The concept of borrowing and borrowing is as old as time itself. When it comes to finances, some individuals have more than enough for themselves, while others barely have enough to make ends meet. As long as there is this imbalance in financial distribution, there will always be a need for credit and a desire to lend.
Borrowing gives a resource on credit with the condition that it be returned after an agreed period of time. In this case, such resources would be money or some financial asset.
The lender can be an individual, a financial institution, a company, or even a country. Whatever the case, the lender often needs some sort of assurance that their funds will be returned to them at the agreed time.
Certain criteria qualify a borrower to take out a loan. This includes the debt-to-income (DTI) ratio of the borrower Dimensions the amount of money from their income intended for the settlement of monthly debt service, stable employment, the value of collateral and actual income.
Creditworthiness plays a crucial role in lending
In general, most financial institutions and companies rely more heavily on the borrower’s creditworthiness than on the above criteria.
Consequently, credit scores are by far the most important factor in deciding whether a borrower should be granted credit. In a world of financial imbalance where borrowing is quickly becoming necessary, particularly due to the recent economic difficulties, individuals, businesses and even governments are expected to keep their credit ratings as favorable as possible.
These ratings, or ratings, can be assigned to individuals, companies, or governments that wish to borrow to make up a deficit. Failure to pay the loan at the agreed time usually negatively affects the borrower’s creditworthiness and makes it difficult for them to get another loan in the future.
In the case of governments, this is probably the case face sovereign credit risk, which is the potential for a government to default on a loan it has taken out. According to Wikipedia, Singapore, Norway, Switzerland and Denmark respectively rank first to fourth among the least risky countries for lending.
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The traditional credit rating is hardly perfect
As simple as it sounds, the concept of credit scoring is far from perfect, due in large part to its centralized nature.
Credit ratings are performed by entities commonly referred to as credit bureaus. Credit assessments of individuals can be performed by agencies such as Transunion, Experian and Equifax. Companies and governments are likely to be rated by firms like Moody’s and S&P Global, to name a few.
While credit bureaus make every effort to assess borrowers’ creditworthiness as transparently as possible, there have been numerous instances of inadequate assessments due to issues such as concealment of material information, static studies, misstatements and human bias.
In a recent article, Dimitar Rafailov, Bulgarian Associate Professor at Varna University of Economics said, stressed the importance of an appropriate and transparent credit rating.
However, Rafailov noted that credit bureaus perceived imperfections in these ratings, and such imperfections “have amplified the negative impact of the global financial crisis and created additional systematic risks.” He pointed out that the errors that plague traditional credit ratings by credit bureaus are often caused by “business models, conflicts of interest, and the lack or ineffective regulation of their activities.”
The patent need for decentralization
The advent of blockchain technology has revolutionized many sectors, most notably the financial sector. As a product of the burgeoning technology, decentralized finance (DeFi) has revealed the possibility of operating 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. Scoring occurs on a blockchain run by a P2P computer system with no central authority or point of control. In addition, a decentralized credit rating removes the traditional credit bureaus from the picture.
Jill Carlson, an investment partner at Slow Ventures, emphasized the importance of a decentralized form of credit assessment. she written down in a 2018 article that “Solutions to decentralized credit scoring could therefore be extrapolated to larger identity systems that do not rely on a single central authority,” further explaining that the problems arising from a centralized credit Scoring concept revealed “more were heartfelt in the last year than ever before,” citing the 2017 Equifax hack.
In 2017, ratings giant Equifax had a security breach caused by four Chinese hackers compromised the data of 143 million Americans.
Antonio Trenchev, a former member of the Bulgarian National Assembly and co-founder of blockchain lending platform Nexo, told Cointelegraph that credit ratings, particularly those prepared by central authorities, are problematic rather than solution-based.
Trenchev boasted how his platform managed to foreclose credit via their Instant Crypto Credit Lines and Nexo Card.
“In this utopian credit landscape that we hope to create, credit scores will be a rarity, and when used, they will be decentralized and fair.”
Grow into a reality
Two years ago, blockchain lending protocol Teller raised $1 million in a seed funding round led by venture capital firm Framework Ventures to bring traditional credit ratings to DeFi.
Although it was the first of its kind in the decentralized world, credit scores are expected to help with the over-collateralization problem that has plagued DeFi lending while ensuring that eligible borrowers get what they deserve.
In November last year, the Credit DeFi Alliance (CreDA) became official started a credit scoring service that determines a user’s creditworthiness using data from multiple blockchains.
CreDA is designed to work with the CreDA Oracle by using an AI to evaluate records of past transactions made by the user across multiple blockchains.
When this data is analyzed, it is minted into a non-fungible token (NFT) called a credit NFT (cNFT). This cNFT is then used to score incentives or rates inherent in the user’s data when the user wants to borrow from a DeFi protocol.
Additionally, CreDA was designed to work across various blockchains including Polkadot, Binance Smart Chain, Elastos Sidechain, Polygon, Arbitrum and more, although it is built on top of Ethereum-2.0.
Recently, the P2P lending protocol RociFi Labs closed raised $2.7 million in seed funding in partnership with asset management firm GoldenTree, investment firm Skynet Trading, Arrington Capital, XRP Capital, Nexo and LD Capital. This is geared towards expanding on-chain credit ratings for decentralized finance.
Furthermore, RociFi works by using on-chain data and AI in addition to ID data from decentralized platforms to determine a user’s rating. The credit rating, like CreDA’s approach, is converted to an NFT called an Unreasonable Credit Score, which can range from 1 to 10. A higher rating means a lower credit rating.
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A wealth of benefits
Assessing a borrower’s creditworthiness can have a profound impact on their life. The need for fair and unbiased judgments in this regard cannot be overstated.
Nonetheless, traditional credit rating bureaus have in many cases misjudged borrowers’ creditworthiness, either through inefficiency or outright bias.
The decentralized credit rating brings fairness to the table. Borrowers are assured of being accurately rated as these ratings are performed by AI on blockchains without the control of any central authority.
Furthermore, with decentralized credit scoring, consumers’ on-chain data is not collected and stored in a centralized ledger, but is scattered across a blockchain managed by a P2P system. This makes it very difficult for hackers to steal user data, as was the case with the 2017 Equifax hack.
From DeFi to decentralized credit scoring, the blockchain industry has brought security and efficiency to the world of finance. Although decentralized credit scoring is still in its early stages, despite the progress already made, there is no doubt that it will evolve into an even better scoring tool in the future.