The Limits of DeFi for Financial Inclusion

2. The limits of DeFi for the democratisation of finance

Decentralised finance markets, including both DeFi protocols and crypto-assets (including stablecoins), have been marketed as a tool to promote financial inclusion. DeFi protocols claimed to constitute an alternative to traditional financial service provision that aims to democratise finance by replacing legacy, centralised institutions with peer-to-peer relationships that can provide a full spectrum of financial services, from everyday banking, loans and mortgages, to complicated contractual relationships and asset trading (Forbes Advisor, 2023[18]).

This chapter investigates the extent to which DeFi protocols, and crypto-asset markets more broadly, have delivered on their promise for the democratisation of finance and the promotion of financial inclusion. It finds that they have largely failed in this objective thus far and have instead exposed retail participants to disproportionately high risks. The chapter then examines alternative FinTech applications that could be better suited to promote financial inclusion in ASEAN and beyond, particularly for MSMEs.

2.1. Decentralised finance and the false promise of democratisation of finance

2.1.1. Professional investors dominating DeFi activity globally

Quantitative evidence suggests that professional and institutional investors have been the most active participants of decentralised finance markets. Using transaction sizes as a proxy, it can be inferred that more than 2/3 of global crypto-asset activity is performed by professional and/or institutional investors in every region analysed, and the share of professional activity as a part of total crypto-asset volume is the highest in East Asia (Figure ‎2.1).

Figure ‎2.1. Professional investors dominate decentralised finance activity in East Asia from July 2019 to June 2020

Source: OECD based on Chainalysis.

Such investors include large individual holders of crypto-assets (so-called ‘crypto-whales’); centralised crypto-asset service providers, including exchanges (collectively known as “centralised finance” or CeFi); and institutional investors such as hedge funds or family offices. The latter are reported by industry sources to have been drawn into these markets by the opportunities for high returns, given that substantial volatility is one of the defining characteristics of mainstream crypto-assets.

When it comes to DeFi protocols in particular, retail participation has been almost negligible throughout the period 2020-2022 globally. Quantitative evidence around the DeFi protocols market suggests that large-sized transactions in DeFi, used as a proxy for institutional and professional investor participation, represented the largest share of DeFi activity throughout the short history of the DeFi market (Figure ‎2.2). Such investors could include hedge funds drawn into the DeFi protocol activity for the unrestricted leverage opportunities provided by DeFi lending and borrowing protocols, where crypto-assets can be posted as collateral to lever up multiple times (OECD, 2022[4]). This activity can also be explained by the prominent role of CeFi providers in the decentralised finance ecosystem. Such CeFi players (e.g. Celsius, FTX) performed multiple – and often conflicting – roles in the ecosystem and were heavily involved in DeFi protocol activity as this constituted means to secure some of the returns promised to their investors (OECD, 2022[3]).

Figure ‎2.2. Negligible minority of DeFi transactions come from retail investors from June 2020 to 31 January 2023

Note: Size of transaction as proxy. Institutional transactions representing those above USD 1 million, professional transactions representing those between USD 10K and USD 1 million, retail transactions representing those below USD 10K.

Source: OECD calculations based on Chainalysis data.

Interestingly, when looking into the inflows and outflows of funds to DeFi protocols, it can be observed that much of the flows coming into DeFi protocols are originating within the DeFi space itself (Figure ‎2.3). This points to the increased use of leverage within the decentralised finance system, with assets borrowed in DeFi borrowing and lending protocols re-used as collateral multiple times for further lending, for example. These flows could also be explained by the opportunistic shift from one platform to another given discrepancies in rates between platforms, or the shift to tokens and protocols depending on the yields offered at any point in time (OECD, 2022[4]).

Figure ‎2.3. Inflow of funds to DeFi by type of investor from June 1, 2020 to January 31, 2023

Note: DeFi category including DeFi protocols and excluding DEXs that are reported separately.

Source: OECD calculations based on Chainalysis data.

Trading behaviour across different types of exchanges also reveals a similar dominance of large professional market participants. The size of trades executed at centralised exchanges (CEXs) and decentralised exchanges (DEXs) indicate that participation in DeFi is dominated by large-size trades, most akin to activity from professional investors, including so-called ‘whales’, rather than small retail players (Figure ‎2.4). The average trade size on DEXs, particularly in the case of stablecoin trading, is ten to one hundred times higher than the average trade size on CEXs. Indicatively, the highest weekly average trade size for Uniswap V2 was USD 14 000 and for Uniswap V3 was USD 95 000, compared against centralised exchanges with average trade sizes of USD 1 000-4 000 (Carey, 2023[19]). This discrepancy can be attributed to differences in the price determination mechanism between the different DEXs and the different capacity of AMMs to absorb large trades resulting to relatively low slippage (Carey, 2023[19]). It can also be attributed to differences in the microstructure of the two types of exchanges, as order books on CEXs split trades based on order size, while liquidity pools on DEXs execute trades in their original size.

