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On Microfinance: Is Blockchain Really the Best Tech to Build With?

Microfinance, which is the provision of tiny loans to impoverished people, has been slated as a way to help individuals and communities establish or grow income-generating ventures.

While there has been some debate over how effective microfinance is to assuage poverty, there has been substantial evidence to suggest that microfinance does have a positive impact: a study authored by Shahidur R. Khandker in The World Bank Economic Review on the effects of microfinance in Bangladesh suggested that “access to microfinance contributes to poverty reduction, especially for female participants, and to overall poverty reduction at the village level.”

“Microfinance thus helps not only poor participants but also the local economy,” the study explained.

Another study published in the Journal of Development Studies on the effects of microfinance in Bolivia found that the microfinance sector “rivals any in the world, and has played a major part in extracting the macro-economy from meltdown since the mid-1980s.”

With the growing popularity of DeFi, or ‘decentralized finance’, more people have access to loans and other financial services than ever before–and as the sector continues to grow, new markets are being accessed, bringing new potential revenue streams and growing the economies of some of the world’s poorest and most remote areas. A number of scholars and analysts have described the global effects of increased access to micro-finance as a “bottom-up” method of lifting the global economy.

How is financial technology being used to revolutionize microfinance (and, overtime, the world economy)? And what kinds of financial technologies are most effective for microfinance?

Why does this matter?

Most technological solutions for finance are not geared toward microfinance applications–after all, is it really worth it for a company to spend hundreds of thousands (or even millions) of dollars to develop technology that will be used within communities with very limited access to capital?

There is an important reason: developing regions have massive potential for economic growth. Early movers within these regions may have a unique opportunity to gain footholds in the early stages of growth in these economies, and could stand to yield massive profits in the long term once these economies continue to grow. Of course, microfinance is definitely not the be-all-and-end-all solution to global poverty.

Peer-to-portfolio lending platforms provide mutual benefits to developing and developed economies

What do the most successful microfinance platforms look like? Sergey Sedov, founder & chief executive of Robocash Group, pointed to “cases when fintech-based micro-finance institutions (MFIs) launch in-house peer-to-portfolio lending platforms.”

“The idea originates from the traditional peer-to-peer lending but differs from it in the role of the microfinance company,” Sedov said to Finance Magnates. “Acting as an intermediary now, it sells assignment rights for issued loans but also provides investors with a repayment guarantee on overdue loans.”

“In one respect, it helps grow financial inclusion in emerging countries. On the other hand, it is an excellent opportunity for residents of developed countries to earn relatively high returns. At the same time, such projects confirm the globalization of financial processes and the tendency of financial companies to diversify their assets.”

The trouble with blockchain…

Indeed, “fintech-based microfinance can qualitatively improve the serving of the underbanked, i.e. people who have a bank account but cannot get a loan because of no official employment or credit history,” he said. “In addition, it can help the unbanked in rural areas lacking branches of financial institutions. Both cases need an alternative approach to the assessment of creditworthiness and payment opportunities enabled by fintech.”

“For instance, an individual with no bank account and living remotely could open an electronic wallet, thus getting access to credit. Sure, it needs high-speed Internet and digital literacy. However, it provides a very effective way to enhance financial inclusion.”

As microfinance continues to grow, it’s unclear as to whether blockchain-based solutions–including DeFi platforms like cryptocurrency exchanges and Bitcoin payment platforms–are up to the tasks associated with microfinance services.

After all, in addition to providing small loans, financial platforms in developing societies must be equipped to scale for many small payments–something that many cryptocurrency networks–including the Bitcoin network–do not handle very well.

“Processing micro-transactions is nearly impossible with block size limits, but heightening security risk is not a tradeoff we should be willing to make.”

Why is this? Emre Tekisalp, Director of Business Development at O(1) Labs, the team behind Coda Protocol, explained to Finance Magnates that “blockchain technology’s scalability issue is rooted in the constraints of the block size. Bitcoin limits block size, which creates competition between transactions waiting to be validated.”

“Users wanting faster processing can pay higher fees to ensure their transactions are prioritized,” Tekisalp continued. “The long queue of low-fee transactions creates an upward pressure towards users choosing higher fees.”

At the moment, this problem doesn’t have an easy solution: “increasing block size may seem like the obvious fix, but this approach creates other issues: namely, the more transactions per block, the greater the data processing capabilities required of validating nodes and miners,” Tekisalp explained.

Then, “as node resource requirements increase, the pool of eligible nodes dwindles, and the blockchain becomes more centralized, which heightens security risk.”

Therefore, blockchain isn’t necessarily very well-suited for sending and receiving micropayments: “processing micro-transactions is nearly impossible with block size limits, but heightening security risk is not a tradeoff we should be willing to make.”

While there have been solutions that can assuage blockchain’s scalability problems, including the Coda Protocol, blockchain’s capabilities to act as a basis for microfinance lending platforms is also questionable. Indeed, Sergey Sedov told Finance Magnates that “blockchain is a promising technology, but it has not yet rooted in microfinance.”

Centralized solutions still seem to dominate DeFi and microfinance

Instead, at this particular moment in time, “financial companies prefer building corporate databases on centralized solutions, which are reliable and allow high-speed processing of endless flows of confidential data.”

However, this doesn’t mean that blockchain couldn’t be in the future of microfinance: “in terms of lending, blockchain could provide a good foundation for a register of loans to a) make disbursals transparent for regulators as much as possible; b) simplify the transfer of loan portfolios between banks and collection agencies,” Sedov explained.

“It would improve the liquidity of financial assets, providing parties with an opportunity for an easy quality check.”

Still, “what is helpful for banks does not always fit the needs of microfinance companies,” Sedov said. “The latter tend to work with their loan portfolios on their own. Striving to form and retain regular customers, they try not to sell or buy data from competitors.”

In general, Sedov explained, microfinance institutions use “fintech solutions [to] secure an accurate remote identification preventing fraud. All these points belong to data analysis and machine learning solutions. They do not use blockchain but can access complex databases built on it,”

“However, this is not an essential requirement,” he added.

“Today, advanced microfinance companies often guide the development of fintech on a broader framework.”

And blockchain or not, a spokesperson for fraud prevention firm SEON Technologies told Finance Magnates that there are a few important features that microfinance platforms must provide on the borrower and lender sides.

In particular, mobile applications: companies that are seeking to work in microfinance must have a robust mobile and online presence.

This is because many of the communities that would benefit from using microfinance platforms are in remote locations without regulator access to brick-and-mortar financial institutions, or even desktop computers. Therefore, mobile technology gives remote communities unprecedented access to financial services.

In addition to greater accessibility, SEON said that mobile applications make it so that “collecting information can be done more easily, and done in only a few steps,” making the process simpler.

On the lender side, “automation is key in reducing costs and thus allowing lower and more competitive interest rates.”

Essentially, “there it is a mutual interest for both parties to have a quick, seamless process with minimal human intervention.

In some respects, the innovative tools that have been developed by microfinance companies have led the way for the rest of the financial industry. Emre Tekisalp said that “today, advanced microfinance companies often guide the development of fintech on a broader framework.”

“Their activities in fintech help reaching earlier untapped audiences and can serve as guidelines for the use of technologies in other areas, [such as] traditional banking.”

What are your thoughts on fintech in the microfinance sector? Leave them in the comments below.


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