Quantifying reputation: bridging DeFi with off-chain credit scoring.
In line with our recently updated vision statement, we start exploring how Taraxa’s audit logging of informal, off-chain transactions can benefit online and crypto communities by adding substantive metrics to identity and reputation.
Lending and borrowing of crypto-assets have so far been a key function in DeFi. With the rise of collateralized lending, the non-collateralized sector has largely been left unattended, which presents a huge missing link in the rapidly growing DeFi ecosystem. The biggest challenge here is the lack of reputation mechanisms to provide a proper level of security to non-collateralized loans. Here’s how Taraxa’s audit logging of informal transactions can help to link DeFi applications with off-chain credit scoring.
The evolution of traditional lending and borrowing: from collateral to credit-based lending.
As the world’s value is getting tokenized, we are now in the middle of a very exciting process of the creation of a new infrastructure that aims to re-create and improve the existing banking and financial services based on digital tokens. In the history of financial services, lending and borrowing evolved from using assets as collateral to complex reputation systems based on credit scores. From ancient Greece and Rome where pawnbrokers collected collaterals from the borrower to lower the lender’s risk, to the early 1800s when banks started offering first unsecured loans based on credit scores. And it’s safe to say that DeFi will follow the development pattern of its traditional counterpart.
Despite all the innovation and entirely new financial primitives proposed in the DeFi space, it has been largely following the development of traditional financial systems: from commercial banking and exchanges to insurance and asset management. However, product design had to be adjusted to the pseudo-anonymous nature of Web 3.0. In the absence of KYC/AML and possibilities to revert transactions inherent to CeFi, only mechanism design could protect all counterparties of DeFi apps from risks of non-performance and fraud. This is the reason why lending protocols in Defi are overcollateralized, i.e. to protect the lender’s funds.
Over-collateralization is a big macroeconomic issue since it greatly limits the amount of debt that could be possibly created. To cover that, traditional credit systems rely additionally on non-collateralized signals to facilitate borrowing. A probabilistic approach based on math and statistics allows the traditional financial system to provide more loans that possibly could be collateralized.
Today, the DeFi lending market sits at $28.6 billion, with the Total Value Locked of $54.8 billion (DeFi Pulse, July 2021). Unlike highly secure and developed off-chain credit systems, DeFi loans are backed solely by collateral (Maker DAO, Aave, Compound), with hybrid versions and advanced lending markets, connecting borrowers and lenders on a platform with multi-collateral systems.
The non-collateralized segment hasn’t gotten any significant traction so far as it’s pretty complex to introduce a working credit scoring system to a pseudo-anonymous on-chain environment: (1) impossible to link a user’s real identity with their previous transactions (infinite number of wallets not linked to each other) (2) off-chain information cannot be used and considered as a reputation metric due to the absence of a trusted linking system.
How can an off-chain credit scoring system benefit decentralized finance applications?
While DeFi was conceived as revolutionary open finance for all with lower compliance overhead, closed systems are hard to get adoption. To go mainstream and establish relationships with institutional players, DeFi needs a reliable way for evaluating risk with the equivalent level of due diligence — a decentralized credit score primitive that allows evaluating counterparty risk without relying on collateral. To add trust and reputation to lending and borrowing through DeFi, we need a system that links on-chain user profiles with off-chain data, transactions, and other reputation-based signals, including information from verified third parties.
By connecting user off-chain identities with their crypto accounts, a proper due diligence process will finally become possible to enable uncollateralized loans. The biggest challenge here is that DeFi is a largely pseudonymous, closed system, making it much more difficult to associate online reputation with an individual. And as we start seeing more solutions that tackle the problem of pseudonymity in DeFi, they’re all still looking at the on-chain data, completely ignoring the existing massive amount of credit score data widely used in traditional finance, since there is no trusted approach to link off-chain data to the on-chain world. The problem is akin to the problem of blockchain oracles that were created to provide data feeds from the off-chain world to smart contracts.
A cornerstone of risk evaluation in global banking systems for decades, the database of offline credit scores presents a good opportunity to link the existing user base to DeFi platforms, building the foundation for verifiable credentials and credit scoring in crypto. By looking at off-chain signals such as user lending history and credit score, we’ll be able to link user identities to their crypto wallets and DeFi platforms. Pulling off-chain signals and credit scoring data into a quantified reputation system based on Taraxa’s audit logging will help to address the problem of pseudonymity in DeFi and build a foundation for non-collateralized lending and more mature decentralized protocols that consider the borrower’s credit history to enable new exciting use cases and financial interoperability at scale.