What does something as boring as compliance software have to do with financial inclusion, decentralization, or economic development of underdeveloped countries? In short, the lack of modularized legal identity is a peg blocking a domino effect of development in inclusive finance, e-commerce, the service economy, and the promised land of a peer-to-peer economy built on top of blockchains. My goal is to share with you the roadmap, and the bet we’ve made— that standardizing identity will do for the world what a brick did for architecture.
State of the World & the Problem of Financial Exclusion
Imagine you just received $500m. What would you do with that money? After a day of compulsory swan dives into the money pool (Scrooge McDuck style), you might turn outwards and start to seriously consider how to spend it in a way that will most positively impact people around you. You might introduce a notion of “return on investment” for this goal, to focus on the efforts that will bring the most value. Of the many efforts you could get involved with—such as science R&D or supporting the arts— say you decided to focus on improving quality of life for those who didn't have the privileges you had growing up.
The current state of the world is such that about half of all people don’t have access to basic financial instruments (World Bank). A lot of them also don’t have access to even more basic necessities like water or energy, but say you choose to focus on uplifting people from having just the basic necessities to being part of the global society - to be global citizens. That means that less than half of the people on the planet have access to a comprehensive set of utilities - a "global infrastructure". This is a term of my own, and I define it roughly as access to a set of basic services: access to education, basic digital communication tools, international transportation, employment opportunities, opportunity to start a business of one's own, and enough financial leverage left that one could extend the same infrastructure to one's family.
At Mati, especially in our LatAm branch, we often hear how banking the unbanked is progressing rapidly - now only around 30% don't have bank accounts compared to roughly 50% just seven years ago. But while that number has dropped impressively over the years, having a bank account and being able to use leverage are two separate things. To illustrate that point, consider that in the US 45m adults have no credit score, and no access to financial products. (GlobalFindex)
“When consumers do not have a credit report, or have too little information to have a credit score, the impact on their lives can be profound,”
- Richard Cordray, director of the CFPB
Consequently most in the world are denied optionality, and are bound by circumstance to struggle in their local environments. What these people are lacking is access to financial products - tools that help people leverage themselves up and into the global society. They need the proverbial fishing rod, rather than the fish. While some may live comfortably in their local context, far too many struggle in their regional economy but are denied access to the global one - an entirely preventable problem. This is no doubt a complex issue, however it is our view that we are not going to progress meaningfully towards the solution without first addressing the issue of a proper identity infrastructure, and building a gateway for everyone to access the global society.
Identity Infrastructure: The Financial Bedrock
What’s preventing banks, and governments from pouring money into the underdeveloped regions and demographics? Well that again is a complicated question, but one important factor is that the primary institutions supplying the money—banks—do not have the data that would enable them to underwrite financial products for a population that has no official documents proving their identities, proving their residence, or showing their income. The ‘informal economy’ that is so pervasive in the underdeveloped parts of the world is the simple reason why banks cannot extend their services. In these areas, many jobs and services are not registered, transaction data is not being generated, cash is the medium of exchange, and the people who most need to access global services remain invisible. It’s not a matter of a bias or a dispreference for the established banks. Banks are like trains that can only run on top of existing rails. No rails, no trains. Along with those trains, and the financial products they distribute, come commerce and the entire service economy—all choked off because of the lacking identity infrastructure. Specifically, if one lacks an ability to generate data that can be used to underwrite risk, those people will not be able to "sell" their risk to anyone outside of those who personally know them.
The existing identity 'rails' like VISA or Equifax, are struggling to find a foothold in these new markets, because the way they operate in developed countries—as a connective tissue between merchants, consumers and banks—just doesn't work the same way across demographics and geographies. The needs of people in the bottom 80% of the economy are different to those in the top 20%. The top have stable jobs, advanced degrees, and family with real estate assets who are happy to co-guarantee large loans like house mortgages. The existing identity infrastructure has been unable to help the masses reach financial marketplaces, because they are not meeting the people where they are—in unstable (often seasonal) gigs, possibly saving up to emigrate to their relatives or to pay for an expensive online course in order to apply for better jobs. In that sense the bottom majority remain an elusive field of financial consumers that exists everywhere where banks are, and yet stay invisible to them.
