Most of the loans made in DeFi are over-collateralized.On the good side, it reduces default risks. But at the same time it sacrifices capital efficiencies.How do we fix the issue? First and foremost, we'll have to construct the credit rating system in DeFi.
1/ Why？In TradFi, lenders want some forms of KYC (Know Your Customer practices) from their borrowers to ensure the ability to pay back.Such KYCs are conducted by big institutions and are transformed into certain credit scores.Due to pseudo-anonymity and privacy reasons ->
2/ in crypto, the KYC measure in TradFi doesn't really apply.Shall we make adjustments on the credibility evaluation in real world and extend it into a decentralized setting?Or shall we invent a completely new system for credit rating?Let's see what people are building now.
3/ The current credit rating protocols in DeFi can be separated into three categories: off-chain, on-chain, and a combination of off and on chain.@CredoraPlatform @useteller @CreDAfinance @TrueFiDAO@cred_protocol @rocifi @getmasafi @SpectralFi
4/ Credora:
Provides private credit evaluation for institutions.The credit calculation is based on three risk metrics: Operations and Due Diligence, Financial Analysis, and Risk Monitoring of a client institution.
5/ Built on top of ZKPs, Credora performs credit ratings for its clients without them revealing specific sensitive information.
To learn more about how ZKPs work, feel free to check：
6/ Teller Finance:
Enables borrowing in DeFi with credit history from real world.Borrowers' off-chain credit ratings are synced with their on-chain loan requests.It's perfectly regulatory compliant because the credit evaluations derived 100% from TradFi standards.
7/ However, instead of asking crypto to follow the exact KYC procedures in TradFi, I believe regulations in the future shall adapt to "crypto-native" rules for legal compliance.So how does on-chain credit rating look like?Let's take Spectral Finance as an example here.
8/ @SpectralFi develops programmable creditworthiness.The protocol computes one's credit standing in DeFi based on on-chain transactional history.E.g., if a wallet has invested in a token that was rug-pulled, if there's any liquidation history, the amount owed and repaid...
9/ The credit computation relies on scorers (could be any entity) training machine learning models to classify risks specifically associated to wallets' on-chain activities.Scorers then can submit the calculated scores without revealing the exact model using ZKPs.
10/ In this way, multiple scorers can aggregate their results for any party while keeping their methods secret.Such open, competitive credit scoring environment is strongly contrary to traditional credit assessments that are conducted in a limited, black-box manner.
11/ Since most DeFi investors have more than one wallet, Spectral allows its users to mint their own "Non-Fungible Credits" (NFCs, ERC-721 token) for bundling multiple wallets.In this way, an investor can receive an aggregated credit score from all the wallets they use.
12/ Another selling point of composable creditworthiness is the the possible products that could be built upon:- Web3 Log In: Access to benefits with a certain level of credit- Credit Delegation: Create a lending and borrowing market for your creditworthiness- And more...
13/ However, there're some limitations:- The wallet bundle in your NFC can't be modified after minted- A malicious player can still pretend to be creditworthy by intentionally creating a bundle of wallets that can receive high credit scores if following the rules
14/ It'll depend on how much adoption crypto & Web3 products receive to see how well on-chain credit ratings can work.But before Web3 officially dominates the world, on-chain credit systems have to incorporate certain level of real-life KYC for transition.
15/ The exact method can be tailored to specific groups of people.E.g., For retail users, we can determine how much KYC is needed for credit rating depending on their time length of interacting with DeFi protocols.The longer someone has used DeFi, the less KYC needed.
16/ It also serve as a great incentive for people to learn and use DeFi, due to a positive loop:
do on-chain transactions -> less KYC, less privacy sacrificed -> do more on-chain stuff and learn how to improve the credit scores because of a transparent on-chain credit rating
17/ I'd love to see a product that perfectly combines on-chain and off-chain sources.Although there are protocols claim to have a rating system of the two, the exact details haven't been released, so there's nothing much for me to analyze so far.
18/ For now, some may suspect on-chain rating tools for their accountability since one can be perfectly "credible" on-chain while defaulting on mortgages in real life...And S&P just rated a B-, the level of a junk bond, to one of the most trustworthy DeFi protocol Compound.
19/ It will be a long debate on how much we should rely on data from on-chain activities.But after we experienced all the Big Fails due to avaricious human decisions and opaque financial statements, I'm sure on-chain rating system will find its place in the near future.
20/ Still, I'm positive on protocols that've been tirelessly building Web3 native credit rating tools, either via offering privacy for KYCs or analyzing on-chain activities.They have constructed the essential infra for an ideal world where every person on the planet uses DeFi.