How decentralized credit ratings are changing the financial system

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

The concepts of lending and borrowing are as old as time itself. When it comes to finances, while some people have achieved financial freedom, many more have barely enough money to live on. As long as this imbalance of financial distribution persists, the desire to borrow and the need to lend will not disappear.

When a loan involves the provision of resources on credit, it is established on the condition that the resources provided by the lender, which can be money or any other financial asset, are repaid within an agreed period of time.

Lenders can be individuals, financial institutions, companies or even countries. In either case, lenders usually need a guarantee that the resources they lent will be returned to them at the agreed time.

The lending industry has various review criteria to qualify borrowers for loans. This includes the debt-to-income ratio (DTI) used to measure the borrower’s income for processing monthly debt service payments, stable employment, the value of collateral, and actual income.

Credit ratings play a vital role in lending

But the reality is that most financial institutions and companies rely more on borrowers’ credit ratings than the aforementioned criteria.

Therefore, credit rating remains by far the biggest factor in deciding whether a loan should be issued to a borrower. In a world of financial imbalances, extremely fast lending is necessary, especially due to recent economic hardships, and individuals, institutions and even governments are expected to maintain their credit ratings as much as possible.

These ratings, or scores, can be assigned to individuals, companies, or governments that wish to obtain loans to address deficits. Defaulting on a loan at the agreed time generally adversely affects a borrower’s credit rating, making it difficult for them to get another loan in the future.

In the case of governments, they are likely to face the risk of a sovereign credit rating adjustment, which means the government could default on loan repayments. According to Wikipedia, the countries with the lowest loan risk are ranked in the top four, followed by Singapore, Norway, Switzerland and Denmark.

Traditional credit rating systems are complete but imperfect

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. These include agencies such as Transunion, Experian, and Equifax for personal credit ratings, and for corporations and governments, such as Moody’s, S&P Global, and others.

Although credit agencies make every effort to assess borrowers’ credit status as transparently as possible, there have been many cases of insufficient assessment results due to issues such as withholding important information, static research, misrepresentation, and human bias. .

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

Rafailov noted that the ratings were perceived by credit bureaus to be inadequate, and that such missteps “reinforced the negative impact of the global financial crisis and created additional systemic risk.” He noted that errors in the traditional credit ratings done by credit bureaus are often caused by “missing or ineffective business models, conflicts of interest, and oversight of their activities.”

Patents need to be decentralized

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

Decentralized credit scoring refers to the use of on-chain (and occasionally off-chain) data to assess the creditworthiness of borrowers without the need for intermediaries. 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.

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

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

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

“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 touted how his platform successfully excluded credit scores with its “Instant Crypto Line of Credit and Nexo Card.”

gradually become a reality

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 the first example of a decentralized world, credit scoring promises to help solve the problem of over-collateralization that plagues lending and borrowing in DeFi and ensure that eligible borrowers get what they deserve.

Last November, the Credit DeFi Alliance (CreDA) officially launched a credit rating service that determines users’ credit limits using data from multiple blockchains.

CreDA utilizes the CreDA Oracle, developed with the help of artificial intelligence, to evaluate users’ past transaction records on several blockchains.

When this data is analyzed, it is minted into an unforgeable token (NFT) called a credit NFT (cNFT). When a user wishes to borrow from a DeFi protocol, this cNFT is used to evaluate the user’s data so that they can obtain a unique incentive or loan interest rate.

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.

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

Additionally, 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 a lower credit rating.

additional contribution

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 fail to accurately assess borrowers’ creditworthiness in many cases, either due to inefficiency or sheer bias.

Decentralized credit ratings bring fairness. Borrowers will get more accurate assessments, all made on the blockchain by AI and not controlled by any central authority.

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

From DeFi to decentralized credit ratings, the blockchain industry brings more solid security and greater efficiency to the financial world. While some progress has been made in decentralizing 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.

Posted by:CoinYuppie,Reprinted with attribution to:https://coinyuppie.com/how-decentralized-credit-ratings-are-changing-the-financial-system/
Coinyuppie is an open information publishing platform, all information provided is not related to the views and positions of coinyuppie, and does not constitute any investment and financial advice. Users are expected to carefully screen and prevent risks.

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