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Decentralized Finance Could Help Rebuild Lebanon’s Economy
By Hugo Dante
For the people of Lebanon, now living in one of the most severe crises in human history, cynicism has a constant presence. For the entirety of living memory, Lebanon’s formal institutions have been a colossal mess, with a slew of dysfunctional governments collapsing while new ones arise from the ashes. But today Lebanon is experiencing an unprecedented period of instability, with one of the worst economic declines in recorded history, hyperinflation and a collapse of its financial system.
Facing total collapse, with no government in sight, the Lebanese have limited access to formal institutions, such as bank accounts, and are instead forced to rely on black markets and militant groups to contend with the crisis. With an economic and financial system tied to such poor institutions, trust becomes a luxury. Economic instability creates power vacuums that are filled by informal forms of governance and exchange. Thus, corruption plagues the land.
While Lebanon’s economic woes are ancient, modern technology may have a solution in the form of decentralized finance—an ecosystem of financial innovations that are intended to replicate many of the characteristics of the modern financial system while removing common barriers. For example, solutions such as smart contracts and digital ledgers reduce the need for trust and facilitate relative anonymity among transacting parties. These innovations have immense potential to ease Lebanon’s burden today.
Lebanon’s Former Prosperity
Despite decades of political turmoil, the people of modern Lebanon have known relative prosperity. They have been accustomed to middle-class lifestyles deeply interconnected with the rest of the world. So great was Lebanon’s allure and prosperity as a cultural and financial center that it once sported nicknames such as “the Paris of the Middle East” or “the Switzerland of the Middle East.” While the Lebanese people grew accustomed to the relative instability of interim governments, competing militias and institutionalized corruption, they largely got by with their quality of life intact.
This improbable prosperity was driven by various factors. First, Lebanon has an open educational system that’s interconnected with the rest of the world. Lebanese universities are highly regarded, particularly the American University of Beirut. This educational system contributed to more than a century of economic migration from Lebanon, forming a large, highly skilled Lebanese diaspora more than double the size of the domestic population. This enormous diaspora is an important source of income for Lebanon. Remittances account for more than 12% of the country’s GDP today and as much as 25% of the nation’s GDP between 2003 and 2009.
Since the end of Ottoman rule, Lebanon has also maintained some form of a currency peg, to either francs, pounds sterling, gold or the U.S. dollar. This peg has contributed to a high level of dollarization in the country, both in bank deposits and in economic activity, creating a strong link between Lebanon and the global economy. The Lebanese government borrowed heavily to maintain this currency peg. For this reason, bank deposits in Lebanon, whether denominated in lira (the official Lebanese currency) or in the U.S. dollar, were treated as fungible within the global financial system. Lebanon developed a relatively advanced finance- and service-oriented economy that relied highly on imports, characterized by large trade deficits and imports of luxury goods.
However, behind the scenes, the system was buckling under pressure as its “nationally regulated Ponzi scheme” became unsustainable. The global pandemic was the last straw that led to Lebanon’s spectacular collapse. For decades, the country’s various dysfunctional governments ran significant deficits, relying on a steady flow of tourism dollars, remittances from the Lebanese diaspora and spending from the prosperous Sunni Arab Gulf states. This deficit spending, it turned out, could not be sustained.
Shiite Hezbollah’s and Iran’s influence continued to grow, and political paralysis prevented the establishment of any lasting stable government—even leaving Lebanon without a president between 2014 and 2016. As a result, the steady flow of dollars used to pay off creditors and bolster looted bank reserves started to dry up. Lebanon’s rise in liabilities were masked by a steady inflow of foreign currency seeking high returns driven by Banque du Liban policy and became untenable. Lebanon’s debt-to-GDP ratio reached more than 150%, with interest payments making up more than one-third of the government’s budget.
Lebanon’s currency peg became infeasible, leading to a collapse in the value of the lira. The collapse led to panic, causing a steady outflow of foreign currency and a run on bank deposits. Ultimately, to stop the outflow, Lebanon’s central bank restricted the withdrawal of dollar deposits entirely. This created an enormous shortage in foreign currencies, exacerbated when the Banque du Liban recognized the lira’s fragility in black markets. The Lebanese central bank later stopped enforcing the collapsed currency peg, allowing depositors to withdraw limited amounts of U.S. dollars at a more favorable exchange rate (3,900 lira to USD) than the official rate, but less favorable than the unofficial black market rate, in which lira trades at a discount of more than tenfold.
Lebanese officials have been reluctant to accept a discount to their purchasing power via formally exiting the foreign currency peg, and the prospect of a haircut on already-decimated bank reserves could be devastating. The result? Significant inflation in the prices of the imports on which Lebanon became dependent, with more than a 400% increase in food prices, and a medical crisis due to a nationwide shortage of medicine and a backlog in medical payments.
