The concept of lending and borrowing is as old as time itself. When it comes to finances, while some people have more than enough for themselves, others barely have enough to get by. As long as there is this imbalance in financial distribution, there will always be a need to borrow and a desire to lend.
Lending consists of giving a resource on credit on the condition that it be returned within an agreed period. In this case, these resources would be money or any other financial asset.
The lender can be an individual, a financial institution, a company or even a country. Whatever the case, the lender often needs some sort of assurance that his resources would be returned to him when agreed.
Certain criteria qualify a borrower to take out a loan. Among these are the debt-to-income ratio (DTI) of the borrower, which measures the amount of money from their income committed to managing monthly debt service, stable employment, value of collateral, and real income.
Credit score plays a crucial role in loans
Typically, most financial institutions and businesses rely more on the borrower’s credit score than on the above criteria.
Therefore, credit scores are by far the most important factor in determining whether a borrower should be granted a loan. In a world of financial imbalance where loans are quickly becoming necessary, particularly due to the recent economic difficulties, individuals, institutions and even governments are expected to maintain their credit ratings as favorable as possible.
These ratings or grades can be assigned to individuals, companies or governments who wish to take out a loan in order to settle a deficit. Failure to pay the loan when due usually has a negative impact on the borrower’s credit rating, making it difficult for them to obtain another loan in the future.
In the case of governments, they are likely to face sovereign credit risk which is the potential for a government to default on the repayment of a loan taken out. According to data from Wikipedia, Singapore, Norway, Switzerland and Denmark rank first and fourth respectively among the least risky countries to lend.
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The traditional credit score is barely perfect
As simple as it sounds, the concept of credit scoring is far from perfect due in large part to its centralized nature.
Credit ratings are performed by institutions commonly referred to as credit bureaus. Personal credit scoring can be done by agencies such as Transunion, Experian, and Equifax. Companies and governments are likely to be assessed by companies such as Moody’s and S&P Global, to name a few.
While credit bureaus strive to assess the creditworthiness of borrowers as transparently as possible, there have been many instances of inadequate assessments due to issues such as concealment of important information, studies static, misrepresentation and human bias.
In a recent article, Dimitar Rafailov, a Bulgarian associate professor at Varna University of Economics, highlighted the importance of proper and transparent credit scoring.
However, Rafailov noted that credit bureaus perceived shortcomings in these ratings and that such shortcomings had “reinforced the negative effects of the global financial crisis, generating additional systematic risks”. He pointed out that errors that affect traditional credit ratings as committed by credit bureaus are often caused by “business models, conflicts of interest and absent or ineffective regulation of their activities”.
The obvious need for decentralization
The advent of blockchain technology has revolutionized many industries, especially the financial industry. Decentralized finance (DeFi), as a product of the burgeoning technology, has revealed the possibility of running financial services with a peer-to-peer (P2P) system, eliminating the idea of an intermediary or a central authority.
Decentralized credit scoring refers to the idea of assessing a borrower’s creditworthiness using on-chain – sometimes off-chain – data without the need for an intermediary. The evaluation is carried out on a blockchain managed by a P2P system of computers without any central authority or control point. Additionally, a decentralized credit scoring erases the traditional credit bureaus from the picture.
Jill Carlson, investment partner at Slow Ventures, highlighted the importance of a decentralized form of credit scoring. She noted in a 2018 paper that “decentralized credit scoring solutions could therefore be extrapolated into broader identity systems that do not rely on a single central authority”, further stating that the issues that arise from a centralized credit scoring concept “have been felt more deeply than ever in the past year,” citing the 2017 Equifax hack.
In 2017, credit rating giant Equifax suffered a security breach caused by four Chinese hackers who compromised the data of 143 million Americans.
Antonio Trenchev, a former member of the National Assembly of Bulgaria and co-founder of blockchain lending platform Nexo, told Cointelegraph that credit ratings, especially those produced by central authorities, are more problematic than based on data. solutions.
Trenchev bragged about how his platform managed to exclude credit ratings through its “Instant Crypto and Nexo Card Lines of Credit.”
“In this utopian borrowing landscape that we hope to create, credit ratings will be scarce and, when used, they will be decentralized and fair.”
Become a reality
Two years ago, blockchain lending protocol Teller raised $1 million in a seed funding round led by venture capital firm Framework Ventures to integrate traditional credit scores into DeFi.
Although the first of its kind in the decentralized world, credit scores should help solve the overcollateralization problem that has plagued lending in DeFi while ensuring that eligible borrowers get what they deserve.
In November last year, Credit DeFi Alliance (CreDA) officially launched a credit scoring service that would check a user’s creditworthiness with data from multiple blockchains.
CreDA was developed to work with CreDA Oracle by evaluating records of past transactions made by the user on multiple blockchains using AI.
When this data is analyzed, it is transformed into a non-fungible token (NFT) called a credit NFT (cNFT). This cNFT is then used to assess incentives or tariffs specific to the user’s data when the user wishes to borrow from a DeFi protocol.
Moreover, CreDA was designed to work on different blockchains including Polkadot, Binance Smart Chain, Elastos Sidechain, Polygon, Arbitrum and many more, although it is built on Ethereum-2.0.
Recently, P2P lending protocol RociFi Labs closed $2.7M seed funding in partnership with asset management firm GoldenTree, investment firm Skynet Trading, Arrington Capital, XRP Capital, Nexo and LD Capital. This is geared towards the expansion of on-chain credit ratings for decentralized finance.
Additionally, RociFi works by using on-chain data and AI in addition to credentials from decentralized platforms to determine a user’s rating. Credit score, as CreDA approach, is transformed into an NFT called non-fungible credit score which can range from 1 to 10. A higher score means less creditworthiness.
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A plethora of benefits
Judgments about a borrower’s creditworthiness can have a profound effect on their life. The need for fair and impartial judgments in this regard cannot be overemphasized.
Nevertheless, traditional credit rating bureaus have failed to accurately assess the creditworthiness of borrowers in many cases, either due to inefficiency or simply bias.
Decentralized credit scoring brings fairness to the table. Borrowers are certain to be assessed accurately because these assessments are performed by AI on blockchains without the control of any central authority.
Additionally, with decentralized credit scoring, on-chain consumer data is not collected and stored on a central ledger but dispersed in a blockchain maintained by a P2P system. This makes it very difficult for hackers to steal user data, as was encountered in the Equifax hack in 2017.
From DeFi to decentralized credit scoring, the blockchain industry has brought security and efficiency to the financial world. Although decentralized credit scoring is in its infancy, even with the progress already made, there is no doubt that it will become an even better assessment tool in the future.