How TradFi Credit Systems Could Unleash On-Chain Capital Migration

Banks make money, for everyone. Banks, and the banking system, created the conditions for our modern world through the provision of affordable credit. Their standard services need to be ultimately emulated by DeFi, and SoLo Protocol, a protocol that provides under-collateralised loans to the general user, wants to do just that.

SoLo will use open banking data such as transaction history and lending outcomes to assess credit worthiness of lenders by marrying it with on-chain analytics. They are building machine learning algorithms to create a fairer credit system that’s built for the modern generation.

Why Banking is Still Important in the Crypto Age

Banking facilitated access to credit and made money move. Credit means that people can take risks, buy houses, start businesses, and have safety nets. Credit creates wealth. Everytime a bank writes a loan, it pumps new money into the economy, creating new jobs, new opportunities, and new technological advances.

Quite a vigorous defence of the TradFi systems that most in crypto know are broken and need to be changed. And it’s true. DeFi has the potential to enshrine a new paradigm of Open Finance, where lending and borrowing is done by all the people, not the institutions. Yet although DeFi advances towards that at fantastic pace, and in time institutions may come to adopt its opportunities, it’s nowhere close in the current state.

The Current State of DeFi Lending and Borrowing

There is plenty of lending and borrowing done on DeFi, you say. Yes, but it is almost exclusively over-collateralised lending, where the amount deposited as collateral is greater than the amount borrowed. If you have more money than you are borrowing, you don’t really need the loan. You could just always perform your activities with the principal. Of course, there are a great many reasons one would want to use credit rather than assets, but they are all to do with investing, liquidity requirements, capital efficiency, and portfolio management.

These are not the concerns of the majority of people. People want cars, houses, to start businesses, to take vacations. They’re good for it, they have jobs, they just don’t have the money right now. This is the essence of consumer credit. People get what they want, the economy remains active, and everyone gets richer. In 2008, after the financial crash that in many ways birthed crypto, governments pumped liquidity into the banks so that they could keep lending to consumers, at all costs. The flaws of this decision have had billions of words written about them, but very few take issue with the fact that affordable, accessible credit is a vital goal – it’s just how you get there.

How SoLo Will Create Access to Credit

The Solo Protocol aims to create affordable, accessible credit available on-chain and ready to deploy in web3. It will offer under-collateralised loans. The borrower will not have to deposit more capital than they are borrowing. I.e, it works like a personal loan, car loan, or mortgage (with the mild exception that mortgages are obviously part collateralised by the house itself).

Of course, lending out money with no oversight can’t happen. Banks use credit scores to determine how likely it is that loans will be repaid. These systems are sprawling and robust and refined over decades of business activity. Yes they are slightly baroque and arcane, and an institution purely playing by the numbers without discretion will not make optimal decisions, but for the most part they give banks a firm guideline or who they should and should not lend to, and what rates might be sensible.

They are unfair though. 39% of UK respondents think so too. There are millions of people who are credit worthy but who have ‘invisible credit’, particularly those of a lower socio-economic background, the young, and new immigrants to countries. “You may be extremely credit worthy but, if you’ve never taken out a credit card for example, you’re practically invisible,” says Tom G, a co-founder at SoLo, “they are ripe for improvement”

Applying machine learning to open banking data is a fairer solution than traditional credit scores. They better capture the truth of those who have slipped through the gaps of the standard credit score system, and find non-linear data that is otherwise disregarded, and are excellent predictors of risk. Credit Kudos, recently acquired by Apple, has already done this to great success. A Bank of England research paper states that machine learning ‘improves the screening of risky borrowers’.

Using Credit Reports to Issue Crypto Loans

SoLo plans to use these new machine learning evaluations of open banking data to make these crypto loans. By combining transactional data with lending outcomes they can create excellent risk predictors, and thus have the basis with which to lend. The SoLo Protocol’s beta has just launched on the website putting this approach into practice. As the project grows, SoLo plans to develop their machine learning algorithm further to assess the credit worthiness of unbanked adults using alternative data like rental and cell-phone payments.

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In this way it hopes to merge TradFi into DeFi and web2 into web3. SoLo will retain all other crypto primitives though. It plans to store personal data anonymously and decentralised, and only access that data if a loan is defaulted upon. It will marry off-chain data (credit score) and on-chain (wallet activity) when reaching its decisions, creating the most complete possible profile of its petitioners, and thus making better lending decisions all round. It’s called your SoLo score, and you can head over to their website and try their beta and see your SoLo score for yourself.

It also creates the possibility for loans that are more in line with standard consumer credit. DeFi loans, although they are over-collateralised, rates of interest for borrowers are extremely high. This is in part due to the immaturity of the system, and also because – in DeFi – users taking these loans are ‘power users’. They are making profit from mixing and matching arcane financial instruments, they are not freeing up capital to start a business, or buy a car. If they are (and it’s possible), it’s because they have a fundamental unshakeable belief in a long position on the underlying collateral (e.g ETH), and more importantly have the ongoing capital to finance that long position for the foreseeable future.

The average user is nothing like this. They just need a loan to either achieve a specific purpose, such as car repairs or a safety net. An emerging new type of user will be someone who has an excellent track record in traditional credit systems, or positive transaction data, but zero web3 exposure. They may, for example, suddenly want to buy a piece of land in popular metaverse. By showing they have excellent ‘web2’ credibilty, they can borrow the crypto for the purchase in the way someone may take out a mortgage to buy a house.

Competitive Interest Crypto Loans Will Create Wealth Explosion

In creating this excess capital by using the data we already know works, the SoLo Protocol may have a transformative effect on web3, by issuing credit that gets new users involved into this new way of the web. It will help generate explosive growth. It will serve as a ramp for users with good credit to get the loans they need for investments. In the medium term, this will be web3 investments, but as crypto adoption grows, SoLo will increasingly look like the bridge that connects the traditional banking systems of web2 to the wonder of web3.