The maturation of the DeFi credit market is a momentous next step in the evolution of the crypto ecosystem. With this inspiration in mind, Decent is diligently incubating the idea of a safer, on-chain consumer credit solution. Our research has revealed the potential for a fixed-rate retail credit solution, de-risked by a suite of configurable risk reduction attestations and made liquid by a secondary marketplace.
Below is a research summary of today’s credit markets, what we uncovered, and our biggest takeaways.
The Problem with Credit
Lending at face value is not inherently problematic. It represents the relationship between someone who wants capital but does not have it and someone who has capital but does not want to spend it. However, the current credit system commodifies the borrower, and credit allocation decision-making is not transparent and is subject to bias.
Product Context
Whether it’s asset-backed lending, undercollateralized lending, credit card programs, corporate or government bonds, business credit, or anything in between, a majority of today’s underlying financial tooling boils down to a form of credit with lender-defined parameters for the borrower. The capital allocator designs these parameters to balance risk mitigation and borrow demand, with the interest rate indicating where the supply and demand curves cross.
Lenders allocate capital if they are comfortable with the risks associated, and borrowers borrow if the terms match their requirements.
In crypto, most credit markets are built with a collateral requirement as the means of risk mitigation. This is likely due to the lack of off-chain accountability if a borrow goes unpaid. Crypto ethos has long been “trustless”—if you can't trust a person to repay, you need to keep something of theirs that you can sell as a precaution.
While the collateralized lending environment has struck product market fit for this phase of crypto evolution, we see the trend starting to shift. After all, uncollateralized or real-world, asset-backed financial markets are bigger.
For example, protocols like Goldfinch, Maple, and TrueFi have included identity and off-chain agreements to enable a non-collateralized lending solution while using the blockchain as their core accounting infrastructure and rails.
The role of crypto lenders is to utilize different protocols, agree to their defined risk mitigation strategies, and allocate their capital. Paralleling the broad DeFi theme of “Lego blocks,” lenders today are able to allocate across different lending products—maybe a lender packages a few products into one asset, akin to an ETF. DeFi’s money blocks give that freedom. However, for DeFi credit players to truly define the risk parameters and create the market, they must create their own protocol. Or, if a credit player has a lending product that they’d like to bring to market but can’t be serviced by the existing set of protocols, they have to build—build the contract infrastructure, build the attention and user base, and create the market.
Traditional financial markets follow a slightly different approach. Groups like i2c, Marqeta, and Mambu operate as an abstracted API layer, allowing companies to configure their lending parameters. Then, companies get licensed providers and capital partners to come together to offer a product.
We’re imagining the formation of a similar technology stack on chain. Here’s the kicker: We envision a permissionless formation without needing a centralized entity to supervise users’ data and assets.
Assumptions and Decisions to Make
We assume that on-chain lending markets serve more users more efficiently, empowering borrowers and lenders with a better experience than that of today’s off-chain financial markets. Building this marketplace as a series of primitives should lay the foundation for a highly configurable system. However, to best penetrate the credit ecosystem market share, a solid initial use case must be created to engage the initial set of beachhead adopters.
User Research
Core to our product approach is building in public. We are receiving continuous feedback and are willing to adapt in the early stages of product research. We reached out to potential users to perform customer discovery around the inner workings of the credit framework and how they interact with credit tools.
Customer Discovery Profiles
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Borrowers
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DeFi native
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DeFi savvy
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TradFi experience only
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Debt collectors
- Debt collector senior manager
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Lenders
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Goldfinch user
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DeFi lender
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Credit manager at an institution
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Fixed-income asset purchasers
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DeFi lenders
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Fund managers
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For context, we went into our user interviews with high hopes that the time had come to bring traditional and real-world-backed lending on chain. We felt DeFi’s lack of credit wasn't a question of demand but rather a need to use the new settlement infrastructure that crypto has provided us for more traditional lending forms. We were wrong, however.
What we learned is that DeFi is deemed to be for “degenerates.” The users engaging with lending products are seeking leverage to fund their market speculation. This activity scales up to the funds playing in the ecosystem, too, hinting at why the number of DeFi borrowers is so low—there is effectively no nonspeculatory source(s) of demand that drives users to crypto.
That said, Blocktower is one fund we spoke with that appears to not be using crypto purely for speculation. When we look into the mechanism by which they are interacting with real-world assets, they are effectively operating as an interoperability gateway between on-chain capital (Tinlake, etc.) and off-chain lenders. This implies the “real” arbitrage they are playing is the cost of funding in crypto versus in the “real world.” The demand for capital is still being aggregated by the non crypto entities who then have an off-chain relationship to Blocktower.
The non-speculative lending market happening on chain is quite small as the demand is small. The funds on the supply side are either looking for greater returns by funding the speculation markets or are actually not interacting directly with the users for simplicity and to avoid certain regulatory requirements.
Research Conclusion
The market adopters today are not ready to bring their crypto world and real world into the same place. The current financial market serves their needs—it’s convenient and it’s tried and true. The DeFi ecosystem is their playground. In one of our interviews, someone said, “You have to build tomorrow's product for today’s users. If you build tomorrow's product for tomorrow's users, you might be waiting for them to arrive forever.” This mindset drives our product market fit decision-making.
Current Market
The credit market structure can be broken down into the following categories (with examples):
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Collateralized
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Real-world asset loans
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On-chain credit
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Collateral-free + undercollateralized
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Third-party risk assessment
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Tools
On-chain Analysis
Considering we’re seeking to have off-chain references come on chain, let’s explore several DeFi protocols with an off-chain context and understand their user adoption. We analyzed their key growth rate metrics.
