Advancing DeFi Lending With A Social Graph Credit System
By Ritik Dutta, founder of Sublime Finance
Blockchain is disrupting traditional finance from all angles. This technology has the power to democratize the world of finance, by giving everyone equal access to self-banking tools and infrastructures.
For example, outdated lending and borrowing processes in traditional finance are not only expensive and complicated, but also crack under the pressure of decentralized finance (DeFi) lending and borrowing protocols.
The past few months have seen rapid growth in DeFi lending protocols as they lead the charge of TVL (Total Value Locked) in the DeFi landscape. Simply put, smart contracts on the Blockchain are revolutionizing the lending system as a lot of capital flows into pools of liquidity that feed the financial instruments available in DeFi.
DeFi loans represent around 50% of the total market capitalization of the DeFi landscape, worth $ 40.28 billion, with platforms such as Aave, MakerDao and Compound Finance leading the way. Besides the decentralized protocols mentioned above, centralized participants are also joining the movement with companies like Nexo, BlockFi and Celsius offering lending and borrowing services.
Overall, DeFi’s popularity is based on the ease and convenience it provides to borrowers. In traditional finance, a borrower would have to submit a good credit score with a FICO score of 640 or higher in jurisdictions such as the United States and the United Kingdom, respectively. In addition, a borrower would need to provide collateral such as a car title or title deed to gain access to credit.
Access to credit in emerging economies
In developing countries, restrictive conditions for accessing loans through traditional financial institutions have prevented millions of people from participating in the global financial industry. In India, for example, a borrower has to post collateral worth around 20 times their annual income before they are even considered for a loan.
For this reason, citizens of emerging economies are more dependent on informal loans, as surveys show that 14% of informal households in India have an informal loan outstanding, compared to only 12% of formal loans. The International Finance Corporation (IFC) estimates that there is an unmet financial need for $ 5.2 trillion small and medium-sized enterprises in developing countries every year. What else, 40% of the credit available to these companies is through informal channels.
Are DeFi loan protocols a solution?
Blockchain loan protocol projects offer part of a solution given that lending in the world of decentralized finance is a different ball game. For example, the well-known DeFi lending protocols are executed with stand-alone smart contracts where the borrower only has to deposit collateral on the smart contract to access the loans. This cuts borrowing time to seconds or minutes, whereas traditional financial loans require weeks or even months of background checks and Know-Your-Customer (KYC) procedures.
However, DeFi loans are anything but perfect. The most popular DeFi lending platforms issue loans on a secured debt position (CDP) model. it means borrowers deposit their collateral in a smart contract and the platform grants them loans up to the value of the collateral. If the borrower defaults, his collateral is liquidated. There are no terms and conditions on DeFi protocols; therefore, borrowers can pay at any time. Additionally, since the industry is still growing and there are no KYC or third-party approval requirements, most DeFi protocols in the industry adopt an oversized CDP loan design that can go up to at 150%. The over-collateralization is deliberately designed as a security measure to ensure repayment of the loan.
A social graph credit system
What if there was a way to create a credit scoring system for DeFi lending protocols so that the trust and mutual connection that make informal lending a reality (especially for people in emerging economies) could be reflected in a protocol?
Such a solution would reinvent credit through the eyes of a Web 3.0 experience where borrowers can access loans from decentralized lenders using their social reputation as a credit scoring system. The system would work in such a way that borrowers could link their identities to their wallet addresses, allowing them to leverage the trust and reputation they have gained online on the credit system. Through a decentralized network, lenders could deposit capital into a contract-controlled smart liquidity pool where borrowers would have access to capital. In the long term, such a platform would evolve into a social graph of credit, thus enabling the development of a participatory credit information system that can be used by anyone in the DeFi landscape.
The particularity of such a solution is that it allows the emergence of an under-guaranteed loan space in DeFi. With a composable architecture, such a solution would compete with oversized lending markets such as Compound and Aave which dominate the existing DeFi lending industry. By establishing a tool through which users can create a social graph for credit without the intervention of a centralized entity, such a system would put the DeFi movement on par with the financial instruments available in traditional finance.
Conclusion: the way forward for DeFi loans
There are many problems inherent in the traditional credit system when it comes to providing individuals and small businesses with access to adequate financing. High costs, debt traps, and arduous approval procedures have pushed most people into informal channels and led to a deterioration in the issuance of loans in traditional financial markets.
While decentralized financial protocols offer part of the solution that will prepare the world for a Web 3.0 global financial industry, they lack the sophistication that comes with legacy systems. Oversized DeFi loan protocols could be a solution for now; However, they are not a viable option in the long term if the mass adoption of DeFi protocols is to be achieved.
A social graph credit rating system can change all of that by enabling undercapitalized lending markets in the decentralized financial ecosystem. Through a social graph scoring system, borrowers could access credit through their online reputation, lowering the barriers to entry for DeFi lending protocols and providing individuals and small businesses with the opportunity to obtain credit. loans efficiently.
About the Author:
Ritik Dutta is the founder of Sublime Finance. Sublime’s mission is to democratize access to credit through chain sub-guaranteed loans.
The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.