Decentralized credit scores: How can blockchain tech change ratings

The concept of lending and borrowing is as old as time itself. Regarding finances, while some individuals have more than enough for themselves, others barely have enough to get by. As long as there is this imbalance in finance distribution, there will always be a need to borrow and a desire to lend.

Lending involves giving out a resource on credit with the condition of it being returned upon an agreed period of time. In this case, such resources would be money or any financial asset.

The lender could be an individual, a financial institution, a firm or even a country. Whichever the case may be, the lender, oftentimes, needs a sort of assurance that their resources would be returned to them upon the agreed time.

Certain criteria qualify a borrower to take a loan. Among these are the borrower’s debt-to-income (DTI) ratio which measures the amount of money from their income committed to handling monthly debt service, stable employment, the value of the collateral and actual income.

Credit rating plays a crucial role in lending

Generally, most financial institutions and firms rely more heavily on the credit score of the borrower than the aforementioned criteria.

Consequently, credit scores are by far the biggest factor in determining whether a loan should be granted to a borrower. In a world of financial imbalance where loans are quickly becoming necessary, particularly due to recent economic hardships, individuals, establishments and even governments are expected to keep their credit ratings as favorable as possible.

These ratings or scores can be assigned to individuals, firms or governments that wish to take a loan in the bid to settle a deficit. Defaulting in the payment of the loan at the agreed time generally has an adverse impact on the borrower’s credit rating, making it difficult for them to obtain another loan in the future.

In the case of governments, they are likely to face a sovereign credit risk which is the potential of a government to default on the repayment of a loan taken. According to data from Wikipedia, Singapore, Norway, Switzerland and Denmark respectively rank first to fourth among the least risky countries to lend to.

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Traditional credit rating is barely perfect

As simple as it sounds, the concept of credit rating is far from perfect due in large part to its centralized nature.

Credit ratings are carried out by establishments commonly referred to as credit bureaus. The credit rating of individuals can be carried out by agencies including Transunion, Experian and Equifax. Companies and governments are likely to be assessed by firms such as Moody’s and S&P Global, to name a few.

While credit bureaus make every effort to assess borrowers’ creditworthiness as transparently as possible, there have been numerous cases of inadequate assessments due to issues such as concealment of material information, static study, misrepresentation and human bias.

In a recent article, Dimitar Rafailov, Bulgarian associate professor at the University of Economics Varna, stressed the importance of an adequate and transparent credit rating.

However, Rafailov noted that credit bureaus perceived inadequacies in these ratings and such failings have “strengthened the negative effects of the global financial crisis, generating additional systematic risks.” He pointed out that the errors plaguing traditional credit rating as made by credit bureaus are often caused by “business models, conflicts of interest and absent or ineffective regulation of their activities.”

The patent need for decentralization

The advent of blockchain technology revolutionized a lot of sectors, especially the financial sector. Decentralized finance (DeFi), as a product of the burgeoning technology, has revealed the possibility of running financial services with a peer-to-peer (P2P) system, eliminating the idea of an intermediary or central authority.

Decentralized credit…