How credit based DeFi Applications work?

[ppopdesk]

Hi everyone,

I have recently been interested about cryptocurrencies and its applications and started reading about DeFi today. In order to establish a credit type system without a centralized authority, we need to ensure that the person who is borrowing crypto from a particular lender (both of whose real world identity is unknown), honestly provides money back with the interest rate. In a centralized system this is ensured through collateral and if the person doesn't repay the loan he is punished by the existing centralized financial and legal institutions. I was wondering how this system is implemented in the case of DeFi as when basing the DeFi application over a cryptocurrency protocol, the protocol only ensures whether the lender to borrower transaction is valid and verifies it but doesn't tell anything about whether the borrower will pay back or not. How are we ensuring that the borrower does indeed pay back?

[Hydrogen]

when basing the DeFi application over a cryptocurrency protocol, the protocol only ensures whether the lender to borrower transaction is valid and verifies it but doesn't tell anything about whether the borrower will pay back or not. How are we ensuring that the borrower does indeed pay back?

Existing loan services share data with financial networks (credit chex) to compile a credit score representing loan risk for individuals. This credit score number determines the interest rate and terms of the loan.

Financial institutions that offer loans partner with various firms and bureaucracy to execute loan default events like car repossession or debt collection.

In some cases, they can go so far as to garnish wages. Which means a certain amount is deducted from your paycheck to help payoff your loan or outstanding debt.

I would guess with the blueprint already being known and followed globally. DeFi crypto would merely following in the footsteps of other financial networks, rather than try to reinvent the wheel. As some crypto loan agencies have done with (mostly) a lack of success.

In extreme cases, prison sentences can sometimes be incurred for lack of debt payment. Historically they are known as "debtors prisons". There was some controversy over the practice years ago around the time of the 2008 economic crisis. But to be honest, I have not heard anything at all about it in quite some time.

[vv181]

The collateral mechanism is also applied in DeFi. There is a thing called Loan to Value (LTV) where a borrower is only able to borrow some percentage amount of their collateral. If some asset prices fall and the loan value gets below the LTV threshold, it gets liquidated and there is a penalty being charged. So within Defi, collateral is a prerequisite and that is one of the ways that ensure the loan mechanism works.

You can see more information regarding it at https://docs.aave.com/risk/asset-risk/risk-parameters, and also at https://docs.aave.com/risk/liquidity-risk/introduction.

[zasad@]

Hi everyone,

I have recently been interested about cryptocurrencies and its applications and started reading about DeFi today. In order to establish a credit type system without a centralized authority, we need to ensure that the person who is borrowing crypto from a particular lender (both of whose real world identity is unknown), honestly provides money back with the interest rate. In a centralized system this is ensured through collateral and if the person doesn't repay the loan he is punished by the existing centralized financial and legal institutions. I was wondering how this system is implemented in the case of DeFi as when basing the DeFi application over a cryptocurrency protocol, the protocol only ensures whether the lender to borrower transaction is valid and verifies it but doesn't tell anything about whether the borrower will pay back or not. How are we ensuring that the borrower does indeed pay back?

In the DeFi ecosystem, you don't have to worry about who your client will return the money received. Collateral rating is usually from 130 to 150%, which means that if you want to get $1,000 in stablecoins, then you need to lock Ethereum for $1,300 in a smart contract. If the price of your collateral drops to critical values, closer to $1,000, then the smart contract will sell your collateral and the contract will be terminated.

[ppopdesk]

Collateral rating is usually from 130 to 150%, which means that if you want to get $1,000 in stablecoins, then you need to lock Ethereum for $1,300 in a smart contract.

But usually loans are usually for borrowing one type of asset, keeping another type of asset for collateral right? If one wants to do this, the given suggestion is not viable right?

[ppopdesk]

Existing loan services share data with financial networks (credit chex) to compile a credit score representing loan risk for individuals. This credit score number determines the interest rate and terms of the loan.

So can this loan system work only if the person's identity and hence background is known?

Financial institutions that offer loans partner with various firms and bureaucracy to execute loan default events like car repossession or debt collection.

In some cases, they can go so far as to garnish wages. Which means a certain amount is deducted from your paycheck to help payoff your loan or outstanding debt.

Also there isn't any outstanding authority for cryptocurrency transactions right as most governments don't really recognise it officially. So are these methods implemented?

[The Sceptical Chymist]

In extreme cases, prison sentences can sometimes be incurred for lack of debt payment. Historically they are known as "debtors prisons".

Debtors' prisons haven't been legal in a long, long time (at least in the US) as far as I know.  I'm too tired to look it up or even read further to see if anyone addressed that, but if Hollywood movies are any way to gauge real life (lol), they went out of style during the Wild West days.

I would guess with the blueprint already being known and followed globally. DeFi crypto would merely following in the footsteps of other financial networks, rather than try to reinvent the wheel. As some crypto loan agencies have done with (mostly) a lack of success.

