DeFi markets will never be able to reach mainstream utilization without effective credit risk assessment. The case for on-chain credit scoring (with help from a June 2022 report from BIS, DeFi Lending: Intermediation Without Information) Let's dig in.👇 [Comments in brackets]

TL;DR Lending is core part of any financial market; DeFi no exception. Anonymity of borrowers results in overcollateralization, limiting access to asset-rich borrowers. Tokenization of assets and increased info on borrowers (without greater centralization) needed for adoption.

Current Market: DeFi exploded in the last two years, with lending protocols reached a peak TVL of $50B TVL in 2022. Lenders see high interest rates as an attractive alternative to traditional savings accounts or money market funds (ex. @compoundfinance @AaveAave @MakerDAO)

This is why Lending is biggest segment of the DeFi market. Here's a look at the ETH ecosystem as of March, 2022:

Traditional Lending Market To understand the gaps in decentralized lending, let's step back to look at traditional markets, starting with the goal: "The core function of the financial sector is to channel savings towards productive investment opportunities." (BIS, 2022)

[I wrote about DeFi's role compared to TradFi is my last thread. Check it out here: https://twitter.com/wandzilak_drew/status/1557743764059238402?s=20&t=ZqjQZ7vrkS9TtaZ8zx6-Ww]

S&P Global recently published a report on "Exploring Crypto and DeFi Risks in Credit Ratings". It breaks down the credit risks in crypto and examines the exposure of a few rated entities (@compoundfinance, @coinbase, @microstrategy) Let's dig in. 👇 [My comments in brackets]

Here's a simple view of TradFi lending: Savers deposit money to earn interest → banks lend funds to borrowers (firms, households) And when banks lend out money, they screen borrowers to assess creditworthiness.

This is to protect the bank, but on the macro, it ensures capital is efficiently allocated. Credit assessment is crucial to financial markets. Some argue the "major purpose of institutions in the lending sector is to collect, distill, and transmit information"

In DeFi, the lending process acts similarly, just without a centralized bank. Instead, smart contracts act as the guardrails for lenders to interact directly with borrowers. Depositors "stake" their crypto assets in liquidity pools, which earns a rate → borrowers pay a rate.

TradFi: Depositor → bank → borrower DeFi: Depositor (stake) → smart contracts and liquidity pools → borrower

This is great from an efficiency and value perspective. On-chain mechanisms take the place of two of the banks core capabilities (facilitating lending and holding assets). But remember, the major purpose of institutions is information gathering and screening.

Are DeFi market participants less "risky" than traditional markets? [Not likely.] So, why can't these same on-chain mechanisms screen potential borrowers for credit risk? Anonymity. In DeFi, the identity of both borrowers and lenders is hidden behind digital signatures.

Without adequate information on borrowers, most DeFi lending platforms still need to mitigate risk. To date, this has been done mostly by offering overcollaterlized loans. These are needed to reduce the risk faced by lending platforms as they cannot adequately assess borrowers.

So, what does this do? It creates barriers for borrowers that aren't asset-rich (i.e. have enough collateral). The financial mechanisms for Web3, a promise of democratization of traditionally limited financial instruments.

This problem was already solved in traditional finance, again, by allowing for transposable and widely applicable metrics, primarily credit scoring. Where payment risk could be assessed instead of requiring additional collateral.

This is why I'm so excited about the work happening in on-chain credit scoring: @cred_protocol - on-chain credit scoring with a new integration with @getmasafi @SpectralFi - a protocol for programmable creditworthiness with funding from @GeneralCatalyst and @socialcapital

And other credit protocols or under-collateralized mechanisms: @goldfinch_fi - decentralized credit protocol allowing anyone to be a lender @maplefinance - brining capital networks on-chain.

@TrueFiDAO - capital market for crypto-native & real world credit @EasyfiNetwork - L2 lending protocol for digital assets. @useteller - bringing financial marketplaces to DeFi