Huobi Ventures Weekly Insights
Insight provided by Evans Huangfu of Huobi Ventures
On-Chain Credit Scoring
Decentralized Finance has grown tremendously in the past two years and the biggest three lending protocols have accumulated more $20bn TVL. However, compared with the size of the micro-credit-based lending market in web2, DeFi is still in its early stage in credit lending. We believe that credit-based undercollateralized lending will be the growth engine for DeFi in the next bull cycle. Read this article to find out how microcredit works in web3.
Decentralized Lending Protocols have been the core driver of on-chain financial activities since the DeFi Summer back to mid 2020. Currently, top lending protocols such as AAVE, Compound and MakerDAO have accumulated more than $20bn TVL. However, the existing lending market is dominated by an over-collateralized model which is being criticized for low capital efficiency. The potential of on-chain identity-based lending — undercollateralized lending/micro lending/unsecured lending is yet to be fully discovered, and we believe that on-chain credit will free out the capital efficiency and be the core engine for the next step growth of DeFi.
Micro-lending in Web2.0
Credit-based microlending/consumer loan model is well developed in web2.0 space by leveraging centralized identity, finance scene & Machine learning/AI algorithms. Institutions such as banks, consumer finance companies, e-commerce companies, etc. are using credit scorecards to evaluate whether customers are high-quality or not. The advantages of the scorecard: 1) it covers the whole process of credit risk control. 2) it uses scientific evaluation methods to digitize risk patterns, which provides a risk scale and reduces the impact of objective factors. 3) it reduces labor costs and improves risk management efficiency. The size of the credit-based finance market is over $1trillion.
Early Web3.0 players Landscape
There are already several players in unsecured lending in web3.0. TrueFi is one of the earliest teams that provides compliant DeFi lending services to credible institutions without any collateral. It generates a credit score by combining on-chain and off-chain data and reputation and determines the borrowing rate. Another player in this space Goldfinch is trying to create the standard of on-chain credit rating system for institutional borrowers with Unique Identity, which is a non-transferrable NFT representing KYC. Other notable players are Clearpool with dynamic interest rate model and Maple Finance. However, it is hard for the existing solutions to expand to the general micro-lending space.
“SoulBound” for web3.0 Micro Lending
Recently, Vitalik introduced the concept of “SoulBound”, which is a Non-transferrable NFT and the potential solution to on-chain credit profile in his paper — Decentralized Society — Finding Web3’s Soul. SBTs are fundamental for web3.0 identity. For example, once the SBTs are bound to the wallet address, the lending application can analyze the user’s financial credit (whether it is able to repay or the repayment is always on time, etc.) based on the user’s “soul”.
With the usage of SBTs, we can create a similar scorecard for DeFi in Web3.0 with on-chain data. By setting the benchmark for different attributes such as holdings of token, transaction history, blue-chip NFT positions, reputation SBT from other protocols, etc., DeFi protocols can properly evaluate and score the users’ repay ing capability and allow qualified users to borrow without collaterals. Since the on-chain transaction scenes are quite limited, it’s safer to combine both on-chain and off-chain reputations to generate a comprehensive user profile.
By looking at the geographic landscape of crypto owners worldwide, we can easily know that there are approximately 100mn users in SEA, Africa and South America where over 40% of the population do not have a bank account. Crypto wallet will be the first “bank account” for this group of people. With certain SBTs such as KYC tokens and a proper analytical model, DeFi lending protocol can directly effect on-chain credit card services to local users.
To sum up, identity-based on-chain micro lending is a promising direction and has huge potential given the current market size of DeFi lending and potential serviceable market. However, the market is still in its early stage since the on-chain activities are mainly arbitrages and swaps. We have to explore more application scenarios in such as e-commerce, gaming, payment, etc. to enrich the user credit profiles. We believe that microcredit will drive DeFi’s growth as DID/On-chain Credit Scoring becomes more mature.