Anyone Can Start a Hedge Fund: How On-Chain Credit Changes the Crypto Economy

There is one thing you can’t do with lending in decentralized finance (DeFi). You can’t borrow more than you can stake. With a few minor and heavily asterisked exceptions, there are no on-chain credit cards, no mortgages, no unsecured loans and no commercial paper in crypto.

James McGirk is a senior writer at Spectral Finance and the co-founder of Lonely ROCKS. This article is part of CoinDesk's Trading Week.

Decentralized finance uses blockchain technologies and smart contracts to gradually replace traditional finance functions. Think of it as a stack of financial pancakes.

Bitcoin created a store of value and a peer-to-peer network capable of shuffling billions of dollars worth of value between accounts in a few minutes. That's the bottom layer. Then there are smart contracts, built on blockchains like Ethereum and Solana, that automate other financial activities.

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Liquidity pools replace money market accounts, supplying coins and tokens for a smooth financial flow between distributed agents.

Piled on top of those are DeFi lenders. Aave and Compound lend and borrow crypto. Their loans are as composable as anything software related. Companies like Alchemy.fi allow you to craft debt derivatives of mind-boggling complexity. You can even borrow hundreds of millions and pay it back within a single transaction to create arbitrage opportunities. Careful with that last one.

The next cake on the griddle will be creditworthiness assessment, i.e., what Ethereum co-creator Vitalik Buterin and company are calling Web3’s “reputation layer,” the infrastructure to bring trust into a trustless environment.

A number of companies, including my employer, Spectral Finance, are cooking up a solution: a credit score based on publicly available blockchain transaction data.

On-chain credit scores would allow lenders to offer different tranches of interest. If you’re a risk-sensitive trader and able to prove it with an excellent on-chain credit score, you’d be able to borrow from a DeFi lender without paying as much interest as your peers.

Eventually, as undercollateralized loans come online, you would be able to borrow and trade from decentralized exchanges (DEX) and lenders without staking your own funds. Better yet, you’d be able to generate credit scores representing entire communities, letting you build a hedge fund with your buddies or borrow funds to build a block of apartments. Or you could always rent your score out.

Building economies

As unsavory as debt can occasionally be for a consumer, it accounts for a huge portion of the real economy. Lending allows people without substantial savings to participate in the real estate market. It allows consumers to buy and use household appliances, cars or go to school. Manufacturing relies on credit to secure raw materials, governments issue bonds to fund projects, small businesses use it to buy inventory.

On a macro level, lending allows capital efficiency. It's like a liquidity pool, allowing different sectors of the economy to keep spinning at maximum efficiency.

TradFi has amassed huge databases of consumer activity and created sophisticated algorithms to sift through this information going back decades to model and assess customer risk.

DeFi uses trustless transactions on the blockchain. Trades between pseudonymous agents using DeFi applications are difficult to track, and that makes risk assessment and asset recovery nearly impossible for on-chain debt markets.

DeFi lenders ignored the problem in the initial rush of DeFi summer, when on-chain lenders didn’t need to worry about capital efficiency. But to continue growing and capturing evermore market share from traditional lenders, DeFi lenders need to accurately price interest according to risk, and eventually offer undercollateralized loans.

One solution would be bringing FICO scores on-chain, using a kind of credit oracle. But connecting off-chain identities to on-chain ones could create a surveillance nightmare. As an aside, this is another reason why central bank digital currencies (CBDC) aren't a fabulous direction for us to collectively turn.

DeFi data

DeFi has a chance to refashion the world's credit assessment infrastructure. The current one is a black box run by a handful of companies or government agencies (depending on which country you live in).

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Historically, entire demographic categories have been excluded from credit. Data capture is dominated by a few companies and is always on by default, so there’s no way to opt out, and correcting errors can be arbitrary and time-consuming, as anyone who's ever dealt with a credit report error can attest.

Ethereum transactions are publicly available. With five years of DeFi transactions to review, there’s just enough data available for sophisticated machine-learning models to make predictions.

Ideally, those models would be decentralized and transparent to the public. Consumers should be able to opt in and create a credit score on demand. With privacy-preserving technologies like Zero-Knowledge proofs, a lender should receive no more information about a borrower than their risk of default, no matter who they are.