Issues with DeFi Lending
Decentralized finance (DeFi) lending applications have taken the cryptocurrency space by storm. They represent over 49% of the total locked value of all DeFi applications. Despite their record growth and success through 2020, they all share a common issue.
Because they are decentralized, autonomous, and permissionless they are unable to collect any information about their users such as their creditworthiness and ability to repay back borrowed capital. As such, borrowers must post substantial collateral in order to borrow funds from these lending platform – sometimes as high as a 2:1 ratio of collateral to borrowed funds. This collateral is locked into a smart contract which can also liquidate it to cover any losses that result from market declines and unreturned capital. However, this makes DeFi borrowing a function of entities that already have substantial capital to start with, greatly limiting its adoption and narrowing the types of entities that benefit from its use.
Currently, only centralized financial institutions like banks are able to provide credit or loan capital to individuals and entities without any up-front collateral. Banks can do this because they collect certain attributes of an individual or entity such as their name, home address, income, history of loan repayments, and outstanding loan balances among other things.
Innovations in Decentralized Identity Management
Today, progress is being made in the decentralized identity space. Some platforms allow individuals to create and maintain digital identity records of themselves on a decentralized protocol. Such platforms can integrate directly with credential issuers to attest to the validity of any identity records issued and maintained, while allowing holders to control the dissemination of this information to specifically permissioned parties. The entire process is cryptographically secured to prevent bad actors from gaining access to this private information, assuring only the intended recipient is in control. Furthermore, individuals can select the specific information they wish to provide, providing as little or as much information as necessary for each use case.
A single self-sovereign identity platform can store a variety of information on an individual, allowing a single source of truth that is infinitely re-usable and scalable. Furthermore, users can update the information in such a decentralized registry by requesting updated identity information from issuing bodies as needed. The entire process can be performed digitally without the need to create, distribute and maintain physical identification assets such as ID cards, or documents.
eRecipients can trust the data because they can verify that it originated by a trusted issuer such as a government body, an industry certification authority, or similar issuing body through the immutable chain-of-custody that blockchains can provide. They can also be assured that although there is no physical interaction with the identity holder, that the information provided was made by that specific individual since only the holder of the private keys would have access to release their identify information.
Solving the Issue of the Unknown Borrower
By leveraging decentralized identity solutions, it is possible for DeFi lenders to obtain the necessary information on their platform users and borrowers to determine creditworthiness and provide a means of collections in the event of default. The implications of this are significant, as it allows a fast-growing industry to provide loans without any collateral posted, matching the lending capabilities of centralized institutions, while providing the benefits and convenience of a fully decentralized and autonomous process.