Over the past 12 months, the dramatic growth in decentralized finance has been driven by one thing: users’ ability to make substantial profits from their cryptocurrencies through lending, investing, and providing liquidity. Depending on risk appetite, DeFi’s return on investment can be tens or even hundreds of times higher than the standard return in traditional markets.
While these interest rates don’t last forever, DeFi holds great promise to transform financial markets in the long run. Earlier this year, former US Comptroller Brian Brooks predicted (I think, accurately) that “autonomous banks” will become a reality before self-driving cars can fly.
However, growth in DeFi’s lending market is currently hampered by a major flaw: the need to over-lend. We see that this requirement scares a large portion of borrowers.
By volume, respect> asset-backed financial systems
The traditional economy – from credit cards to the dollars themselves – is backed largely by reputation and credit, not just assets. As individuals, we are valued based on our credit history, and not just on the fact that we are really direct owners. In the same way, there are methods for assessing the capital strength of borrowing companies and institutions. These “reputational economies” are a large part of the traditional financial system that DeFi can and will compete with.
In the current DeFi landscape, excess collateral is needed in part due to the borrowed nature of blockchain transactions. The lender rarely knows the identity of the borrower, which creates an unacceptable degree of risk as there is no way to guarantee a return.
Even on a pseudonym basis, DeFi also lacks adequate credit rating or borrower risk assessment mechanisms. So, making sure someone has the right character in the game is the only way to ensure that they do well with their payment obligations. In the event of a default, the secured lenders can simply pay off the borrower’s guarantees.
The solution to bridging the gap between the asset statement and the risk management of unsecured loans is simple. Ideally, the credit model should be robust enough to support active lending, rather than serving as a purely theoretical framework.
Credit Score Structure in the Network
The main finding is that evidence of lack of knowledge enables very reliable credit ratings on the chain without disclosing confidential information about the borrower.
Credit points are calculated in a secure location (private and very secure data chip).
Credit points as well as confirmation of settlement are uploaded to the blockchain.
Settlement confirmation is confirmed with a smart contract.
Off-chain credit scores can include personal information such as borrowers, leverage use, and even your customer information. None of this private information will be uploaded to the blockchain – only the accounts’ confirmation showed that they accounted for a credit rating according to the protocol design.
This data can also be combined offline with existing protocol data such as recovery history. Creditworthiness can then be assessed using a multidimensional model very similar to the current retail and institutional lending sector in conventional finance.
Portability is critical
One of the most important considerations is that these credit ratings must be fully portable and even configurable (like DeFi Lego blocks) across the various DeFi protocols and blockchain. This is especially important now because we’re seeing new DeFi systems at the same level start to thrive on platforms like Polkadot and Binance Smart Chain, which don’t share the same chain history of lenders and borrowers. Portability can allow existing lending platforms, which currently require more than 100% collateral to borrow, to begin offering unsecured loans to those with the lowest ratings.
Of course, such a system does not mean that we should abandon excessive lending to those without a credit history or reputation. However, the truth is that introducing DeFi’s reputation-based lending will give a major boost to the ecosystem, making it attractive to a much wider range of potential users. This will lift restrictions on DeFi’s lending growth and pave the way for greater institutional participation and unlimited future expansion.