Loans and credits are two important parts of DeFi, but they have been missing an effective operational credential: a decentralized credit rating.
The concept of lending and borrowing is as old as time itself. When it comes to finances, while some individuals have more than enough for themselves, others barely have enough to get by. As long as this imbalance in the distribution of finances exists, there will always be the need to borrow and the desire to lend.
Lending consists of giving a credit resource with the condition that you repay it after an agreed term. In this case, those resources would be money or any financial asset.
The lender can be an individual, a financial institution, a company, or even a country. Whatever the case, the lender often needs a kind of guarantee that he will receive his resources back within the agreed period.
There are certain criteria that qualify a borrower to take out a loan. Among them is the borrower’s debt-to-income ratio (DTI), which measures how much of their income goes toward monthly debt service, stable employment, collateral value, and real income.
Crucial Role of Credit Rating in Loan Granting
In general, most financial institutions and companies rely more on the credit score of the borrower than on the aforementioned criteria.
Consequently, the credit score is by far the main factor in determining whether a borrower should receive a loan. In a world of financial imbalance where loans are rapidly becoming necessary, especially due to recent economic difficulties, individuals, establishments and even governments must keep their credit ratings as favorable as possible.
These ratings or scores may be assigned to individuals, businesses, or governments that wish to take out a loan in an attempt to pay off a shortfall. Failure to repay the loan at the agreed time often has a negative impact on the borrower’s credit rating, making it difficult for them to obtain another loan in the future.
In the case of governments, they are likely to face sovereign credit risk, which is the possibility of a government defaulting on a borrowed loan. According to data from Wikipedia, Singapore, Norway, Switzerland, and Denmark rank first to fourth, respectively, among the least risky countries to grant loans.
Traditional Credit Rating is Barely Perfect
Although it may seem simple, the concept of credit scoring is far from perfect due, in large part, to its centralized nature.
Establishments commonly known as credit bureaus carry out credit scores. Agencies such as Transunion, Experian, and Equifax carry out the credit rating of individuals. Companies like Moody’s and S&P Global, to name a few, can evaluate governments and other companies as well.
Although credit bureaus strive to assess borrowers’ creditworthiness as transparently as possible, there have been numerous instances of improper assessments due to issues such as withholding material information, static study, misrepresentation, and human bias.
In a recent article, Dimitar Rafailov, a Bulgarian associate professor at the Varna University of Economics, highlighted the importance of proper and transparent credit rating.
The Patent Need for Decentralization
The arrival of Blockchain technology revolutionized many sectors, especially the financial one. Decentralized finance (DeFi), as a product of burgeoning technology, has revealed the possibility of managing financial services with a peer-to-peer (P2P) system, eliminating the idea of an intermediary or central authority.
Decentralized credit scoring refers to the idea of assessing a borrower’s creditworthiness using on-chain—sometimes off-chain—data without the need for an intermediary. The evaluation takes place on a Blockchain managed by a P2P system of computers without any central authority or control point. Additionally, a decentralized credit score erases traditional credit bureaus from the picture.
By Audy Castaneda