Informal Institutions and Decentralized Finance
As is common in countries undergoing prolonged periods of turmoil, informal institutions emerged in Lebanon. The country has been plagued by perpetual power struggles dating back further than the civil war, particularly among militias and mafias divided along religious and ethnic lines. But the crisis has only contributed to Hezbollah’s growing influence, with its financial arm, the al-Qard al-Hasan Association, forming a uniquely stable lifeline for many Lebanese. When the crisis came to a head, the Lebanese people were quick to turn to black markets, using social media proficiently to fuel a burgeoning underground market for foreign currencies and other goods. Other examples include a purported “bitcoin boom,” in which CoinDesk claims that the Lebanese crypto wallets could account for as much as $5 million in bitcoin volume monthly.
For a people like the Lebanese, accustomed to both new and informal institutions, the viability of technological solutions is apparent. Where trust in traditional banking systems is limited, alternatives are emerging that offer traditional products such as savings accounts, payment systems, lending and borrowing markets, insurance products, derivatives and even decentralized identity protocols. For the Lebanese facing a total collapse of the traditional system, there is nothing to lose. When using the status-quo financial system is costly and uncertain, it becomes easier to experiment with and adopt new technologies.
Decentralized finance, or “DeFi,” has evolved into a broad term that encompasses a diverse array of innovations in financial technology, payment systems, exchanges and networks based on blockchain and cryptocurrency technologies. Technologies commonly described as decentralized finance have varying degrees of “decentralization,” but generally they do not rely on central banks or traditional financial intermediaries. These technologies are new and evolving rapidly, and as a result they are often far beyond the scope of current regulatory systems, creating significant challenges for governments seeking to understand and monitor transactions in this space.
Decentralized finance relies on alternative institutional structures, made possible by technology such as smart contracts, to facilitate transactions and offer financial products and services without relying on traditional financial intermediaries. For example, DeFi uses blockchain technology, an immutable digital ledger secured and verified by a network of nodes that records transactions or other forms of data as blocks in a chain. These records are made irreversible—and therefore secure from fraud—by the distribution of the ledger among the various nodes in the ecosystem. DeFi technologies are applied in creative ways to replicate many of the various instruments in the mainstream financial system.
Beneficial DeFi Innovations
Two DeFi innovations that have gained the attention of financial and securities regulators all over the world are stablecoins and tokenization. Stablecoins are cryptocurrencies structured to have a value pegged (generally through reserves) to an asset, basket of assets, fiat currency or commodity such as gold. They have been widely adopted and are becoming mainstream. Visa recently announced it settles transactions in USD Coin, and stablecoins have the largest daily transaction volumes of any cryptocurrencies.
Global regulators see stablecoins’ clear potential to facilitate payments and promote financial inclusion, leading to a consultative document by the Basel Committee on the prudential treatment of crypto-assets. Vice Chairman Randal Quarles of the Federal Reserve, in a speech titled “Parachute Pants and Central Bank Money,” lauded stablecoins for their potential benefits of facilitating and adding transparency to foreign transactions.
However, stablecoins are not without risks. Given that the technology is new, regulators have not caught up with innovation, meaning there are no clear, universal standards for the management of stablecoins or the appropriate treatment of reserves. Problems have already arisen, and some companies that offer stablecoins are now facing potential criminal inquiries. As the volumes and market caps of these coins grow, so do the implications for global financial stability. Transparency surrounding the management and reserves of stablecoins is becoming a critical priority.
Despite these risks, global financial regulators and monitoring agencies such as the Financial Stability Board recognize the welfare-improving potential of stablecoins. In the case of Lebanon, which is dealing with a severe financial breakdown that has reduced the ability of Lebanese to freely transact, stablecoins have the potential—once the concerns surrounding transparency and financial stability have been addressed—to become a fungible and relatively liquid global alternative free of Lebanon’s institutional baggage, including corruption.
Tokenization also has the potential to address many of the weaknesses associated with poor institutions. Tokenization is the issuance of a blockchain token to represent a real (and exchangeable) asset. In most cases, transactions of tokens are automated and secured with smart contracts and blockchain technology. The technology has numerous potential applications, including the issuance of secure IDs and digital deeds. In the U.S. and Europe, it is even used for entirely legal and regulatory-compliant transactions of third-party digital securities. Many companies are now building on the potential of this technology, with applications for the arrangement of transactions in private or non-listed assets, including hedge fund positions, venture capital, peer-to-peer insurance, real-estate deals and even microfinance.
Tokenization, like the broader DeFi ecosystem, offers greater levels of security to the transaction of traditional assets. For this reason, it can solve many of the problems with trust and lack of clear institutional frameworks that businesses in developing countries such as Lebanon often face. Tokenization can be used to limit liability and risk in contracts and could even be used to access potential capital from all over the world.
While the crisis in Lebanon is a sad example of the consequences of a fragile institutional framework, we can look to the future with optimism, knowing the potential of technology to provide alternatives where traditional institutions fail.