Credit Rating: Enforcing Trust Through Code

Credit Rating: Enforcing Trust Through Code

This blog post serves the purpose of being a short introduction to the content of the actual paper. The actual paper (in PDF format) can be found in the 3six9 Innovatio Documentation.

Find the paper here: Credit Rating: Enforcing Trust Through Code

Purpose of this Paper

The aim of this paper is to provide a market overview of a relatively undiscovered service that could make the ecosystem advance considerably. We hope that this paper can serve developers and investors as an overview of what is working, what has failed to work, and what is in development in the field of credit rating for crypto. We have explored on-chain, off-chain, and other approaches to credit rating done by existing projects.

Every chapter is dedicated to an umbrella of credit rating solutions followed by projects that fall under that category. For example, the first chapter is Third Party Risk Assessment followed by a summary of the approaches deployed by Credora, Cred Protocol, and Teller Finance.

With this approach, we hope that it will be possible for the reader to properly focus on specific solutions considering the opportunities and obstacles they present.

These classifications are of course a simplification. Approaches can implement and even straddle different dynamics across these categories, but this framework provides a useful heuristic for analyzing the vast and varied approaches to the credit rating problem

Short Introduction

A key requirement for undercollateralized lending is credit rating. The reason is very simple: counterparties do not want to lend capital out to individuals who will walk away with the money or to people who have a history of questionable financial behavior. The sole purpose of credit rating and credit rating agencies is to gather enough information to affirm “this user is eligible for this type of loan”. Traditionally, credit rating is based on credit scoring, which estimates the risks of lending using elements of quantitative and qualitative analysis.

In the previous paper, “Undercollateralized Loans”, we outlined the current market landscape regarding this type of service within DeFi. We concluded that without some sort of native form of DeFi credit rating undercollateralized loans are simply not feasible. There needs to be some insurance that the borrower is able to pay back the loan and traditionally that is done through know-your-customer practices (KYC). In DeFi, where pseudo-anonymity and privacy rule, there are certain problems with properly conducting KYC. In this paper, we would like to revisit the problems of credit rating in DeFi and solutions currently on the market.

Let’s first consider how credit rating is done in the traditional world to offer some context and perspective. In the status quo, the credit rating industry is extremely concentrated. Ninety-five percent of all credit rating businesses are conducted by just three companies referred to as “The Big Three”. The two firms Moody’s Investors Service (Moody’s) and Standard & Poor’s (S&P) collectively control over  of the global market and Fitch Ratings (Fitch) controls . The reason for the high concentration of this market is disputed, with some arguing that it has to do with reputation and that these firms are considered authorities in that regard. This has historically represented a high entry barrier for newer firms.

Credit rating is important as it plays a crucial role in the creation of more liquid markets and forms trust between lenders and borrowers. By assessing the risks involved and the creditworthiness of the borrowing party, the credit rating agency functions as an information intermediary that can be trusted by both parties. Usually, a score is assigned based on an analysis of a person’s/entity’s credit and often translated to a FICO standard.

Earlier this year, DeFi protocol Compound was rated by one of “The Big Three”, S&P. The fact that a DeFi protocol was being rated by a major, well-respected financial rating agency, was truly a breakthrough and moment of recognition for DeFi. That being said, the rate Compound received was a B-, traditionally interpreted as “junk” and used for distressed, high-yield debt. This score was justified by the skepticism from the TradFi world towards stablecoins, in particular for their “unpeg risks”, the high-interest rate offered (), and the incompatibility of stablecoins with fiat money...

Finish the report here: Credit Rating: Enforcing Trust Through Code

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🗡 ABOUT 3six9 Cognitio

3six9 Cognitio is the 3six9 Innovatio research and education wing which is currently researching on a variety of topics such as undercollateralized loans, zkKYC, optimized stablecoin designs and much more.

Our team of researchers and content writers work in tandem with 3six9 Core Team. The goal is to have an in-house team to cover all of 3six9 needs with regards to content, impactful research and analysis that we can leverage when building out our products, as well as pushing interesting research papers for our community.

Our goal with 3six9 Cognitio is to also build out a central hub for all things crypto. We aim to build a place where it's easy to learn about the complex crypto space in a digestible way. Onboarding and welcoming new users to the space is important to us. As well as keeping our community up to date with the latest Open Finance related trends and providing you with alpha.

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