Credit-based DeFi may truly subvert traditional finance

Original: https://pensivepragmatism.substack.com/p/credit-based-defi-is-it-possible?utm_source=%2Fprofile%2F1834009-marco-manoppo&utm_medium=reader2

Author: Marco Manoppo

The cornerstone of the world economy is credit. Your next-door neighbor borrows money from the bank to expand her coffee shop, and then contributes to the overall economy and society by providing jobs for baristas and places for college students to study. We live in a world that has been operating under this system for at least the past few centuries, which creates debt cycles. I won't go into the details because that's Ray Dalio's playground and he's already created a ton of content on it.

In order to obtain credit, a person needs to demonstrate their creditworthiness, usually by demonstrating that they are a disciplined borrower who always pays their debts on time. Meanwhile, those fortunate enough not to have to borrow funds are penalized by the current credit scoring system and viewed as less attractive borrowers. Let me borrow money to buy 6 figure JPEGs on the internet and pay responsibly in 6 monthly installments so they know!

In addition, the current credit system also faces the problem of discrimination. Even in developed countries, this remains a chronic problem that needs to be addressed. Difficulty accessing credit is also a problem faced by entrepreneurs in countries, emerging markets, and other “typical credit-free” communities, not just from a racial perspective. The problem here is that once a person is deemed untrustworthy, it becomes increasingly difficult to get out of the situation because you will most likely need credit in the first place.

It creates a perpetual cycle that pushes you down the rabbit hole — or, if it does the opposite, it creates a perpetual cycle that, by allowing you to borrow $2.3 billion in extremely correlated, illiquid, undercollateralized assets, will You are sent to "Valhalla Palace (the palace where the fallen soldiers and Odin live forever)".

Fintech and pure online lenders help, but if implemented effectively, cryptocurrencies and blockchain technology have the potential to significantly improve credit access to the world in a fairer way. While cryptocurrency hasn’t solved this problem yet, it’s the only industry that’s at least trying to. As long as DeFi stays in its current debit-based, over-collateralized system, it will never truly disrupt traditional finance.

In this post, we introduce services that attempt to connect real-world economic activity to DeFi. We're just getting started, but it's a necessary step in the right direction.

Here are the gist:

• DeFi can create a fairer financial system and provide easier access to capital in our increasingly digital and globalized world.
• In the current debit-based system, DeFi does not unlock new primitives that can be further used in real life.
• DeFi needs to expand to credit-based systems to truly disrupt traditional finance.
• Emerging markets stand to benefit the most from the expansion of DeFi credit in the short term due to increased USD accessibility.
• A crypto-native credit scoring system is necessary to effectively scale DeFi into the real economy, even with some centralization trade-offs in the short term.

Integrate the real world

DeFi has boomed over the past two years, but its use cases are mostly related to speculation and maximized in a player-to-player environment, as tokens are used for mining rewards. We can see that TVL correlates almost 1:1 with broader cryptocurrency market capitalization and altcoin price performance.

This is ironic, as the DeFi ethos originally began as a way to create a more open and fair financial system. The advent of DeFi has inspired the possibility of improving systems that minimize human-level trust with computer-level trust and transparency. However, the debacle of centralized cryptocurrency lenders over the past few weeks has often thrown the wrong spotlight on DeFi. Pantera Capital wrote an article refuting all the misguided journalists who put the blame on “DeFi” rather than centralized crypto companies.

In fact, the real goal of DeFi is to "improve" the current financial system to achieve a more seamless and transparent capital flow. While there are some low-hanging fruit such as increasing the efficiency of financial assets through tokenization and other financial market-focused use cases, as our world becomes more digital and global, the ultimate form of DeFi will be one that provides more credit capacity.

Overcollateralized Crypto Loans

The current standard in DeFi is to provide more funds than you borrow, so that the protocol can fully function without trusting the borrower. They don't have to go to the trouble of identifying the borrower, assessing the borrower's creditworthiness, and taking steps to recover the borrower if the loan was used to buy a yacht.

In an over-collateralized system, the value of the collateral needs to be at least equal to or greater than the value of the loan. Typically, we're talking about an LTV ratio of over 50%. So, for over-collateralized crypto loans, the mechanics are simple: Provide collateral > repay > get your assets back > or get liquidated.

But when it comes to undercollateralized loans, things get a little more complicated.

Undercollateralized loans allow investors to obtain credit by providing collateral that is less than the value of the loan. In some cases, investors may not need to provide collateral at all. In the traditional financial system, lenders would assess a borrower’s creditworthiness through a variety of standardized metrics such as credit scores, track records, and even credentials or influence. In developed markets, legal action and other court cases ensue if borrowers fail to repay their loans. In emerging markets, you can even expect loan sharks to force you to pay back, which can physically hurt you, but I digress.

Benefits of Undercollateralized Loans

Compared with the existing credit market, the loan scale of DeFi is very small. Global unsecured/undersecured debt exceeds $10 trillion in 2021, and consumer debt exceeds $15.6 trillion. If DeFi is serious about integrating, disrupting, or even replacing the current financial system, it needs to venture into the undercollateralized world.

