Introduction
Shylock to Antonio:
This kindness will I show.
Go with me to a notary, seal me there
Your single bond; and, in a merry sport,
If you repay me not on such a day,
In such a place, such sum or sums as are
Express'd in the condition, let the forfeit
Be nominated for an equal pound
Of your fair flesh, to be cut off and taken
In what part of your body pleaseth me.
[Shakespeare, W. Merchant of Venice. Act 1, Scene 3. (Accessed April 26, 2022)].
As instructed by the Merchant of Venice, set in 16th century Italy, the conceptualization of the borrowing and lending of assets demonstrates the entrenchment of these mechanisms in our society. What is clear is that lending is a direct result of a financial imbalance in asset distribution between the individual members of a financial community. Some members have more than enough to care for themselves with assets to spare while some have barely enough to survive.
So for so long as this imbalance exists, so too will lending. Those without enough to survive will want to borrow while those with extra will want to lend (dependent on terms and creditworthiness).
So specifically, what is lending? An overly simplistic answer to this would be: "Lending involves giving out a resource on credit with the condition of it being returned upon an agreed period of time. In this case, such resources would be money or any financial asset" [Pessarlay, W. Decentralized credit scores: How can blockchain tech change ratings. (Accessed April 26, 2022)].
However, a more comprehensive definition of lending is:
The term loan refers to a type of credit vehicle in which a sum of money is lent to another party in exchange for future repayment of the value or principal amount. In many cases, the lender also adds interest and/or finance charges to the principal value which the borrower must repay in addition to the principal balance. Loans may be for a specific, one-time amount, or they may be available as an open-ended line of credit up to a specified limit. Loans come in many different forms including secured, unsecured, commercial, and personal loans.
[Kagan, J. Loan. (Accessed April 26, 2022)].
Loans in Traditional Finance
In typical traditional finance, the lender almost always requires some type of assurance that the loan will be repaid at the time agreed upon. Usually this assurance takes the form of a lender checking that a borrower meets certain criteria. This information is obtained by the lender by requesting a credit rating report on the borrower.
Certain criteria qualify a borrower to take a loan. Among these are the borrower’s debt-to-income (DTI) ratio which measures the amount of money from their income committed to handling monthly debt service, stable employment, the value of the collateral and actual income.
[Pessarlay, supra].
More and more typically now, lenders are relying upon a borrowers credit score to determine loan eligibility rather than the actual criteria. Nonetheless, the credit ratings and credit scores are less than perfect assessments of creditworthiness. Why?
The imperfection results from the centralization of the organizations actually researching and preparing the credit ratings and scores. "While credit bureaus make every effort to assess borrowers’ creditworthiness as transparently as possible, there have been numerous cases of inadequate assessments due to issues such as concealment of material information, static study, misrepresentation and human bias" [Id].
In a very interesting article written by Dimitar Rafailov, associate professor at the University of Economics Varna, this was examined at length. However, a brief summary of the article is presented which highlights the problem:
The adequacy of credit ratings is crucial for normal functioning of debt markets. Failures of credit rating agencies have strengthened the negative effects of global financial crisis, generating additional systemic risk. The errors of the agencies can be explained by many reasons as business models, conflicts of interest and absent or ineffective regulation of their activities. To overcome these major problems, we can apply different approaches.
[Rafailov, D. [The Failures of Credit Rating Agencies during the Global Financial Crisis – Causes and Possible Solutions](The Failures of Credit Rating Agencies during the Global Financial Crisis – Causes and Possible Solutions). (Accessed April 26, 2022)].
DeFi as the Product of Blockchain Technology Cries for the Running of Peer-to-Peer Financial Systems
With the exponential growth of DeFi, the possibility of running a system of financial services in a peer-to-peer system has emerged. And yes, this includes cryptocurrency loans. As such, all of the mechanisms necessary to conduct cryptocurrency loans would be with no intermediary, third party, or central authority. And out of necessity, decentralized credit scoring would need to be developed.
Decentralized credit scoring refers to the idea of assessing a borrower’s creditworthiness using on-chain — at times off-chain — data without the need for an intermediary. The assessment is done on a blockchain run by a P2P system of computers without any central authority or point of control. Moreover, a decentralized credit rating erases the traditional credit bureaus from the picture.
[Pessarlay, supra].
In a very informative article by Jill Carlson, an investment partner at Slow Ventures, she discusses the possibilities for peer-to-peer models for credit scoring:
Rather than rely on attestations by a single authority or an oligopoly, lenders can use a web of trust model. Parties known to or trusted by the lender can make attestations about the attributes or historical behavior of the borrower. These can be made by institutions, like wallets or exchanges, or individuals.
Borrowers seeking to prioritize trust-minimization at all costs can take an even more decentralized approach and provide lenders only with their on-chain funds and transaction history as a proxy for credit score. This is obviously a weak indicator of creditworthiness and is a set up prone to exit scams — meaning this loan would demand a much higher interest rate — but for some users, this trade-off in favor of privacy may be worth it.
[Carlson, J. Decentralized Credit Scoring. (Accessed April 26, 2022)].
Decentralized Credit Scoring Approaches Reality
On November 25, 2021, CreDA (Credit DeFi Alliance), the world's first decentralized credit rating service officially launched its platform following a successful open beta. "CreDA provides on-chain credit ratings using the CreDA Oracle, which employs artificial intelligence (AI) to examine the user's historical transactions in the crypto space across multiple blockchains. This data is used to calculate a credit score that is then minted into a secure non-fungible token called a credit NFT (cNFT). The cNFT enables the user to unlock preferential rates and incentives across a variety of use cases e.g. reduced borrowing rates on DeFi platforms" [GlobalNewswire. New DeFI platform CreDA looks to de-risk the world of crypto. (Accessed April 26, 2022)].
In addition, recently, "P2P lending protocol RociFi labs concluded a seed funding of $2.7 million in partnership with asset management firm GoldenTree, investment firm Skynet Trading, Arrington Capital, XRP Capital, Nexo and LD Capital. This is geared toward expanding on-chain credit ratings for decentralized finance.... RociFi works by using on-chain data and AI in addition to ID data from decentralized platforms to determine a user’s rating. The credit rating, like CreDA’s approach, is turned into an NFT called a nonfungible credit score which could range from 1 to 10. A higher score means less creditworthiness" [Pessarlay, supra].
Final Thoughts
Credit scoring, at its heart, is basically just one form of an entities reputation - an aspect of its identity. As such, "solutions for decentralized credit scoring, therefore, could be extrapolated into larger identity systems that do not rely on a single central authority. Attestations could go beyond historical transactions and extend to KYC/AML, accredited investor status, or even governments attesting citizenship, residency, and visas" [Carlson, supra].
But whatever form these new decentralized credit scores may take, the necessity for their development can not be overstressed. It is clearly time for the old systems of identity and credit to give way to appropriate decentralized mechanisms. As the blockchain infrastructure gains maturity and financial markets based in said infrastructure emerge and grow, more complex mechanisms will be required to run the systems and the greater majority of these systems will require perceptions concerning identity and credit (creditworthiness). The present system of centralized credit scoring is patently insufficient to meet the needs of these new systems.
Decentralization is clearly the answer to ensure a fair and unbiased assessment of creditworthiness.