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, giving everyone equal access to self banking tools and infrastructure.
For instance, outdated lending and borrowing processes in traditional finance are not only expensive and complicated, but also cracking under the pressure of decentralized finance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) across the DeFi landscape. Simply put, smart contracts on the Blockchain are revolutionizing the loan system as plenty of capital flows into liquidity pools that power the financial instruments available in DeFi.
DeFi lending makes up about 50% of the total market capitalization of the DeFi landscape, amounting to a value of $40.28 billion with platforms such as Aave, MakerDao and Compound Finance leading the charge. Apart from the above-mentioned decentralized protocols, centralized participants are also joining the bandwagon with companies such as Nexo, BlockFi and Celsius offering capital lending and borrowing services.
Overall, DeFi’s popularity rides on the backdrop of 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 U.S. and U.K., respectively. Additionally, a borrower would have to provide collateral such as a car title or house deed to get access to credit.
Access to credit in emerging economies
In developing countries, the restrictive requirements of getting access to loans through traditional finance institutions have locked out millions from participating in the global financial industry. In India, for instance, a borrower has to put up collateral worth around 20 times his or her annual income before even being considered for a loan.
For this reason, citizens in emerging economies rely more on informal loans as surveys show 14% of informal households in India have an outstanding informal loan compared to just 12% formal loans. The International Financial Corporation (IFC) estimates that there is an unmet financial need of $5.2 trillion from small and medium-sized enterprises in developing nations every year. What’s more, 40% of the credit available to these enterprises is all taking place through informal channels.
Are DeFi lending protocols a solution?
Blockchain lending protocol projects offer part of a solution given the fact that lending in the decentralized finance world is a different ball game. For instance, well-known DeFi lending protocols are run with autonomous smart contracts where the borrower only has to deposit collateral to the smart contract to access loans. This shortens the borrowing time to seconds or minutes, while traditional finance loans take weeks if not months of background checks and KYC (Know-Your-Customer) procedures to fulfill.
However, DeFi lending loans are anything but perfect. Most popular DeFi lending platforms issue loans on a collateralized debt position (CDP) model. this means that borrowers deposit their collateral into a smart contract, and the platform issues them loans up to the value of the collateral. If the borrower defaults, their collateral is liquidated. There are no terms and conditions on DeFi protocols; therefore, borrowers can pay at any given time. Plus, since the sector is still growing and there are no KYC or third-party approval requirements, most DeFi protocols in the sector take on an over-collateralized CDP lending design which can go as high as 150%. Over-collateralization is purposefully designed as a security measure to ensure loan repayment.
A social graph credit system
What if there was a way to create a credit scoring system for DeFi lending protocols such that the trust and mutual connection that makes informal loans a reality (especially for people in emerging economies) could be reflected in a protocol?
Such a solution would re-imagine 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 operate such that the borrowers can link their identities to their wallet addresses thus allowing them to leverage the trust and reputation they have gathered online to the credit system. Through a decentralized network, lenders would be able to deposit capital in a smart contract-controlled liquidity pool where borrowers would have access to capital. Over the long term, such a platform would evolve into a social graph for credit thus allowing the development of a crowdsourced credit information system that can be used by anyone in the DeFi landscape.
What’s unique about such a solution is that it enables the emergence of an undercollateralized lending space in DeFi. With a composable architecture, such a solution would rival overcollateralized lending markets such as Compound and Aave which dominate the existing DeFi lending sector. By establishing a tool through which users can build a social graph for credit without the involvement of a centralized entity, such a system would bring the DeFi movement at par with the financial instruments available in traditional finance.
Conclusion: The way forward for DeFi lending
There are many problems inherent to the traditional credit system when it comes to allowing individuals and small businesses access to adequate financing. The high costs, debt traps and arduous approval procedures have pushed most people into informal channels and have led to a deterioration of loan origination in traditional finance markets.
While decentralized finance 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. Overcollateralized lending DeFi protocols might be a solution for the moment; however, they are not a long-term viable option if mass adoption of DeFi protocols is to be achieved.
A social graph credit scoring system can change all that by enabling undercapitalized lending markets in the decentralized finance ecosystem. Through a social graph scoring system, borrowers would be able to access credit through their online reputation, thus lowering barriers to entry for DeFi lending protocols and providing opportunities for both individuals and small businesses to obtain loans efficiently.
About the author:
Ritik Dutta is the founder of Sublime Finance. Sublime is on a mission to democratize access to credit through on-chain undercollateralized lending.
The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.