Finance: The Economic Bedrock
An economy cannot grow without financial products. They're like the oxygen in the economic engines around the world. Products like credit cards, car leases, school tuition loans, small business loans, basic types of insurance, 401k safety nets —Let's call these Basic Finance, as part of a bigger group of products and services that one may call Basic Utilities.
Consumer financial products are essentially risk management tools. That’s wall street lingo for: tools and methods for protecting yourself from catastrophic situations. For example, at the point of sale of an airline ticket, one might buy an additional protection to cancel their flight some time in advance for a full refund (minus a fee). It’s an insurance product that functions as a de-risking tool for people who value optionality or for those whose schedules are uncertain. Similarly, farmers buy crop insurance to de-risk a potential weather catastrophe or other anomaly that may wipe out their seasonal revenue. Financial providers will help you de-risk for a fee, which ends up being quite profitable because individuals overestimate their risk exposure, whereas institutions have a way of estimating average risk in markets (ekhem...well, some markets better than others).
You get the picture: we de-risk in order to predict the future as best we can, and to minimize costly surprises. This may not be how an average person thinks about credit cards, the most common risk product, but ultimately that is why we all use risk management tools in our daily lives. More importantly, financial products are utilities, like gas and water. They’re not a luxury. In order to live comfortably in a fast changing society one needs to lean on those products in order to de-risk, and to grow safely. We don't want people to be prevented from using water, just like we don't want anyone to be restricted from getting the education they want. Consider setting up a restaurant, a gas station, or even sending your child to a good but expensive school. Those are all investments that will not pay off until years later. If something should happen - you lose your job, your house crumbles during an earthquake, or you have an unexpected medical bill - you may risk not being able to afford food or other essentials. Losing a job has varying economic consequences, all of them negative. However, for someone who has a few children to feed, no husband, very limited employment prospects, and no savings, losing a job is a nightmare scenario. We can all agree that is a risk people in such situations would love to be able to mitigate, for example by getting a loan to pay for retraining to find a better job.
Consider Mexico, a country with nearly 130m people, and nominal GDP of $1.3 trillion (IMF). This puts it at 15th largest GDP in the world. Yet, with such an impressive economy it's a place where roughly 70% do not have access to basic financial products, and almost half live under the poverty line (ENIF). Brazil, Indonesia, India, Nigeria and many others have similarly jarring statistics. As I mentioned above, the US itself considers 45 million adults as not worthy of Basic Finance utilities, and some put this number as high as 70m adults in the US alone. This is either due to the lack information on them or some past mishap that will forever haunt their financial history - that is, they are not allowed to de-risk and are forced to live in financial instability.
For a minority in the world, de-risking investments are easy to make—either because the risk is low on most basic types of investments, or because the money invested represents a small part of their overall wealth. People and businesses usually have too much risk, and this is especially true in insecure places in the world where the population is desperately trying to find a path to a more stable and secure livelihood. The minority mitigates their risk by selling it to institutions that handle risk, to help them stabilize their lives. The majority (again, we are talking about more than half of all people on earth) cannot do that.
Let's recap: there are billions of people who have risk. Basic Finance providers want to buy risk. Why is there such a discrepancy in the marketplace then? What's the problem?
The problem is that identity has not been standardized and modularized across countries and demographics. Consequently the necessary global financial marketplaces cannot exist, and people are forced to grapple with their local financial institutions, which are busy serving their most profitable sector of least risky ‘risk sellers’ instead of struggling to assess risk on a new market they’ve never dealt with. Banks have a finite amount of money, to buy risk with, and like a restaurant with limited seating and a line of hungry people outside, they end up serving those who can pay the most, that is those whose risk is the cheapest. So the people who most need to be served are asked for all sorts of proofs of identity, birth certificates, history of employment, lending history and of overall financial responsibility, that most will not possess.
