DeFi.

Parting observations

While current solutions, such as overcollateralized or unsecured lending, may not be the final frontiers in unlocking financial freedom for small businesses, a combination of on-chain trust establishment through a third-party, over-collateralization, and off-chain underwriting may be the way forward in creating alternative financing options for small businesses in developing countries.