On chain credit score protocols are inevitable but have yet to gain traction
On chain credit scores have potential to enhance the financial freedom of many
On chain credit scores can be used for authoritarian purposes if put into the wrong hands
The current Credit Bureau industry is an Oligopoly dominated by 3 companies
The banking industry has failed us. The majority of the world is unbanked and lacks access to loans.
Crypto solves this.
Crypto has done a phenomenal job of democratizing the borrow and lending process. Users that lack a proper credit history, or are unbanked (but have some crypto) can take out crypto collateralized loans without even needing to provide KYC, depending on the loan provider. Smart contracts have enabled the automatic liquidation of borrowers’ collateral when their LTV falls below a predetermined value agreed upon by both parties. The collateral is locked in an escrow smart contract, so the lender doesn’t need to worry about the borrowers credit history. This has been a huge win for democratizing capital globally, however; we still have a long way to go.
Today we have a large selection of collateralized loans to choose from: Aave, Compound, Anchor, Solend, and the list goes on. Loans on these platforms are often heavily overcollateralized, sometimes up to 150%. This encourages safe borrowing practices which is awesome, but also favors whales who have large amounts of capital, which is not awesome. Thus far, crypto has largely been an “asset based” economy (collateralization) rather than a “reputation based” economy (credit scores), like most of TradFi is. The crypto space has yet to implement a credit system where users can take out uncollateralized loans. In this Op-Ed we discuss how on chain credit scores can potentially empower DeFi users, a few barriers to creating this solution, and a few protocols that are innovating in the credit space. After all, over 75% of Americans have a credit card which means this will likely open up new capital floodgates for DeFi.
Why Should We Want On Chain Credit Scores?
Do you have a credit card? Have you ever taken out a loan?
If you have, you may be aware of the centralized entities that decide how much credit you are allowed to have and how much you are allowed to borrow. These entities have created their own criterion to judge whether you are eligible for a loan. This criteria usually includes your name, address, social security number, debts, and payment history. Collecting this info is their way of knowing whether they can count on you to pay them back. This information is compiled, graded, and the subsequent value is called a “Credit Score.” The precise methods in which this information is aggregated and judged is kept secret behind the closed doors of these private companies. These private companies also own this data that they’ve collected from you.
Now, you’re probably thinking…
What does this have to do with crypto?
TradFi processes like this are inherently linked to crypto as they are the problems that crypto can solve providing us freedom from traditional systems.
The credit score industry is dominated by 3 credit bureaus, a certified oligopoly. This means that there are three private companies that control most of the “free” world’s ability to take out loans. They own your private data, share it with third parties, and have their own algorithm that determines what data is valuable and how this data is aggregated to determine your credit score.
Blockchain credit scores can solve this.
As you know, there is much history related to your crypto wallet addresses. Your balance, the loans you’ve taken, the tokens you’ve farmed, the NFTs you’ve minted, it’s all there. Anyone can load up a blockchain explorer and see it all. This is similar to how your purchase history is linked to your credit card, except your wallet address is public for anyone to search. This is important to keep in mind when considering linking your real identity to your on chain activity. Our transactions are more public than ever before, and if you value privacy then you may want to consider precautions to protect your data.
Data stored with banks and credit card companies are centrally owned and can be shared, hacked (see Equifax 2017 Data Breach affecting 147M people), and sold by the companies that own it. Whereas in crypto, you control your wallet. When different protocols inevitably begin to pop up offering on chain credit scores, you have the freedom to choose which protocols you will allow to use your data. You have the freedom to link or not to link your real identity to your wallet address, keeping your wallet activity pseudonymous (but not private) if you so please. This makes credit score protocols compete for our data, putting the power back into the users hands.
The public nature of blockchains can facilitate lenders to be more responsible than their TradFi counterparts. All the loans they issue will be publicly auditable, which could help avoid shady practices like what the mortgage brokers did causing the crash in 2008.
Watch this to understand the level of “shadowy super loans that led to the 2008 financial crisis.”
Now that we’ve addressed a few ways blockchain credit scores could help our financial freedom, let’s discuss some problems with the on chain credit score model.
Problems With On Chain Credit Scores
Problem 1: Exit Scams
The “exit borrower” is one who builds up a reliable borrowing history for quite some time in order to be eligible to take out a monstrous loan, only to never pay back that final loan they receive. Due to the anonymous (but far from untrackable) nature of wallet addresses, exit scams like these could ravage crypto credit providers.
Problem 2: Portability & Merging of Wallets
As of today, there are numerous layer one blockchains that settle billions of dollars with their specific user bases. There are many users that have multiple wallets across multiple chains. If we are to create an accurate representation of on chain credit, there must be a way to bundle the histories of multiple wallet address from different chains. We must also be able to port this aggregated credit score from chain to chain. Given the current state of bridges, we are a ways away from reliable and accessible portability.
Innovations In These Areas
Mars Protocol proposes a mechanism to extend credit to prominent protocols (not individuals) voted as trustworthy by their governance. The Martian Council, the Mars protocol governing body, will be able to vote on which protocols are trustworthy enough to receive lines of credit from the protocol. Extending credit to large protocols is a step in the right direction, as their treasuries are deeper than individuals, usually public, and they have a lot more to lose (their entire user base) if they default. However, this method still comes down to trust, and the possibility of a protocol committing an exit scam is still possible. This strategy is also similar to B2B (business to business) loans except this time its P2P (protocol to protocol).
Spectral is working on an interesting solution to composability and portability of credit scores. Spectral has created “NFC,” or “non-fungible credit.” NFCs allow users to bundle wallets and sync their on-chain transactional history into a single ERC-721 composable asset, which acts as a representation of their DeFi behavior. This would be composable all across Ethereum DeFi, however the method of portability to other chains remains to be solved. There are numerous bridges that wrap NFTs from ETH to SOL for example, so it’s possible these NFCs could be transferred in that manner.
The emergence of protocols creating on chain credit scores is inevitable. What is not guaranteed is whether this will be a net positive or negative for the space. On one hand, on chain credit can help eliminate the current oligolopy that uses arbitrary metrics and prevents many from participating in the global financial system. On the other hand, on chain credit scores sound awfully similar to social credit scores which can be authoritarian if put into the wrong hands. The innovations of blockchain and their potential to be used for negative purposes lay in the human wielding the protocol and the protocol design. Perhaps what is most important here is that these on chain credit scores are not controlled by government, and that our willingness to provide our wallet addresses remains voluntary. This way these protocols will compete for our data, and we will only provide our wallets to those that are dedicated to fair processes and judgement.