Why Going Global is Necessary
You may now ask: but why don't we just let the local economies buy their own local consumer risk? After all, they understand those markets better. Sure enough we have done just that, and the outcome is that all those local Basic Finance providers have focused on the top minority of the population, the wealthiest people whose risk is less 'risky' than that of the bottom majority. Selling loans to people who come from wealth and who are not only buying higher value assets but also are almost guaranteed to repay is obviously more profitable. The only reason why a Basic Finance provider would rationally ever decide to look for sellers of 'riskier' risk, is if they already bought every possible lowest risk there was in their local economy, but they still have money left to allocate. Most banks in underdeveloped countries aren't that wealthy.
Only the biggest financial institutions can afford to build infrastructure, but so far they haven't deemed these regions, and new or subprime consumers in general, as worthwhile. It's not for the lack of interest. Building identity infrastructure, such that Basic Finance providers can assess what risk they're buying, is itself a very difficult problem. But it is made harder by the fact that most financial providers take identity for granted and don't consider that the existing infrastructure, built just a few decades ago, could actually be improved and extended to everyone any time soon. The opaqueness and the inherent complexity of our identity infrastructure that makes it so inconspicuous is also the same reason why detecting misuses of our identity data and privacy breaches are so frequent and so surprising.
With these broad strokes you can see why providing Basic Finance to a riskier population requires more money. Not just because those services are less profitable, but also because infrastructure first needs to be developed and distributed in order to begin to address this new population — a problem that has become harder still as people who are not used to ever interacting with banks see them as evil corporations, out to get them and their money. Only global providers have the type of clout and demand for this volume of risk.
What’s necessary is an identity platform that is cheap, and easy to use by any local or global company, enterprise or startup. Remember: no rails, no trains, and without it no commerce, no services, and no equitable economy. With proper identity infrastructure this domino can start, and finance utilities will very quickly fill all risk markets, because people will always want to be more comfortable, want to de-risk, feel safer, and in turn will always need financial products. If we want to move fast and equip all people with Basic Finance we need digital marketplaces where local and global Basic Finance providers can easily buy standardized risk. But in order to standardize risk, standardized identity is necessary.
Trust as a Commodity: Public Utility or Market Solution?
International organizations like the World Bank, or the IMF help only marginally, and usually they're involved at a very abstract level. Such organizations are usually not powerful, or laser focused enough to go after ambitious goals that require bringing together an international coalition behind a big goal. In this case the goal would be one of finding an agreement on financial standardization, standardization of identity and management of internal censuses, and then requiring all the member countries to follow through and enact these policies on local levels. Such changes are just very difficult to affect politically, and would realistically require far too much political capital.
The organizations that are already well on their way to enacting this change in practice are companies we all love to use—ride hailing companies like Uber, progressive banks and financial providers, Crypto companies, asset sharing companies like Airbnb or Hertz, and many more to come. All of those examples, and many more, have ambitions to provide global solutions. However, unlike Spotify, Netflix or even Apple, who don’t acquire risk when selling their services, the companies mentioned above must buy risk (if only indirectly) in order to expand. The way a financial institution acquires risk is obvious, but it’s important even for the gig and P2P platforms. Platforms like Airbnb or Uber make an implicit promise to their users regarding the quality of service, and that means that they’re responsible for whatever goes on during the consumer-supplier interaction. Every time Uber lets a new driver into their network they take on some level of compliance risk that may, and indeed sometimes does, come to haunt them. In order to de-risk, and to allow every perfect stranger to interact with every other, it requires knowing they are who they say they are.
Even if you have a strong ideological preference for governments to provide mission critical infrastructure, consider that governments cannot, and usually don't, provide all utilities. It's too technical and operationally difficult for even the most basic utilities, so governments often outsource them to industrial providers. If identity is to become like water or energy, it has to follow the same development steps.
