The Scoring System In Traditional And Crypto Finance — Are There Any Integration Possibilities?
The scoring systems play an integral part in the development of traditional finance and now gradually emerge in the crypto world. For now, these scoring models not only assure the sustainability of the two financial fields but also pave the way for their integration.
The scoring system in Traditional Finance
Why do we need a scoring system in Traditional Finance?
Because of the loss of control over non-performing loans and the inherent prejudice in credit evaluation and lending practices, the invention of credit scoring was the pressing solution for the finance market many years before and remains crucial these days.
A scoring system in traditional finance is a measure to evaluate credit risk and help lenders make informed decisions about lending money. These scores can have a significant impact on the interest rates and terms offered to borrowers.
For example, whenever you sign up for your first-ever credit card or apply for a mortgage loan from a bank or a credit company. Your credit score is the main determinant of whether or not you’ll be able to reach the loan. Your credit report and that three-digit credit score number can also make a big difference in how much interest you’ll have to pay on loans as well as the types of loans or credit cards you’ll qualify for. That’s how the scoring system is used in traditional finance.
How the scoring mechanism in Traditional Finance works?
Throughout the long history of finance, scoring systems have been developing significantly. Up to now, there are several popular models used in traditional finance, including:
- Credit score: A credit score is a number that represents an individual’s creditworthiness based on their credit history. The score is calculated based on factors such as payment history, credit utilization, length of credit history, and types of credit.
- Risk rating: A risk rating, a score given to a business, indicates the level of risk associated with lending to that business. The rating is based on factors such as financial stability, industry trends, and the overall economic environment.
- Bond rating: A bond rating, a score given to a bond, indicates the level of creditworthiness of the issuer. The rating is based on factors such as the issuer’s financial stability, credit history, and the overall economic environment.
When it comes to individual loans, the credit score is the most popular scoring model. Among many credit scoring systems, Fair Isaac Corporation’s, known as the FICO score, is the most widely used in the financial industry when being employed by more than 90% of top lenders.
FICO Scores are calculated using many different pieces of credit data in your credit report. This data is grouped into five categories: payment history (35%), amounts owed (30%), length of credit history (15%), new credit (10%), and credit mix (10%).
For instance, when you apply for credit, the lender will request a credit report from one or more credit bureaus. This documentation will show your FICO score and other information lenders use to evaluate your creditworthiness, such as payment history, credit utilization, and length of credit history.
The scoring system in Crypto Finance
Why do we need a scoring system in Crypto Finance?
How is cryptocurrency developing at the present?
Cryptocurrency is developing vastly in the past few years with the rise in crypto assets users from 5 million in 2016 to 402 million in 2022, according to Statista.com). Among various fields, DeFi (Decentralized Finance) is the most robust market with the Total Value Locked (TVL) in Defi protocols at approximately 40 billion today and this number is still on the rise (according to Stelareum’s real-time graph).
Along with this improvement, the demand for borrowing crypto has been increasing in recent years. According to a report by Genesis Capital, a digital asset lending firm, the total value of outstanding loans in the cryptocurrency lending market increased from $1.2 billion in Q1 2019 to $8 billion in Q4 2020.
Is there any risk in crypto finance?
However, the higher the stakes, the greater the risks. The risk of loan default is even higher in crypto finance compared to the traditional market due to the lack of governing body and regulations. Moreover, in the Crypto space, one person may have many anonymous addresses, so it’s difficult for lenders to detect the borrower’s bad behavior in the past.
In 2021, Nexo, a cryptocurrency lending platform, reported that it had experienced some defaults on its over-collateralized loans. According to Nexo, the defaults were caused by a combination of market volatility and borrower fraud.
These remaining risks bring on the urgent need for credit scoring in Crypto Finance to make it more credible and sustainable.
Similar to Traditional Finance, in Crypto, credit score also plays the role of a gauge of the ability and possibility to pay the loan of the borrowers in the market.
How the scoring system in Crypto Finance works?
A quick look into the Crypto Credit Scoring system
Recently, there have been over 20 key scoring platforms emerging to provide credit scores of individual on-chain to help lenders as well as crypto businesses in decision-making.
Crypto credit scores are a relatively new concept in the crypto world, and therefore, there is no standard approach to calculating them. While each organization and platform has different models to calculate the crypto credit score, they commonly consider some key factors:
- Payment history: This includes information about your past payments, such as whether you have paid your loans or credit card bills on time.
- Credit utilization: This refers to the amount of credit you have used compared to the total credit available to you.
- Length of credit history: This refers to how long you have been using credit.
- Public reputation: This includes information about your reputation in the community, such as online reviews or social media activity.
- Collateral: If you are applying for a loan or other type of credit, the value and type of collateral you can offer may be taken into consideration.
- Trading activity: This includes information about your trading history, such as trading volume, frequency, and success rate.
Are there any integration possibilities of Crypto Finance and Traditional Finance?
The need for crypto and traditional finance integration
Since its emergence in 2009, the cryptocurrency market has experienced significant growth and evolution over the past decade, with an increasing demand for holding Crypto along with traditional assets. Besides that, some traditional scoring organizations also started to provide crypto-scoring services to evaluate the credit trustworthiness of blockchain-based companies. They also aim at putting users’ credit scores on-chain, allowing users to share this credit score information with lenders on the blockchain to borrow digital assets.
According to Global Institutional Client’s research (surveyed 271 Institutional Investors about their attitudes toward investing in digital assets):
- 88% of Institutional Investors are comfortable with a digital representation of cash using blockchain-based technology.
- 97% of Institutional Investors agreed that “tokenization will revolutionize asset management” and be “good for the industry”.
Furthermore, governments around the world gradually accept cryptocurrency and are considering creating their own digital assets (Called Central Bank Digital Currency).
With the current situation, the integration of crypto and traditional finance is possible in the not-too-distant future.
Overcome existing barriers
However, gaining trust from traditional finance organizations is a huge challenge as the crypto market still contains high risk, which is down to the biggest problem “Identity”. In Traditional Finance, every individual information must be identified with the requirement of an ID card, living address, etc. In contrast, in the Crypto world, most of the user information is anonymous, which makes crypto credit score may not sound trustworthy.
Moreover, because of the vast ocean of data on the blockchain, service providers find it difficult to crawl and analyze data about all users and their connections to other entities, especially those active on different chains or owning more than one wallet.
The solutions for these two main problems are now feasible with the application of big data, AI, ZK-Knowledge, etc. These cutting-edge technologies will be also applied in Centic to bridge the gap between traditional and crypto finance.
Conclusion
The scoring systems play significant roles in both traditional and crypto finance, assuring the sustainability of these two.
Despite the remaining problems, it will soon be the key factor, bringing traditional and crypto finance together.
