How Decentralized Credit Ratings Are Changing the Financial System

Borrowing and lending are two important parts of DeFi, but they have always lacked an effective operating certificate: decentralized credit ratings.

The concepts of lending and borrowing are as old as time itself. When it comes to finances, while some people have achieved financial freedom, there are many more who barely have enough money to get by. As long as this imbalance in financial distribution persists, the desire to borrow and the demand for loans will not disappear.

When a loan involves the provision of resources by way of credit, it is conditional upon the repayment within an agreed period of time of the resource provided by the lender, which could be money or any other financial asset.

Lenders can be individuals, financial institutions, companies or even countries. In either case, lenders are generally required to have a guarantee that the resources they lend will be returned to them at the agreed time.

The lending industry has various criteria to qualify a borrower for a loan. These include the debt-to-income ratio (DTI), which measures a borrower's income to handle monthly debt payments, stable employment, the value of collateral, and actual income.

But the reality is that most financial institutions and companies rely more on a borrower's credit rating than on the aforementioned criteria.

Therefore, credit rating remains by far the biggest factor in determining whether a loan should be granted to a borrower. In a world of financial disequilibrium, superlative lending is a necessity, especially due to recent economic difficulties, where individuals, institutions and even governments are expected to maintain their credit ratings as long as possible.

These ratings, or points, can be assigned to individuals, companies, or governments that wish to obtain loans to cover deficits. Defaulting on a loan by the agreed time generally has an adverse effect 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 the risk of a sovereign credit rating adjustment, i.e. the possibility of the government defaulting on its loan repayments. According to Wikipedia data, the countries with the lowest loan risk rank, and the top four are Singapore, Norway, Switzerland and Denmark.

As simple as it sounds, the concept of credit ratings is far from perfect, largely due to its centralized nature.

Credit ratings are assessed by agencies commonly known as credit bureaus. Including institutions such as Transunion, Experian and Equifax for personal credit ratings, and for companies and governments, such as Moody's, S&P Global and other companies.

While credit bureaus make every effort to assess borrowers' creditworthiness as transparently as possible, there have been many cases of inadequate assessment results due to occasional withholding of important information, static research, misrepresentation, and human bias. .

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

Rafailov pointed out that the credit bureaus believed that these ratings were deficient, and that this failure "reinforced the negative impact of the global financial crisis and created additional systemic risks." He noted that the errors that cause traditional credit ratings done by credit bureaus are often caused by "absent or ineffective oversight of their activities, business models, conflicts of interest and oversight".

The emergence of blockchain technology has completely changed many industries, especially the financial industry. Decentralized Finance (DeFi), as a product of emerging technologies, reveals the possibility of running financial services in a peer-to-peer (P2P) system, eliminating the heavy participation of intermediaries or central institutions.

Decentralized credit scoring refers to the use of on-chain (and occasionally off-chain) data to assess a borrower's creditworthiness without the need for an intermediary. Evaluations are carried out on a blockchain run by a P2P system of computers without any central authority or point of control. Decentralized credit ratings wipe traditional credit bureaus from the picture.

Slow Ventures investment partner Jill Carlson expressed the importance of decentralized credit scoring. In a 2018 article, she noted that "solutions to decentralized credit scoring can lead to larger-scale identity systems that do not rely on a single central authority." She noted that the problems posed by the concept of centralized credit scoring More profound than ever in the past year, citing the 2017 Equifax hack.

In 2017, credit ratings giant Equifax suffered a security breach caused by four Chinese hackers, exposing the data of 143 million Americans.

Antonio Trenchev, a former member of the Bulgarian National Assembly and co-founder of blockchain-based lending platform Nexo, told Cointelegraph that credit ratings, especially those produced by central agencies, are more problematic than solutions-based credit ratings.

“In this utopian lending scenario we hope to create, credit scores will be a rare thing, and when they are used, they will be decentralized and fair.”

— Trenchev brags about how his platform has successfully ruled out credit scores with its “instant crypto credit lines and Nexo cards.”

Two years ago, blockchain lending protocol Teller raised $1 million in a seed round led by venture capital firm Framework Ventures to bring traditional credit scoring into DeFi.

While this is only a first for the decentralized world, credit scoring promises to help address the over-collateralization problem that plagues lending in DeFi and ensure eligible borrowers get what they deserve.

Last November, the Credit DeFi Alliance (CreDA) officially launched a credit rating service that uses data from multiple blockchains to determine a user’s credit limit.

CreDA utilizes CreDA Oracle developed with the help of artificial intelligence to evaluate the user's past transaction records on several blockchains.

When this data is analyzed, it is minted into a non-forgeable token (NFT), called a Credit NFT (cNFT). When a user wishes to borrow money from a DeFi protocol, this cNFT is used to evaluate the user's data so that they can receive unique incentives or loan rates.

Although CreDA is built on Ethereum -2.0, it has been made to operate across different blockchains, including Polkadot , Binance Smart Chain, Elastos Sidechain, Polygon, Arbitrum, etc.

Most recently, P2P lending protocol RociFi Labs completed a $2.7 million seed round in partnership with asset manager GoldenTree, investment firms Skynet Trading, Arrington Capital, XRP Capital, Nexo, and LD Capital. The goal is to expand on-chain credit ratings for decentralized finance.

In addition, RociFi determines user ratings by using on-chain data and artificial intelligence, as well as ID data from decentralized platforms. Similar to CreDA's approach, RociFi credit ratings are converted into NFTs called Unforgeable Credit Scores, which range from 1 to 10. A higher score means lower creditworthiness.

Judgments about a borrower's creditworthiness can have a profound impact on their lives. The need for impartial and impartial judgment in this regard cannot be overemphasized.

Still, traditional credit rating agencies have in many cases failed to accurately assess the creditworthiness of borrowers, either due to inefficiency or pure bias.

Decentralized credit ratings bring fairness. Borrowers will get more accurate assessments, and these assessments are carried out on the blockchain by artificial intelligence and are not controlled by any central authority.

Furthermore, with decentralized credit ratings, consumers’ on-chain data is not collected and stored on a central ledger, but dispersed across a blockchain maintained by a P2P system. This makes it very difficult for hackers to steal users' data, avoiding a repeat of tragedies like the 2017 Equifax hack.

From DeFi to decentralized credit ratings, the blockchain industry has brought more solid security and higher efficiency to the financial world. While some progress has been made in decentralized credit ratings, the industry as a whole is still in its early stages. There is no doubt that it will grow into a better loan assessment tool in the future.

Original Author: WAHID PESSARLAY

Creator: shaun

Reviewer: Yofu

Original: Decentralized credit scores: How can blockchain tech change ratings