That makes complete sense....but if that's true, what makes DeFi lending any kind of financial breakthrough?  I mean, there's been a P2P lending section on this forum for years, so that little experiment has proven beyond a doubt that collateral is essential for any loan between strangers (unless the lender enjoys losing money).

I see no way whatsoever for any crypto wizards, no matter how brilliant they are, to get around the fact that borrowers of crypto will scam if given the slightest opportunity to.  And if they report scammers to banks, credit rating agencies, or law enforcement, why even bother?

[ppopdesk]

That makes complete sense....but if that's true, what makes DeFi lending any kind of financial breakthrough?

Im guessing that using DeFi will have lessened interest rates as there is only on two people to benefit here (The lender through the loan interest and the borrow through actually borrowing the money) and not the bank which would've taken up a share for itself for acting middleman

[Dr.Bitcoin_Strange]

I was wondering how this system is implemented in the case of DeFi as when basing the DeFi application over a cryptocurrency protocol, the protocol only ensures whether the lender to borrower transaction is valid and verifies it but doesn't tell anything about whether the borrower will pay back or not.

When taking a loan from the centralized authorities like the bank, we are required to have some physical collateral like land and property. Again, an agreement is presented before you, so you should sign it in case your loan date is past due and you are not able to repay it. You either have to reinstate the loan for another period of time or your collateral will be taken if you are unable to repay the loan. So, in terms of Defi, the last time I took a $500 crypto loan (I can't remember correctly), I deposited $700 in Bitcoin as collateral, and before the loan request was verified, I had to agree to a term/policy that "if Bitcoin price falls below $25,000, my collateral will be sold to cover my loan and the interest." (Then Bitcoin's price was still about $48k+).

 

How are we ensuring that the borrower does indeed pay back?

Every loan (centralized or decentralized) has a collateral component, and the collateral will either compel the borrower to repay the loan or lose their collateral. A loan that doesn't only have atarched collateral is a case of P2P if perhaps the borrower and the lender have a mutual relationship.

[ppopdesk]

I deposited $700 in Bitcoin as collateral, and before the loan request was verified, I had to agree to a term/policy that "if Bitcoin price falls below $25,000, my collateral will be sold to cover my loan and the interest." (Then Bitcoin's price was still about $48k+).

But usually loans are usually for borrowing one type of asset, keeping another type of asset for collateral right? If one wants to do this, the given suggestion is not viable right?

[hugeblack]

Im guessing that using DeFi will have lessened interest rates as there is only on two people to benefit here (The lender through the loan interest and the borrow through actually borrowing the money) and not the bank which would've taken up a share for itself for acting middleman

The problem does not lie in the fees of the bank, which is the third party, but in the currency that was borrowed, which the smart contract will implement once the price reaches a certain limit (that limit is mostly in stablecoins, which poses another risk)
So, the problems in this area are related to the risk, which is greatly magnified.


In short, you are the weakest party, and in all cases, whoever manages the smart contract is a beneficiary.

[Hydrogen]

Debtors' prisons haven't been legal in a long, long time (at least in the US) as far as I know.  I'm too tired to look it up or even read further to see if anyone addressed that, but if Hollywood movies are any way to gauge real life (lol), they went out of style during the Wild West days.

Men who can't make child support and alimony payments sometimes end up in jail.

That could be one example of debtor's prisons being alive and well in the modern era.

I think most prefer garnishing wages as a better method of debt repayment.

That makes complete sense....but if that's true, what makes DeFi lending any kind of financial breakthrough?  I mean, there's been a P2P lending section on this forum for years, so that little experiment has proven beyond a doubt that collateral is essential for any loan between strangers (unless the lender enjoys losing money).

I see no way whatsoever for any crypto wizards, no matter how brilliant they are, to get around the fact that borrowers of crypto will scam if given the slightest opportunity to.  And if they report scammers to banks, credit rating agencies, or law enforcement, why even bother?

The significance of Defi loans was them partnering with or establishing comprehensive credit chex networks similar to ones used by banking institutions. Something which had never been done before in crypto.

Home and car loan markets were markets that crypto had never been able to penetrate due to lack of infrastructure support. It appears that could change in years to come as crypto credit chex limits the capacity of scammers and begins to rollout more reliable services.

[zasad@]

Collateral rating is usually from 130 to 150%, which means that if you want to get $1,000 in stablecoins, then you need to lock Ethereum for $1,300 in a smart contract.

But usually loans are usually for borrowing one type of asset, keeping another type of asset for collateral right? If one wants to do this, the given suggestion is not viable right?

In a cryptocurrency decentralized system, there are no loans without collateral. Otherwise, creditors would go bankrupt.
If you ask why is this necessary?
This is handy for many hodlers because you can get stablecoins for your needs by leaving bitcoin or ethereum as collateral.