Credit scores have been a cornerstone of risk evaluation in the global banking systems for decades.
They allow banks to determine who qualifies for a loan, at what interest rate, and what credit limits. Lenders use these scores to evaluate the likelihood that the borrower will fulfill their obligations and repay their loan.
The global lending and payments market reached $6.7 trillion in 2020. It will possibly reach $7.6 trillion in 2021.
If you’ve ever applied for a bank loan, you’ll know that these traditional credit scoring systems and in-depth identity verification processes work together. These include proof of address and a copy of a passport or official identification.
Now, Europe’s Open Banking initiative, PSD2, is set to bring credit scoring into the 21st century. It will make it possible for lenders and borrowers to access a full picture of an individual’s financial history in real-time.
Its introduction into financial services systems will revolutionize the loan process. It will increase speed, accuracy, and more importantly, financial inclusion.
DeFi lending still in its early stages
In comparison to this highly sophisticated system, lending and borrowing in the DeFi industry is still in its nascency.
However, as we know, over the past 12 months it’s grown at an incredible rate. Total Value Locked (TVL) in DeFi as of March 2021 stands at $39.7 billion, according to DeFi Pulse.
What’s more, it is lending that makes up for the largest segment of that market. The DeFi lending market sits at $17.8 billion. Decentralized exchanges follow closely behind at $15.6 billion.
What the DeFi industry has been missing is a credit scoring system that provides a full picture of an individual’s varied crypto assets across different wallets and chains.
To increase trust and reputation when it comes to lending and borrowing through DeFi, we need a system that supports cross-chain interaction and verifiable credentials.
By connecting user identities with personal accounts, users can bind their digital assets and contact addresses making it easy for the correct due diligence to take place.
Crypto credit scores will allow lenders to view the borrower’s eligibility. However, they will also help them to avoid over-collateralization when looking to borrow assets. They will have the ability to put their positive credit scores to use and to access more rewarding opportunities.
A picture of assets needed for DeFi and traditional merger
As the DeFi industry progresses to merge with traditional financial systems, there will need to be an evaluation of on-chain and off-chain assets.
To create a trusted merger between these two worlds, a full picture of traditional and digital holdings and history needs to be made available.
This will further bolster the benefits of legislation like Europe’s PSD2. It will provide a more rounded, integrated look at asset holdings and histories, including crypto assets, in real-time.
However, as we’ve seen with any new technology that deals with highly sensitive data, we must be cautious.
Privacy and security must be put first
Any decentralized credit scoring system applied to DeFi lending and borrowing needs to put user privacy and security first. We cannot ask individuals to give up their data sovereignty in exchange for a well-working DeFi lending system.
Decentralized digital identity systems can help immensely here. By coupling decentralized credit scoring with a decentralized digital identity system, no one party will hold full control over an individual’s financial data.
The buck will stop with the individual. The World Economic Forum has been promoting these kinds of digital identity solutions for a long time. In addition, the UK Government endorsed their use universally as the cornerstone of future economies.
If DeFi is serious about going mainstream and further nurturing relationships with institutional players, a reliable means for evaluating risk in a timely, accurate manner while permitting the same level of due diligence is integral.
In addition, for the DeFi industry wants to win the trust of mainstream finance, it’s imperative that it stays humble to its users. It must also avoid the mistakes many disruptors in big tech have made in recent years.