Will smart contracts usher in a new wave of financial inclusion?
Digital financial inclusion involves leveraging technology to reach communities that are excluded from—or have limited access to—a range of formal financial services. World Bank Findex data indicate that while progress has been made in expanding access to transaction accounts, individuals’ access to other financial services, such as credit, is still fairly constrained. IMF data on policy holders with insurance corporations suggest that access to insurance is similarly low. Enter smart contracts—self-executing code-based agreements that are typically hosted on blockchain networks. Smart contracts have been lauded for their potential to facilitate a variety of contractual processes, especially contract-heavy financial services, such as credit and insurance. Proponents argue that the self-executing and immutable nature of smart contracts will unlock value for consumers and firms by reducing transaction costs, particularly the reliance on costly third parties for monitoring and enforcing agreements. While there are some feasible short-term smart contract use cases, widespread deployment of smart contracts will depend on an extensive uptake of distributed ledger technology and blockchain. If blockchain ushers in a wave of decentralization in the financial industry, smart contracts would be embedded in a wide range of financial transactions. But even if smart contracts are widely deployed, can they help advance digital financial inclusion? And what issues do policymakers need to consider to enable a responsible and effective deployment of smart contracts?
A recent World Bank report investigates these questions, focusing on smart contracts’ potential applications to financial inclusion and their implications. The report concludes that smart contracts can drive inclusion among consumers and micro, small, and medium-sized enterprises in certain financial services, such as insurance and supply-chain finance. In other areas, such as short-term unsecured credit, the impact would be more limited. Where could smart contracts drive financial inclusion gains? Smart contracts can drive financial inclusion in situations where process frictions and operational, fraud, or legal risk contribute significantly to the cost of financial services. They can also be valuable in cases where trust is a barrier to the uptake of financial services. Yet smart contracts will not alleviate a variety of common impediments to financial inclusion, including credit risk and income irregularity, distance and inaccessibility, limited awareness and financial literacy, and cultural factors. To illustrate, consider two financial products that have implications for financial inclusion and are frequently cited as smart contract use cases: index-linked insurance and short-term unsecured loans. Index-linked insurance, such as weather index insurance, may be well-suited for smart contracts because underlying events, such as a rainfall index, can be deterministically coded. The adoption of smart contracts in the index-linked insurance space will not solve many common impediments to insurance penetration—such as irregular incomes and limited public awareness—but could help with some issues, including product suitability and trust. If smart contracts lower the cost of providing insurance, insurers could focus more resources on product, distribution, and business model suitability. To this end, smart contracts could be effective in alleviating frictions in the claims process, including those involving paperwork filing, handling, investigation, and settlement. Smart contracts could also streamline premiums collection and other administrative tasks, improving insurance companies’ efficiency. Regarding trust, smart contracts would help improve transparency and move at least some control over the claims process into consumers’ hands. In some cases, smart contracts may enable fully automated claims, eliminating the burden on customers to file claims, thereby improving the timeliness and reducing the uncertainty of payouts. Alternatively, consider short-term unsecured loans: Although smart contracts could yield efficiency gains across various phases of a loan lifecycle, the application and approval processes for many forms of unsecured lending, such as credit cards and mobile money-based loans, are already highly automated. In addition, a significant driver of the cost of consumer credit is credit risk, and smart contracts will do little to improve borrowers’ creditworthiness. So, in this case, the benefits of smart contracts may be limited. Global business leaders are confident about the utility of smart contracts. In Deloitte’s 2019 Blockchain Survey of over 1,300 global senior executives, 95 percent of the respondents believe smart contracts are an important benefit of blockchain. However, widespread smart contract adoption is conditional on blockchain uptake, and while blockchain optimism is strong, applications are incipient. Although 83 percent of Deloitte’s survey respondents believe a compelling business case exists for blockchain, the share of respondents who have initiated blockchain deployments decreased from 34 percent in 2018 to 23 percent in 2019. Despite the slow uptake of smart contracts, policymakers can begin evaluating important policy issues to ensure the responsible and effective deployment of such contracts. As elucidated in the World Bank report, key considerations should include how smart contracts will accommodate financial consumer protection standards, customer due to diligence requirements, and foundational legal determinations, as well as how smart contracts could benefit from standardization, vetting, and data source automation. Addressing these questions and ensuring effective implementation of smart contracts can ultimately contribute to advancing access to useful and affordable financial services.