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Goldfinch yields come from real-world lending, and investments are collateralized off-chain, which makes them distinctly different from the highly volatile DeFi lending you may be familiar with.
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TrueFi is the protocol for uncollateralized lending, powered by the first-ever on-chain credit scores and governed by holders of the TRU token.
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On Maple, industry-leading credit experts manage fast-flowing lending businesses where pooled capital is lent to profitable crypto
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Looking into on-chain lending behavior, competitors believe that collateralized on-chain behavior can be used to assess creditworthiness for uncollateralized borrows. However, this limits the users that are able to adopt the lending solution. We produced two dashboards to derive the number of potential users that these other protocols are able to target.
By looking at Compound and AAVE as examples where users with existing DeFi lending exposure might interact, we were able to derive that, while the AUM amassed by these protocols was meaningful, the number of borrowers was quite low, sitting at only 28,271 unique borrowers on AAVE and 41,800 unique borrowers on Compound with an average of 31 borrowers a day. This means that, of the current market participants, the total addressable market would be under 70k users (assuming all addresses correlate to a unique user rather than one user controlling multiple addresses). This gives us further conviction about the importance of having a solution that can be utilized by new entrants into the ecosystem.
Risk Analysis
Regulation
Building a credit protocol presents a number of potential regulatory risks. When building a trust-involved lending environment, it is likely that the identity of the users will have to be verified. Therefore, turning a blind eye to required compliance standards (KYC/OFAC/Sales of securities/investor accreditation) is not a solution. Moreover, the secondary market assets being created and sold are likely to be deemed securities. This further requires segmentation of who is able to interact with what part of the product, akin to the path Goldfinch took.
Competition
We believe competition for this credit solution is traditional financial markets rather than DeFi itself. DeFi has limited itself to trust-minimized, collateral-based lending solutions, or trust-involved B2B lending operations. The credit solution we’re thinking through is a relatively “first of its kind” in the crypto market. However, the functional offering provided does not greatly differ from getting a car loan or personal loan from the traditional markets.
Therefore, these credit market categories and perhaps fintechs are also our competition.
Execution Risk
The execution risks of building a credit system are plentiful. First, it is a marketplace of capital with an additional marketplace for liquidity. For the supply of capital to be worthwhile for the lender, the solution needs sufficient demand from the borrower. In order for the lender to feel comfortable with the “liquidity” of their deposits, the solution needs a sufficiently liquid market for the fixed-income asset derivatives.
Therefore, organizing all parts of the marketplace in advance and rallying them around one instance of the system implementation mitigates execution risk.
Security Risk
Smart contract risk is present across all DeFi protocols. Being on chain, this credit solution is no different. However, with the Risk Reduction Attestations (R-Rats), there is an element of data privacy and security that is customary with TradFi operations but not native to DeFi operations. Having user information disclosed to certain parties under certain conditions gives rise to bad actors attempting to gain access to this information for nondirect monetary value.
Therefore, this solution has information security requirements in addition to smart contract risk requirements.
Credit Scoring
The long-tail value of this protocol culminates in the means of derived risk mitigation. Here, risk mitigation is effectively the “credit score.” Current solutions are under the impression that leveraging past behavior of on-chain protocol interactions is sufficient in assessing the riskiness of the borrower. We believe this impression has two overarching false assumptions. First, it assumes that the behavior of risk-insulated protocol interactions (borrowing against collateral) is reflective of future behavior on risk-mitigated protocol interactions (undercollateralized). Also, it assumes that there is enough borrower demand from users that are already DeFi-native.
A major theme for why we are pursuing a credit solution is its potential to bring new people into crypto. We want to show the magic of this infrastructure to people who may not yet have interacted with anything other than an exchange. We are operating on different assumptions compared to others pursuing this protocol vertical.
An early-stage protocol’s credit score is not something that can be defined today. Fintechs have tried and failed for years to derive their own “proprietary” credit scoring. When credit solutions say “trust our model” but don’t put their money where their models are, lenders should be skeptical. Instead, we see value in R-Rats. This empowers the lender to define the risk parameters that they’re willing to lend against.
For example, if a Canadian-based lending fund only wants to lend to Canadians that have made on-time rental payments for their apartment for the last 1.5+ years and earned a salary exceeding 80k a year, they should be able to define those parameters, and then users must attest the necessary information to be approved.
This information, as well as the payment behavior between the borrower and the lender, serve as attributes that build the user's credibility in the system over time and may become the basis for a score.
Credit Consequences
Credit without consequence is subject to manipulation and loss of value. Consequences are essential for a functional lending ecosystem.
Traditional, undercollateralized lending markets tend to leverage FICO scores, debt collectors, and cosigners as their source of consequence. An on-chain solution does not need a redefined system. We’re fixing the engine—the wheels and chassis aren’t a problem. Debt collectors are a required user category in the protocol ecosystem. If a user fails to repay, there must be a way to attempt to recover the value.
Research Conclusion
Our world revolves around human-mediated systems of credit that build bias against the borrower. Enabling real-world lending to happen on chain is a viable alternative credit solution that empowers real-world users. DeFi’s proven blockchain and smart contract solutions are a powerful technology pair for instant financial interactions but have largely been in service of a financial market that exists separate from the "real world.” We see a credit market opportunity to be the bridge, leveraging the power and tools of DeFi to inspire new markets to settle on chain. Financial markets depend on credit, credit depends on risk mitigation, and risk mitigation depends on trust. Trustless systems require trust to build over time, and that’s what we intend to do.
Stay tuned for updates on the next steps for our credit protocol’s quest for product market fit. In the meantime, we’ll leave you with this thought: Today’s collateral is generally trusted, but off-chain attestations are not. And we’re going to show you how that can change.
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