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.

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