Figure ‎2.4. Average trade size in DEXs vs. CEXsof March 1, 2023 – July 22, 2023

Source: Kaiko.

2.1.2. Retail investors disproportionately affected by the crypto winter

Despite the prominence of professional investors in decentralised finance markets, there are still sizeable amounts of retail users participating in these markets. In fact, the number of small wallet holders, which is used here as a proxy for retail users, has been increasing over the period 2020 – H1 2023 for mainstream crypto-assets (Figure ‎2.5). Given that self-custody of crypto-assets (self-hosted wallets) require more technical knowledge and skills than accessing crypto-assets through a centralised interface (e.g. trading platform or exchange), retail investors tend to access crypto-assets through centralised trading platforms/exchanges and were therefore exposed to the failures of CeFi players during the crypto winter. The absence of safeguards for investor and consumer protection in many of these markets, retail investor participation merits the attention of policymakers (OECD, 2022[3]).

Figure ‎2.5. Number of retail holders of mainstream crypto-assets and stablecoins from 2020 to H1 2023

Note: Retail holders considered as holders with maximum 1 Bitcoin or 10 Ether tokens in their wallet, respectively (LHS) and that have a balance of up to USD 10 000 equivalent of USDC or USDT (RHS).

Source: OECD calculations based on Chainalysis data.

The 2022-23 crypto-asset market downturn has left retail investors particularly exposed to important losses without any recourse. The impact of the crypto-asset failures on many retail crypto-asset market participants has been disproportionately high compared to large crypto-asset investors or dominant market participants who appeared to close positions with limited losses or even a profit. Indicatively, in the case of the Terra Luna collapse, several large investors appeared to have exited their positions in UST much earlier than many smaller investors, while some small investors also continued buying during the collapse (Shah and Latif, 2022[20]; Bloomberg, 2022[21]). In line with this trend, analysis of transaction data on Bitcoin trades show evidence of smaller Bitcoin wallets being net buyers during the crypto-asset market downturn, against large wallets that offloaded their Bitcoin holdings in the aftermath of the failures (OECD, 2022[4]) (Figure ‎2.6). Empirical studies based on data on major crypto trading platforms over August 2015 – December 2022 show that a majority of crypto app users in nearly all economies made losses on their bitcoin holdings (Cornelli et al., 2023[22]).

Figure ‎2.6. Small Bitcoin holders net buyers during the crypto winter, large holders sellers as of end September 2022

Note: Change in holdings of Bitcoin for a size category, expressed in millions of crypto-assets held by the entity at the last week for each month.

Source: (OECD, 2022[4]).

2.1.3. Complexity and non-custodial nature of DeFi make them unsuitable for underbanked/underserviced parts of the population

In addition to involving unregulated or uncompliant financial service provision, the complexity of DeFi protocols and their non-custodial nature make these practically difficult, if not outright unsuitable, for retail participants and therefore unfitting for financial inclusion purposes. For a non-programmer, it is difficult to interact with the interfaces of DeFi protocols if one is not familiar with blockchain technology and has no coding skills, given the technical complexity of DLTs and composable DeFi applications (OECD, 2022[2]). Even with the emergence of more user-friendly interfaces, most aspects of current DeFi activity are difficult to grasp for the average retail participant in need of access to basic financial services. Complex strategies of leveraged trading and rehypothecation of crypto-assets are the prevailing activities in DeFi today, which clearly cannot lend themselves to objectives such as the promotion of access to basic financial services. For their most part, these do not involve any real assets or financing of real projects, thus making them unfit for real economy financing purposes. When it comes to DeFi lending protocols in particular, due to the anonymity of borrowers, over-collateralisation is pervasive, and reliance on collateral limits access to credit to borrowers who are already asset-rich, negating financial inclusion benefits (Aramonte et al., 2022[23]).

The non-custodial nature of DeFi is one of its main defining characteristics that could be unfitting for the average retail investor. Users hold exclusive control over their private keys, and thus, their own assets (until they transact) without assistance from intermediaries such as traditional regulated custodians (OECD, 2022[2]). This means that users are exposed to increased risk of losing their assets, as the loss of private keys translates into loss of access to their investment. Indeed, the loss of a user’s private key is one of the most common risks facing inexperienced users and translates into loss of access to all assets associated with the private key, as decentralised spaces do not allow for forced transfer mechanisms (OECD, 2020[24]). The use of non-custodial or un-hosted wallets as the means to access the DeFi ecosystem at this stage of development of the market adds an extra layer of complexity and risk that are once again unfit for the uninitiated and non-tech savvy average retail user. It should also be noted that retail investors are therefore most likely to invest in DeFi protocol activity through centralised intermediaries, as has been the example through staking products offered to them by centralised entities.

