The Risks and Benefits of On-Chain Credit Protocols

"Unsecured lending" repeats some of issues of undercollateralized lending that blew up some crypto firms, but offers a potential solution.

AccessTimeIconJun 23, 2022 at 6:53 p.m. UTC
Updated May 11, 2023 at 5:33 p.m. UTC
AccessTimeIconJun 23, 2022 at 6:53 p.m. UTCUpdated May 11, 2023 at 5:33 p.m. UTCLayer 2
AccessTimeIconJun 23, 2022 at 6:53 p.m. UTCUpdated May 11, 2023 at 5:33 p.m. UTCLayer 2

There’s something of a truism that the real work of industry gets done during bear markets. In fact, just today a Bank of England deputy governor said that crypto projects that survive this “crypto winter” could become “tomorrow’s Amazons and eBays.”

"A lot of companies went [following the dot-com crash], but the technology didn’t go away,” BoE’s Jon Cunliffe said. Crypto certainly has its believers – even as dollars hemorrhage out of the markets, people are still taking jobs in Web3, announcing protocol redesigns and hiring for the future.

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But if crypto wants to create another Amazon or eBay, it’s going to have to find ways to build products that people want to use. Right now, the industry is incredibly circular – a bit like a bubble. Many popular products were essentially mechanisms to recirculate and relend capital across a range of yield-generating, blockchain-based platforms.

Most, though not all, of the distressed lending platforms and hedge funds today were caught off guard when their undercollateralized bets went into the red as prices dropped. The problem is rooted in unaccountable speculation but also the fact that much of crypto’s activities never left the internet.

Or, as billionaire investor Mark Cuban said, “companies that were sustained by cheap, easy money – but didn’t have valid business prospects – will disappear.”

Crypto, which once thrived at the far end of the risk curve, benefited from the loose monetary policy of the Federal Reserve. Now that interest rates are rising, and a recession looms, it’s likely investors will be wary of crypto’s purely digital thesis playing out.

But, as Cunliff said, crypto still offers a unique opportunity. Open protocols enable open innovation and invention. And it’s likely that crypto will produce something that has purpose beyond speculation. A growing sector of crypto – credit-based, unsecured lending – might offer a safer way to bet by bringing in more of the outside world.

The Defiant, a crypto-focused publication, recently wrote about the nascent field of crypto-native “credit protocols.” These applications “are using new methods to set credit ratings to would-be borrowers in the crypto space and release lending.” Essentially, these protocols offer crypto-based loans if you’re willing to reveal something of your on-chain, or sometimes, real-world identity.

Credit protocols like Centrifuge, Maple Finance and TrueFi also sell themselves by offering “unsecured” lending opportunities. While this might seem to be a repeat of the flagrant lending that blew up Celsius and Babel, for instance, the difference is these tools are attempting to tie their offerings to “off-chain assets.”

In traditional finance, credit scores are used to determine if loans should be issued and at what price to a borrower. The field is dominated by a handful of firms, is consolidating among a few and is known for making catastrophic judgment calls.

“Decentralized credit scores” – for degens and white gloves like Alameda Research alike – take the classically crypto approach of using “algorithms” to determine creditworthiness. In theory, this means unbiased and accountable decisions.

There are various approaches to this problem – perhaps including the “soulbound token” Vitalik Buterin proposed as a way to establish long term reputations on-chain – and if done right could be a way to address the backroom trading and rehypothecation of customer assets that blew up crypto recently.

Some look only at a user’s record of on-chain transactions, while others look off-chain. The problem is multiplied in that many traders and outfits spread their credit history across chains. Some of the most sophisticated options are using artificial intelligence and NFTs to establish a user's identity.

Right now, the safest options in DeFi offer over-collateralized loans. MakerDAO, for instance, issuer of the DAI stablecoin, requires borrowers post more crypto than they take out to account for price risk. Maker is attempting to establish rails to the traditional world of finance, even proposing something like a mortgage so people can invest in the housing market.

Critics say Maker’s approach is “not capital efficient” because the collateral it requires just sits there idling. Leverage brings risk, which “unsecured lenders” are looking to lessen by bringing in know-your-customer requirements and legally binding loan terms. Some, like Teller, look at someone’s credit card payment and banking history.

That said, apart from the growing spate of venture capital financing in unsecured, credit-driven lending protocols, there’s little reason to trust these systems and scores. So do your own research. In an odd twist, one of the principal risks to crypto lenders – regulation – might be the easiest solution to actually establish trustworthy reputations on-chain.

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Daniel Kuhn

Daniel Kuhn is a deputy managing editor for Consensus Magazine. He owns minor amounts of BTC and ETH.