ESG (short for environmental, social, governance) investing is often summarised as ‘sustainable’ investing. However, this is an over-simplistic definition as it disregards the two other equally important issues the acronym stands for. The social aspect encompasses investment opportunities that maximise human welfare and successfully deal with pressing social issues.
Given the context of the recent Bitcoin craze, this article will explore how the cryptocurrency space can be used to deliver social benefit, rather than just lining “hodlers” pockets. The way this could be achieved is through DeFi (decentralised finance).
What exactly is DeFi?
DeFi is the talk of the town in the cryptocurrency community. It is defined as "an umbrella term for a variety of financial applications in cryptocurrency or blockchain geared toward disrupting financial intermediaries" (Coindesk, 2020). Think of it this way; cryptocurrencies are attempting to revolutionise the currency aspect of traditional financial markets, whilst DeFi is attempting to revolutionise the rest of it. This includes core activities such as insurance and lending focused at developing countries, where documentation and access to financial services is limited for around 3 billion people, as spoken about by Charles Hoskinson on a TED talk in 2014.
DeFi combines the 3 pillars of blockchain, decentralised transaction systems and smart contracts, to achieve the hopeful ambition of bringing greater prosperity to developing countries, where the traditional financial systems fails. We will demystify what these three pillars are below.
The first, blockchain, allows for a large, secure and distributed ledger where information such as property rights, credentials, identities and agreements can be stored. The system's security lies in its tamper-proof cryptography, which is continuously monitored and approved by the network. Once a piece of information in entered onto the blockchain it is there permanently, making it the perfect place to put personal identities and build up a credit history. The beauty of it being decentralised is that no one can be de-platformed and have their key information disputed. Hernando De Soto Polar estimates $10 trillion worth of wealth locked up due to a lack of documentation. Blockchain can prove to be one way to circumvent this dilemma by providing secure storage of data.
Decentralised transaction systems are a way of removing the need for intermediaries in financial exchanges. Unlike the traditional finance systems where banks operate as a ‘middle man’ to process and approve transactions, decentralised systems remove this requirement. Instead, transactions are not governed by one central party but approved by multiple ‘nodes’ (users) in the network. It focuses attention on only using “middle men of value” which don't take utility away from the end consumer. This allows transactions to be faster and cheaper, which could be significant in the case of remittances. The global remittance market had an estimated value of $682.6bn in 2018, with projections to reach $930.44 by 2026 (Allied Market Research, 2020). Remittance costs are typically between 8-12% of the transaction value (World Bank, 2020) making it incredibly costly to send money home to developing nations, for workers who are already likely low income-earners.
Lastly, smart contracts boast an effective way to execute contractual obligations when necessary criteria are met automatically. This can act as a social benefit source in a technological age where speed and convenience are key. Smart contracts could be developed to automatically pay out insurance funds when you sufficiently documents and evidence your car accident. This can allow you to bypass all the unnecessary regulation and delay when you have suffered from an accident and dealing with insurance companies is the last thing you want to do.
What does the future hold?
Discussed are just a handful of ways in which decentralised finance and its associated technologies offer the opportunity for the social good in the domain of ESG. As can be seen by media headlines on cryptocurrencies, the financial landscape is rapidly changing. However, DeFi is not short of potential risks and the gigantic change that will need to occur before the ambitious goals are achieved is no less than terrifying. But as Charles Hoskinson told me on a call last week, “It is the audacity of the dreamer that makes the world change”.