2.1.4. Speculative forces driving crypto-asset activity rather than real use-cases: short-termism and the case of stablecoins

Crypto-asset activity has been driven to a large extent by speculation and fear of missing out, particularly during the prolonged period of ultra-low interest rates. Previous OECD analysis has shown that other motives, such as the use of crypto-assets for portfolio diversification or as an inflation hedge, do not hold (OECD, 2022[4]). Based on surveys, the upside potential for yield in crypto-assets appears to have attracted the interest of investors (private and professional alike) as a vehicle for speculation given the potential for outsized returns.

Several additional arguments can further substantiate the conclusion that crypto-asset use is a speculative instrument rather than a tool with real practical use cases, such as payments. The difficulty in valuing crypto-assets and the huge volatility of these assets make them unsuitable for payments purposes. When looking at trading data classified by duration of holding prior to the trade, holders of less than two weeks have historically the lion’s share of total flows, followed by exchanges (Figure ‎2.7). This may indicate short-termism in trading activity of crypto-asset holders and speculative investment behaviour.

Figure ‎2.7. Total crypto-asset flows by time horizon profile

Note: Flows a weekly basis.

Source: OECD calculations based on Chainalysis data.

When it comes to stablecoins, one of the possible uses of such instruments is for payments and international remittances (see Section ‎1.4). In Europe, surveys of crypto-asset owners have indicated that these are hardly ever used for payments (ECB, 2022[25]). The extent to which many existing unregulated stablecoins are being used for these purposes in ASEAN and beyond is difficult to assess, although there are some indications that stablecoins are currently being used mostly for cases other than remittances. Stablecoins, and in particular USDC and DAI, have been extensively used in DeFi protocols as collateral in lending and borrowing (Figure ‎2.8). Unregulated stablecoins give rise to multiple risks for users and for markets overall, including unreliable reserves and unclear redemption rights for holders, making them unsuited for safe remittance use cases.

Figure ‎2.8. Stablecoin usage in DeFi activity one of the major current use cases globally

Source: OECD Calculations based on Chainalysis data.

Data on USDC usage in DeFi are indicative of the heavy use of stablecoins in DeFi markets, particularly from professional investors. The majority of USDC trading happens in DEXs (Figure ‎2.9), and it is estimated that in 2022, DeFi lending protocols MakerDAO, Compound and Aave held on average about 10.5% of the total USDC supply (Figure ‎2.10).

Figure ‎2.9. USDC trading volume on DEXs vs. CEXs

Source: Kaiko.

Figure ‎2.10. USDC liquidity deposited on ETH-based DeFi lending protocols

Source: Kaiko.

The high correlation between stablecoin and altcoin (unbacked crypto-assets beyond the mainstream bitcoin and ether) flows in ASEAN could underline the increased use of stablecoins as a medium of exchange within crypto-asset markets, rather than for international remittance use cases (Figure ‎2.11). Indeed, crypto-asset exchanges do not allow trading across all possible crypto-asset pairs, and trading of small altcoins need to go through a stablecoin first. Similarly, stablecoins can be used to transfer funds from one chain to another, given their existence in multiple chains (‘multi-chain’ stablecoins).

Figure ‎2.11. Correlation between Stablecoin and Altcoin in ASEAN from 2020 to 2022

Note: Assets included: BUSD, DAI, DOGE, FTT, LTC, TRX, TUSD, USDC, USDP, USDT_BTC, USDT_ETH, USDT_TRX, XRP

Source: OECD calculations based on Chainalysis data.

It should also be noted that currently, the stablecoin market is a highly concentrated market, both at the issuance and at the holding level. At the issuance level, the top two stablecoins account for 87% of the total market (as of 4 July 2023) (Figure ‎2.12). At the holder level, investors account for a quarter and close to one half of total stablecoins available for the top two stablecoins, USDT and USDC respectively (Figure ‎2.13).

Figure ‎2.12. Stablecoin market breakdown from July 2020 to July 2023

Source: OECD calculations based on CoinMarketCap and CoinMetrics data.

Figure ‎2.13. Stablecoins holding distribution by type of holder

Source: OECD calculations based on Chainalysis data.

Many retail investors driven into decentralised finance markets by speculative motives may not be sufficiently aware of the risks related to such investments, and this is why policy consideration and action is warranted. Consistent policy frameworks around decentralised finance, coupled by a better understanding of the risks involved by investors, should be fostered. In parallel, there is merit in considering promoting other FinTech applications with possible beneficial impacts on financial inclusion, some examples of which are provided in Section ‎3.