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Background & Opportunity
Reputation-based credit is a foundational element of mature and efficient capital markets. A lender’s effective and efficient evaluation of a counter-party’s credit risk, and the subsequent pricing of their overall cost of capital, is the core mechanism at the heart of global credit markets. Trillions of dollars of debt is issued, priced, and repriced daily as the global credit market interprets a constant flow of new and historical data that forms a counter-party’s reputation.
Despite the important role that reputation plays in mature financial markets, DeFi lending has historically relied on indiscriminate mechanisms of risk management, where all borrowers are treated equally, and given the same terms regardless of the real or historical credit risk they represent. DeFi market participants are largely unidentified, and lenders have no clear legal recourse against defaulting parties. The lack of an identity and reputation layer in the DeFi stack has forced the first generation of crypto credit markets to depend on highly inefficient collateral mechanisms to ensure credit markets remain solvent. These mechanisms require substantial capital buffers due to the high volatility of collateral assets. Market participants gain no advantage over time for being a creditworthy borrower, and are subject to the same onerous collateral requirements and interest rates as those participants with a poor or inexistent track record.
Building accurate and efficient reputation-based credit markets would represent a step-change innovation for the DeFi lending industry, unlocking immense efficiencies.
- It would offer material improvements in the cost of capital for the majority of borrowers who demonstrate effective risk management behaviors.
- It would allow the most sound and creditworthy borrowers to increase their capital efficiency over and above that of other participants, providing a significant competitive advantage.
- It would allow lenders to supply liquidity preferentially based on the credit risk of individual borrowers, leading to the formation of a credit spread between different risk profiles.
The development of an effective reputation layer supporting DeFi credit represents the next major frontier for crypto finance.