Banking the Un(der)banked: Enabling Financial Inclusion Through Stablecoins
At their core, banks operate as intermediaries that pool funds from depositors and facilitate interest-bearing loans to borrowers. (1) Although the latter serves as a primary source of revenue for banks – as well as a means for lenders to grow their assets – the disbursement of funds to creditors is also a key catalyst for economic development and the accumulation of wealth. (2) As early as the 18th century BCE, in the ancient civilization of Babylon, the Code of Hammurabi first defined the terms of lending agreements and thus established the precursor to modern banking. (3) Over the ensuing 4,000 years, banks have functioned as a cornerstone of the Traditional Finance (“TradFi”) system, where centralized institutions control how money flows through societies. (4)
The success of TradFi is predicated on inclusion, as the diversification of deposits provides banks with greater resilience and acts as a potential buffer against “bank runs” during periods of financial stress. (5) Furthermore, broader access to banking services – particularly among lower-income households and small businesses – has a stabilizing effect in communities, while enabling shared prosperity. (6) Taken together, financial inclusion is fundamental to social progress and has been deemed a foundational element to achieve the United Nations Sustainable Development Goals (“SDGs”). (7)
Despite the potential for TradFi to pursue profits coupled with purpose through financial inclusion, the reality is that banking systems have been notoriously exclusionary towards marginalized communities. (8) In fact, a 2019 report by the Federal Reserve found that 22% of American adults (or 63 million individuals) were either unbanked – and completely disconnected from TradFi – or underbanked (collectively “un(der)banked”). (9) Moreover, this phenomenon disproportionately affects Black and Hispanic communities as they are three times more likely to face financial exclusion. (10) Many of these disparities can be attributed to the legacy of “redlining,” where discriminatory housing practices promulgated by the Federal Housing Administration during the first half of the 20th century precluded banks (and any potential mortgages) from co-locating with communities of color. (11)
Without access to TradFi, un(der)banked Americans are forced to rely on alternative financial services which present an array of risks and can perpetuate cycles of poverty. Creditors in these circumstances often have no choice but to borrow from disingenuous lenders at predatory rates and are usually without a secure location to deposit income. (12) Instead, the un(der)banked might have to cash checks at payday lenders and pawn shops that charge exorbitant fees. (13) Even those with access to a bank account might be deterred from fully participating in TradFi due to overdraft penalties, ATM withdrawal charges and other burdensome costs that could offset the benefits of banking. (14)
Whereas TradFi necessitates physical banking infrastructure to serve clients, Decentralized Finance (“DeFi”) allows for peer-to-peer (“P2P”) conveyance of cryptocurrencies without the need for a third-party bank to validate transactions. (15) Rather, smart contracts – self-executing agreements programmed on a blockchain – orchestrate the transmission and settlement of funds between digital wallets. (16) Unlike TradFi, where customers require background checks and minimum balances to open an account, DeFi can be accessed by anyone with a smartphone or internet connection. (17) Accordingly, DeFi offers the capacity to reach un(der)banked individuals in remote and underserved areas with limited TradFi banking coverage. (18)
Given the volatility of popular cryptocurrencies on the market, and the need for predictability in DeFi, stablecoins have emerged as a digital asset class that are intended to maintain a “pegged” value. Fiat-backed stablecoins are expected to be backed 1:1 by government-issued currency, as is the case with USDT and USDC which are both collateralized with U.S. dollars. Alternatively, stablecoins can be pegged to commodities (such as gold) or even another cryptocurrency. Algorithmic stablecoins, such as Dai on the Ethereum blockchain, are programmed to maintain a set price by adjusting the number of tokens in circulation based on market dynamics.
Theoretically, stablecoins can “bank” the un(der)banked by providing access to a digital currency that can be stored in a wallet without minimum balance requirements and can be used to instantly process payments. Additionally, the disintermediation of centralized banks – which are well known for maximizing profits on interest rate spreads – could allow for DeFi borrowers to obtain credit on more favorable terms and subsequently provide higher yields to lenders. Stablecoins could bring much needed capital to communities that have been excluded by TradFi and boost local economies.
In the present cryptocurrency climate, however, stablecoins are not without risk. The recent collapse of TerraUSD, which wiped $40 billion off the market, has called into question the viability of algorithmic stablecoins and the manner in which they should be regulated. (19) In light of the recent de-pegging of Circle-issued USDC, arising out of fears that Circle lacked adequate U.S. dollars to collateralize its tokens, fiat-backed stablecoins have become increasingly scrutinized on the basis of their available reserves. (20) Here, too, regulators are actively developing frameworks to ensure that stablecoins are as “fully backed” as advertised.
