Introduction
One of the main functions of any financial system is to provide borrowing and lending for its participants. Those who don’t need money currently lend funds for those who need them at the moment. Borrowing and lending are old economic activities, so old that they date back to ancient societies.
The modern way of lending and borrowing is called credit and it is of vital importance to our economy because it allows businesses to leverage their own capital. But since the lender bears the risk of borrower’s default, for taking out a loan the borrower should provide something of value which is called collateral. In case of mortgage lending, it is a property; in most other forms of lending, it is typically money.
If you want to buy a house, you pay, say, 30% down payment for the value of the property and borrow the rest from the bank. Thus, the bank creates credit which is the difference between the market value of your property and down payment. A credit card is an instance of credit creation where the collateral is the creditworthiness of the borrower.
DeFi lending
Decentralized finance (DeFi), a new paradigm in the financial system, also makes it possible for its users to lend and to borrow. But most DeFi lending at the moment is overcollateralized. That is the borrower has to provide collateral which is more valuable than the loan amount. Current DeFi lending protocols work like this: you want to take $1,000 loan, fine. Put down $1,500 into the protocol.
This makes sense because in DeFi, unlike in TradFi where commercial banks have a lot of data about you and thus can rely on your creditworthiness, lenders and borrowers don’t know each other. When someone borrows from the lending protocol, you don’t know her credit history. Overcollateralization ensures that if the borrower defaults on her loan, the collateral will be sold to give lenders’ money back.
However, as may realize, overcollateralized lending is capital inefficient. Why put down collateral worth $10,000 to take out $5,000 loan? So, to make undercollateralized loans possible is one of holy grails of DeFi. Undercollateralized loans would be the best of two worlds for borrowers – not depending on an intermediary who decides whether the borrower can take out a loan, and capital efficiency. In DeFi, users don’t depend on a central entity; anyone can borrow from the protocol if she puts down sufficient collateral. Thus, making undercollateralized lending a reality will unlock more economic value for the whole ecosystem which is essential for the mass adoption of DeFi.
DECO protocol
One of the challenges for undercollateralized lending is that these loans are riskier for lenders than their overcollateralized counterparts because in case of the borrower’s default the collateral value will not be sufficient to cover the loss. This implies that the lender has to have more information about the borrower to decide whether she has the ability and willingness to pay the loan back. This is what is called the borrower’s creditworthiness in traditional finance, and typically includes relevant data such as her credit history, and payment history.
These data are stored off-chain, in databases which decentralized applications don’t have access to. Enter decentralized oracles (e.g., Chainlink), and one might assume that the problem has been solved. Well, almost. The problem with the oracle networks is that when they fetch off-chain data onto the blockchain the data becomes public. This means that the borrower’s creditworthiness data will be visible to everyone. So, how to break out of this conundrum?
Enter DECO protocol. DECO is an oracle technology that preserves privacy of an individual. Using zero-knowledge proofs, DECO allows users to verify the veracity of claims about themselves without disclosing all the personal data. What this means is that the user can keep private information, such as her full name and financial status, while proving some claims about herself. The main thing in my view is that this is possible to do with only proving that your data point exceeds some predefined threshold without publishing the data on the blockchain. For example, if you want to prove the claim that your credit score is higher than the threshold set by a credit bureau you can do so without disclosing your actual credit score. So, not only you prove your creditworthiness with the minimal possible information about yourselves, but you can also verify the claim that the source of your data is official and authoritative.
