DeFi and the 3 Cs


Imagine thinking that no collecting sensitive data is basically bad.

That entity seemed to be the subtitle of two memorable lines on the front page of last Sunday New York Times story on the regulatory repression against cryptocurrency lending.

In a passage explaining decentralized financial platforms (DeFi), the authors note, with vague disapproval, that “the websites don’t even collect users’ personal information.”

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The blow is reinforced a few paragraphs later, discussing the Compound Lending Protocol, complete with air quotes.

“Each of the nearly 300,000“ customers ”is represented by a unique 42-character list of letters and numbers,” the authors write, alluding in Gray Lady style to a user’s wallet address. “But Compound doesn’t know their names or even what country they’re from.”

Four years after the break-up of the credit reporting agency Equifax, which disclosed the personal information of 147 million people, would it kill the Times to at least consider the advantage of not keeping such records?

“On the normal website you can’t buy a blender without giving the website owner enough data to learn your whole life history. In DeFi, you can borrow money without anyone even asking for your name, ”Brady Dale wrote on CoinDesk last year.

Of course it’s a catch, as he quickly added: “DeFi apps don’t bother to trust you, because they have the guarantees you reserved to pay off your debt (on Compound, for example, a $ 10 debt will need about $ 20 in collateral).”

This only side-based approach to lending done so far in DeFi has disadvantages for the borrower and lender. A challenge for the industry is to push the boundaries of the current model without sacrificing the privacy-preserving innovation that the Times implied was some kind of outrage.

To understand those boundaries, we need to get around the swollen, suffocating world of traditional finance.

The Cs of credit

There is a reason that banks are asking mortgage applicants to pay stumps and bank statements, and there is no twisted desire to get borrowers to reveal their innermost secrets.

“The foundation for determining the credit quality of secured consumer loans like mortgages … has been well established through the years of the three C-insurances,” Clifford Rossi, a business professor at the University of Maryland, said in an email to CoinDesk.

In Rossi’s formula, the Cs mean “Credibility or payability, Ability to repay the duty and Side (equity interest).” Other versions of this old banker’s statement also include a fourth C, for Capital (savings), and sometimes a fifth, for Conditions (reasons for taking out the loan).

“Trust in any of the Cs could miss other important aspects of the borrower’s risk profile that could ultimately cause greater or lesser collective risk to the holder of that risk,” said Rossi, a former bank manager and regulator. .

For example, if Bob put 20% on his home and Alice puts only 10% on his, just on the basis of that factor you would assume that Bob’s is the safer loan. He has more skin in the game and thus a stronger incentive to pay more.

If times get tough, Bob more often eats beans instead of steak to keep his family at home, while Alice is more likely to send the lender the house keys and skip town – everything else.

But suppose Bob’s credit score (usually calculated by programs of a company called FICO) is 640, just above the threshold to be considered substandard and a full 100 points less than Alice’s. Suppose further that Bob’s debts eat up 40% of his income, while Alice’s debt-to-income ratio (DTI) is only half of that.

“While deep [housing] a market downturn (e.g. as of 2008) both borrowers could naturally encourage by default to look at their equity interest alone, the second borrower is less likely to default due to their higher FICO and lower DTI, ”said Rossi.

“The thing is, secure lending is not one-dimensional and [lenders] should consider offsets between the 3Cs in a multi-faceted manner, “he said.” They could in some circumstances under- or over-price the risk if they only use one factor. “

The result for DeFi is that if lenders could rely on more than just collateral, they could make more informed credit decisions, and thus charge lower rates to borrowers.

A way forward?

It is multiple efforts on foot to allow multidimensional, judicious DeFi lending. One of the most promising comes from Aave, the largest DeFi project, with $ 15.7 billion in total value locked in (TVL), which means tied into its smart contracts.

Last year, Aave introduced a credit delegation that allows users who deposit guarantees in the system to basically rent out their credit lines to someone they trust. The depositor earns an extra return, and the borrower receives an unsecured loan.

In presentation this summer, Stani Kulechov, founder and CEO of Aave, outlined a future where a credited delegate would allow people to borrow against their good names – not their government names, necessarily, but their Ethereum Name Service (ENS) domain names.

These are designed to be used as cryptocurrency wallet addresses, instead of the usual number of letters so appalling for the Times, and as usernames across various websites and programs. The ENS name of Ethereum creator Vitalik Buterin, for example, is Vitalik.eth.

In one scenario envisaged by Kulechov, Aave depositors could delegate their lines of credit to a decentralized autonomous organization (DAO), an entity without central administrators. The owners of DAO would vote to delegate that lending power in turn to ENS domains that requested it.

“This is the future of DeFi,” Kulechov said. “If we make this work [at] scale … we have a lot of ability to empower communities in real life and basically put more DeFi liquids into traditional finance. “

Stani Kulechov, founder of Aave, at Consensus 2019 (CoinDesk archive)

But how would these contracts be fulfilled? If the borrower defaulted, the lender would not need to sue them, as the borrower’s chain reputation would be on the line, Kulechov argued.

“I think we should always abandon the idea that if there is no collateral or if there is no capacity to make legal recourse, you cannot have the relationship and the borrower will escape,” he said.

Rather, the transparency of the blockchain would make it clear to everyone that ENS names were worthless, giving borrowers an incentive to repay their loans so that they would not end up on further lending. “I myself will not fulfill my own ENS name because it will look bad,” Kulechov said. “Due to the nature of the blockchain … you kind of don’t want to have such an event stored there.”

In this model, the borrower’s repayment history – information traditionally stored in files at lenders, viewable by banks for a fee – would be there for all to see. But a check on the identity of the borrower, the ENS domain name, would remain with the borrower – at least, provided they master the keys to their cryptocurrency.

That’s a big warning, given the terrible stories about crypto users losing their private keys. However, compare this arrangement with the status quo, where the keys to your identity – your Social Security number, home address, date of birth – are entrusted to the obviously porous Equifaxes of the world.

Which system would you prefer?



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