• There are generally 3 main issues to address:
• How to Assess Credit
• Integrate Real World Assets (RWA) on-chain
• Actions when a borrower becomes a bad actor

To effectively address these issues, I can't think of a way that doesn't involve some kind of centralization, like relying on existing laws and courts. That said, any form of improvement to the traditional credit system through DeFi will unlock enormous value, even if there are centralization trade-offs in the short term. We're talking faster transactions, reduced administrative hassle, simplified convenience, immutable records of ownership, and real-time traceability and verification.

So let's break it down.

Crypto-native credit scoring

Traditionally, lenders need to evaluate you based on your credit history/repayments to show that you are a responsible borrower, thus enabling you to get credit and even lower interest rates. Likewise, your wallet address with a long history of on-chain transactions, such as liquidity mining, governance participation, and even loan repayments, can be used to form an encrypted credit profile. This profile will be unique to the wallet address and can be used by various platforms to simplify loan evaluation, such as how traditional financial institutions maintain, analyze and access your credit history.

However, this has some serious drawbacks. For ordinary borrowers, especially those without bank accounts, there may not be enough on-chain data available, and due to the anonymity of the wallet, if the borrower defaults on the loan, he/she can switch to another wallet when applying for other loans . One way around it would be to link on-chain IDs to a single wallet, but purists would argue that goes against the spirit of decentralization. Additionally, crypto-native credit ratings seem promising to lay the groundwork for fully on-chain and decentralized lending in the future, although this will only happen when crypto reaches mainstream adoption. Currently, ordinary users lack sufficient on-chain activity to form encrypted credit profiles.

However, it's important for builders to continue experimenting with different models, even if it means there will be some centralization tradeoffs. For example, we can imagine how Soulbound tokens could be used as a way to store credentials on-chain, forming the basis of an on-chain credit scoring system.

Real World Assets (RWA)

Next, enter RWA. @ChainLinkGod wrote a great post on this topic, so I won't dig into it, but the bottom line is:

DeFi needs to put RWA on the chain on a large scale.

If you think that means it's not fully decentralized, then lock yourself in a closet and read the last part. The point is, even if we solve the on-chain borrower on-ramp problem and have a strong crypto-native credit scoring system, we still need on-chain RWA to balance yield and enable economic activity - can't let people borrow USDC in Ohm fork # 69, you want to use the funds to fund real economic activities, such as opening a new restaurant, and then the debt/claims/equity related to the restaurant is tokenized on the chain for the lender to obtain income.

We're starting to see this real-world integration, although it's still only scratching the surface. MakerDAO has decided to diversify its income strategy by investing $500 million in DAI in U.S. Treasuries and IG corporate bonds. Other projects moved directly into emerging markets as they realized DeFi had the potential to be an alternative source of funding to bridge funding gaps and expand credit in these markets. Goldfinch, which focuses on Mexico, Nigeria, Southeast Asia and India, generated $100 million in active lending over a 12-month period.

catch bad guys

Brainstorm how we can prevent bad actors from running away after borrowing funds in DeFi without relying on existing laws, and the government will need to make a post itself, but I don't think it is currently possible (or never will be possible). There will always be some kind of KYC and AML enforced somehow.

However, if you do find a magical way to fully implement credit-based DeFi on-chain with a "code is law" mentality, let me know and I'd like to invest.

Driving DeFi Forward

People borrow capital to take risks, build additional income streams, improve their lives and contribute to society. DeFi needs to continue experimenting with credit-based undercollateralized models and further integrate with the real-world economy to truly disrupt the existing financial system and provide fairer access to capital for the global population.

If DeFi sticks to the purist mindset of decentralization, it will never merge with the real economy, which means we will always be stuck in a PvP environment where the primary use case for these tokens is speculation.

As the world becomes more digital, global capital flows will become more intertwined. Most traditional cross-jurisdictional capital platforms and credit providers make money by charging exorbitant middleman fees. DeFi will be in the perfect position to disrupt existing business models and capture enormous value in the process.

Over the past few days, some hoaxes have been slowly unleashed about 3AC. Even that might be an understatement. The extent of their depravity and needless risk-taking only goes to show that Kyle and Su's true goal is to become the richest man in the world by trading the magic internet currency. I have been working in the crypto space for about 6 years and have seen many famous people with star power come and go. I definitely did not foresee 3AC flopping so unbelievably like a Martin Scorseses movie - but in retrospect, when your money managers start to go wild and spit out Trust your instincts when saying things like revanchism. The Dunning-Kruger effect is real.

Note: The Dunning-Kruger effect refers to the fact that people with incompetence draw wrong conclusions based on their ill-considered decisions, but cannot correctly recognize their own shortcomings and identify wrong behaviors, which is a phenomenon of cognitive bias . These incapacitated people are immersed in the illusory advantages created by themselves, often overestimating their own ability level, but unable to objectively evaluate the ability of others.