Decentralized credit scores: How can blockchain tech change ratings

Borrowing and lending are two important parts of DeFi, but they have been missing an effective operating credential: a decentralized credit rating.

The concept of lending and borrowing is as old as time itself. Regarding finances, while some individuals have more than enough for themselves, others barely have enough to get by. As long as there is this imbalance in finance distribution, there will always be a need to borrow and a desire to lend.

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.

The lender could be an individual, a financial institution, a firm or even a country. Whichever the case may be, the lender, oftentimes, needs a sort of assurance that their resources would be returned to them upon the agreed time.

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.

Credit rating plays a crucial role in lending

Generally, most financial institutions and firms rely more heavily on the credit score of the borrower than the aforementioned criteria.

Consequently, credit scores are by far the biggest factor in determining whether a loan should be granted to a borrower. In a world of financial imbalance where loans are quickly becoming necessary, particularly due to recent economic hardships, individuals, establishments and even governments are expected to keep their credit ratings as favorable as possible.

These ratings or scores can be assigned to individuals, firms or governments that wish to take a loan in the bid to settle a deficit. Defaulting in the payment of the loan at the agreed time generally has an adverse 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 a sovereign credit risk which is the potential of a government to default on the repayment of a loan taken. According to data from Wikipedia, Singapore, Norway, Switzerland and Denmark respectively rank first to fourth among the least risky countries to lend to.

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Traditional credit rating is barely perfect

As simple as it sounds, the concept of credit rating is far from perfect due in large part to its centralized nature.

Credit ratings are carried out by establishments commonly referred to as credit bureaus. The credit rating of individuals can be carried out by agencies including Transunion, Experian and Equifax. Companies and governments are likely to be assessed by firms such as Moody’s and S&P Global, to name a few.

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.

In a recent article, Dimitar Rafailov, Bulgarian associate professor at the University of Economics Varna, stressed the importance of an adequate and transparent credit rating.

However, Rafailov noted that credit bureaus perceived inadequacies in these ratings and such failings have “strengthened the negative effects of the global financial crisis, generating additional systematic risks.” He pointed out that the errors plaguing traditional credit rating as made by credit bureaus are often caused by “business models, conflicts of interest and absent or ineffective regulation of their activities.”

The patent need for decentralization

The advent of blockchain technology revolutionized a lot of sectors, especially the financial sector. 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 central authority.

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.

Jill Carlson, an investment partner at Slow Ventures, expressed the importance of a decentralized form of credit scoring. She noted in a 2018 article that “solutions for decentralized credit scoring, therefore, could be extrapolated into larger identity systems that do not rely on a single central authority,” further stating that the issues that have come from a centralized credit scoring concept “have been more deeply felt than ever than ever in the last year,” citing the Equifax hack of 2017.

In 2017, credit rating giant Equifax had a security breach caused by four Chinese hackers who compromised the data of 143 million Americans.

Antonio Trenchev, former member of the National Assembly of Bulgaria and co-founder of blockchain lending platform Nexo, told Cointelegraph that credit ratings, especially as produced by central authorities, are more problematic than solution-based.

Trenchev boasted of how his platform has managed to rule out credit scores via its “Instant Crypto Credit Lines and Nexo Card.”

“In this utopian borrowing-scape we hope to create, credit scores will be a rarity, and when they are used, they will be decentralized and fair.”

Growing into 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 incorporate traditional credit scores into DeFi. 

Although it was the first of its kind in the decentralized world, credit scores are expected to help with the problem of over-collateralization that plagued lending in DeFi while making sure that eligible borrowers get what they deserve.

In November last year, Credit DeFi Alliance (CreDA) officially launched a credit rating service that would ascertain a user’s creditworthiness with data from multiple blockchains.

CreDA was developed to work using the CreDA Oracle by evaluating records of past transactions carried out by the user across several blockchains with the help of an AI.

When this data is analyzed, it is minted into a nonfungible token (NFT) called a credit NFT (cNFT). This cNFT is then used to assess incentives or rates peculiar to the user’s data when the user wishes to borrow from a DeFi protocol.

Moreover, CreDA was made to operate across different blockchains including Polkadot, Binance Smart Chain, Elastos Sidechain, Polygon, Arbitrum and more, despite being built on Ethereum-2.0.

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.

Moreover, 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.

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A plethora of benefits

The judgments made with regard to a borrower’s creditworthiness can have a profound effect on their life. The necessity to have fair and unbiased judgments in this regard cannot be overemphasized.

Nonetheless, traditional credit rating bureaus have failed to accurately assess borrowers’ creditworthiness in a lot of cases, either due to inefficiency or just plain bias.

Decentralized credit rating brings fairness to the table. Borrowers are certain of being assessed accurately because of the fact that these assessments are carried out by AI on blockchains without the control of any central authority.

Furthermore, with decentralized credit rating, the on-chain data of consumers are not collected and stored on a central ledger but scattered throughout a blockchain maintained by a P2P system. This makes it very hard for hackers to steal users’ data, as was encountered in the Equifax hack of 2017.

From DeFi to decentralized credit rating, the blockchain industry has brought security and efficiency to the financial world. Although decentralized credit rating is in its early stages, even with the advancements already made, there’s no doubt about its growth into an even better assessment tool in the future.