The P2P Economy and Decentralization
Some consider decentralized networks as an answer to the problem of trust and identity. The vision I’ve frequently heard is that somehow through a hive-mind behavior we will settle on a global village where trust just emerges from the network. This concept is as vague as it is pervasive. In the excitement for decentralized applications and open finance, people often end up touting decentralization and decentralized algorithms as the solution to all of our internet woes. While blockchain will bring amazing tools, and finally let us control our own data, it doesn’t actually reinvent the wheel when it comes to finance. When one is selling risk to a stranger we must let them assess risk, which means giving them access to our identity and history. In that sense, staying anonymous—one of the principal features of many of the most popular blockchains—is antithetical to using financial tools. The buyer of risk, whether it’s a group of people in a crowd lending community, or an actual bank, needs to not only assess risk but also maintain and limit their risk positions, which means there has to be consequences if one was to say, escape from paying back their lender. This is technically called counterparty risk, and without a 3rd party holding the two interacting parties to a high standard, the interaction quickly denigrates. In other words, if we want to help the next wave of decentralized economy thrive we must first develop tools to manage and mitigate counterparty risk. Without this layer the underdeveloped economies will stay underdeveloped, and the concept of blockchains will remain just a cool magazine headline.
Just consider the difference between Airbnb and Craigslist. One provides a standardized platform where guests and hosts can feel safe because they know there’s another party that has a financial incentive to maintain order. In the other, there is no such Leviathan...and fraud ensues. Let’s say someone were to build an Airbnb competitor on a blockchain—call it BlockBnb. They would nevertheless have to interfere in a centralized manner, similar to Airbnb’s dispute center, or allow a centralized 3rd party in there, to function as an arbiter—that is, unless they figured out a complete algorithmic description of all possible future outcomes and how to handle them in an automated manner. Assessing risk is about predicting the future, and assessing what could happen in the worst case. When someone burns down your apartment on BlockBnb you will want to lean on the institution that bought the risk of your apartment burning down (an insurance company), who will in turn want to manage their risk by requiring verified identity of all the involved parties.
The promise of the blockchain, and all of the crypto apps that come with it, is therefore equally limited by identity, just as its centralized analog apps are. I've been addressing the blockchain technology indirectly throughout the article because, decentralized or not, if we genuinely hope to extend financial services to underdeveloped regions we have to lower the risk of transactions, for both consumers and suppliers. If those platforms are to be successful the underlying technology will be hidden.
“The promise of crypto is really big, it feels like the promise of the internet itself. It isn’t just buy, sell, store. It’s got to be use, it’s got to help bank the unbanked. It’s got to help foster financial inclusion. This is a watershed moment on that journey.” - Tyler Winklevoss
Some of the applications we find most exciting, and inspiring, are peer-to-peer marketplaces. We are leaning into that space to see how we can better enable makers to start crypto projects easier, and with less compliance overhead.
The Future We See Coming
When I discovered that a lack of identity standards is limiting the development of the other half of the world, I decided I wanted to personally do something about it. I started a company that standardizes the identity of users online—a process called KYC—in a way that is modular and based in a modern API. Now, after two years, with the help of our excellent engineering talent of our growing team and the financial expertise of some of the silicon valley's finest, we are proud to be standardizing identity for companies, from the big ones we all know and love to those just beginning development. By letting companies and organizations easily acquire risk from consumers and suppliers, we want to help them expand their services all around the world, and make people’s lives more livable.
What gets us excited now is extending this infrastructure to even more industries—enabling people to start businesses, communities, decentralized co-ops and new interesting services we had not yet heard of. Last but not least, we are excited to develop further a part of identity infrastructure I didn't spend much time discussing here—privacy, and putting identity data into the hands of the rightful owners: the users. I’ll save this one for the next article!
If you like what we're doing, and want to help out, reach out to me directly at @getfilip or firstname.lastname@example.org. We're currently looking to add more passionate people to our team!