Ultimately, financial inclusion can create a more equitable society and boost economic activity by increasing access to capital in communities. Looking beyond the United States, with an estimated two billion people – or 25% of the global population – disconnected from financial services, there is both a tremendous need and opportunity for the implementation of stablecoins. (21) As regulators continue to establish the parameters for safer DeFi systems, banking has the potential to become an industry that achieves sustainable profits alongside scalable impacts to its customer base.
1 Jeanne Gobat, Banks: At The Heart of the Matter, Finance & Development (2012) https://www.imf.org/en/Publications/fandd/issues/Series/Back-to-Basics/Banks.
2 Mary Hall, How the Banking Sector Impacts Our Economy, Investopedia (June 23, 2021) https://www.investopedia.com/ask/answers/032315/what-banking-sector.asp.
3 Annabelle Amery, A Brief History of Loans: Business Lending Through the Ages, Become (October 23, 2018) https://www.become.co/blog/a-brief-history-of-loans-business-lending-through-the-ages/.
4 Natalia Martchouk, The History of the Financial System, trimplement (August 11, 2020) https://trimplement.com/blog/2020/08/history-finance-system/.
5 Martin Melecky, Financial Inclusion for Financial Stability: Improving Access to Deposits and Bank Resilience in Sync, World Bank Blogs (September 10, 2013) https://blogs.worldbank.org/allaboutfinance/financial-inclusion-financial-stability-improving-access-deposits-and-bank-resilience-sync.
6 Financial Inclusion, The World Bank (March 29, 2022) https://www.worldbank.org/en/topic/financialinclusion/overview.
7 Igniting SDG Progress Through Digital Financial Inclusion – 2023 Edition, reliefweb (February 16, 2023) https://reliefweb.int/report/world/igniting-sdg-progress-through-digital-financial-inclusion-2023-edition.
8 Courtney Davis, Driving purpose and profit through financial inclusion, Deloitte Insights (March 30, 2021) https://www2.deloitte.com/us/en/insights/industry/financial-services/purpose-through-inclusive-finance.html.
9 Report on the Economic Well-Being of U.S. Households in 2018 – May 2019, Board of Governors of the Federal Reserve System (June 14, 2022) https://www.federalreserve.gov/publications/2019-economic-well-being-of-us-households-in-2018-banking-and-credit.htm.
11 Katherine Carter and Patrick Hain, How Equitable Access to Banking Improves Economic Conditions for Everyone, National League of Cities (July 10, 2020) https://www.nlc.org/article/2020/07/10/how-equitable-access-to-banking-improves-economic-conditions-for-everyone/.
12 Emily Guy Birken, The Costs of Being Unbanked or Underbanked, Forbes (December 2, 2022) https://www.forbes.com/advisor/banking/costs-of-being-unbanked-or-underbanked/.
13 Paul Solman and Diane Lincoln Estes, Millions of ‘unbanked’ Americans lack adequate access to financial services, PBS NEWS HOUR (December 26, 2022) https://www.pbs.org/newshour/show/millions-of-unbanked-americans-lack-adequate-access-to-financial-services.
14 Banking and Poverty: Why the Poor Turn to Alternative Financial Services, Berkeley Economic Review (April 15, 2019) https://econreview.berkeley.edu/banking-and-poverty-why-the-poor-turn-to-alternative-financial-services/.
15 James Royal, What is DeFi? A beginner’s guide to decentralized finance, Bankrate (April 15, 2022) https://www.bankrate.com/investing/what-is-decentralized-finance-defi-crypto/.
16 DeFi & USDC: A Guide to Dollar Digital Currency and Decentralized Finance, Circle (2023) https://www.circle.com/en/digital-dollar-stablecoin-solutions-for-defi.
17 Stably, How Stablecoins can affect the unbanked and those in developing markets, Stable Trade (August 20, 2018) https://medium.com/stabletrade/how-stablecoins-can-affect-the-unbanked-and-those-in-the-developing-markets-da20646a7bbc.
18 John Wingate, The role of cryptocurrency in advancing financial inclusion, Cointelegraph (February 10, 2023) https://cointelegraph.com/innovation-circle/the-role-of-cryptocurrency-in-advancing-financial-inclusion.
19 Prashant Jha, How Terra’s collapse will impact future stablecoin regulations, Cointelegraph (May 27, 2022) https://cointelegraph.com/news/how-terra-s-collapse-will-impact-future-stablecoin-regulations.
20 Sage D. Young, USDC Stablecoin Depegs from $1; Circle Says Operations Are Normal, CoinDesk (March 10, 2023) https://www.coindesk.com/markets/2023/03/11/usdc-stablecoin-depegs-from-1-circle-says-operations-are-normal/.
21 Mitsuhiro Furusawa, Financial Inclusion: Bridging Economic Opportunities and Outcomes, International Monetary Fund (September 20, 2016) https://www.imf.org/en/News/Articles/2016/09/20/sp092016-Financial-Inclusion-Bridging-Economic-Opportunities-and-Outcomes.