AI-Powered Credit Scoring for DeFi Lending

So far, in our series on the convergence of AI and blockchain technology, we have had the opportunity to explore several exciting and groundbreaking use cases of the blend of technologies. Everything from enhancing the risk mitigation mechanics to drastically improving the interoperability of AI protocols across blockchains and what a post-quantum computing AI-enhanced DeFi landscape might look like.

Now it is time to turn our attention to another, albeit less exciting, but no less important use case. The issue of credit scoring within DeFi. While this issue may seem on the surface about as interesting as watching paint dry, there are actually some really interesting dynamics that begin to take shape when credit scoring is placed on DeFi protocols with enhanced AI learning models.

For this article entry, we will begin by addressing how the traditional credit scoring industry operates and how having good versus bad credit can significantly impact the most important areas of your life. We will then explore how blockchain and AI protocols can improve the traditional model before diving into how the blockchain Teller protocol is leading the charge. Let’s dig in.

The Fundamentals of Credit Scores 

No doubt you are already acutely aware of what a credit score is and the role it plays in your everyday life. Everything from your mortgage and car loans to accessing higher lines of credit and better insurance rates. Yet, if they are being completely honest, most people are unaware of how their mystical credit score is determined and how they become more or less credit-worthy. 

Determining Factors

It ultimately comes down to several factors from your finances and what the likelihood is that you will be able to eventually pay off, or at least make regular minimum payments on the credit that is issued to you. The score is typically made up of the length of your payment history, the regularity, and consistency of payments made, as well as the proximity to your credit limit, the types of credit you take on, and how frequently you add new credit to your life.

Unsurprisingly, lenders prefer trustworthy borrowers who repay their debts on time, reliably, and predictably. It is also the primary reason why such a heavy degree of the score is determined by how close the borrower remains to their credit limits, while the length of time they have maintained the credit is less impactful. The lower the amount of credit you maintain on a regular basis, the higher the likelihood that you will be able to make payments on it since the interest on the credit will be lower and more manageable.

The Magic Credit Score Number

All these aspects of your credit score are calculated and combined to give you a total creditworthiness number between three hundred and eight hundred and fifty. This magic number is combined with other factors of your finances, including income, to determine the exact amount of credit you can obtain. The score will ultimately determine the likelihood of obtaining additional credit at your level and the interest rate at which the credit can be accessed.

How Important is a Good Credit Score?

Now that we have determined what a credit score is and how it is determined, we should examine exactly how important having good versus bad credit scores can be. The short answer is that your credit score ultimately underpins not only how much credit you can access but also the rates of interest applied to that credit. Good credit scores can access higher amounts of credit at lower return rates versus lower credit scores being limited in volume with a higher return rate.

While this may seem obvious and inconsequential to most people, if we dig into the numbers a little deeper, we find a vicious cycle emerges. Those with good credit scores continue to access higher credit levels, while those with lower limits struggle to pay off their current credit partly because of the extra burden of higher interest rates. A 30-year mortgage will cost someone with a poor credit score, on average, 33% more than someone with a good credit score. Similarly, insurance rates skyrocket for those with poor credit scores compared to those with good scores. The same thing happens if we look at other areas of credit. Credit cards notably have a significantly higher delinquency rate for those with poor credit scores than those with good scores.

How Does Technology Improve Credit Scores

The simple solution to having a bad credit score is improving your creditworthiness by making frequent larger payments over time and without taking out any additional loans or credit. The unfortunate reality is that predatory credit practices emerge because they are financially beneficial for lenders to do so. Lenders can price delinquency rates into their lending models to extract the most value from borrowers.

Blockchain technology specifically comes into the equation because it can create a more dynamic system with immutable, transparent credit histories. This enables several interesting new dynamics to the equation. It can enable the inclusion of both on-chain and off-chain data by introducing unorthodox collateral like cryptocurrencies and digital assets that legacy lenders avoid. 

It also enables the forensic tracking and identification of predatory loan practices. Most importantly, blockchain technology and the DeFi industry have opened lending and borrowing markets for everyone who wants access. Peer-to-peer lending and microloans can be issued through smart contracts that automate the process and enable new or historically low creditworthy borrowers to access markets they may have been excluded from. A more dynamic credit scoring practice can be established as individuals build their creditworthiness across the open markets.

A Credit-Scoring Blockchain Case Study

One of the leading credit score-building DeFi marketplaces is Teller Finance. At teller, a lender or borrower can access time-locked loans on any ERC20 token with no margin calls. What makes Teller Finance unique beyond its access to a diverse marketplace of borrowers and lenders is its time-based loan options. Repayments are made accessible and dynamic through the Teller Dashboard, and borrowers' profile histories can be used as immutable evidence of their repayment history. The marketplace enables a diverse cross-section of lenders so even the smallest microloan can be accessed.

Challenges to Blockchain-Enabled Credit Scores

There are challenges to establishing a new on-chain credit scoring system that can be implemented across legacy markets. We have previously examined the issue of data silos across independent blockchains and how interoperable layer zero blockchains are only as strong as their weakest bridge. The same remains true for establishing an on-chain credit score. For all the benefits that Teller Finance creates, it is still siloed off to the Ethereum ecosystem.

There is also the issue of data privacy for individual lenders and borrowers. When it comes to lending markets, it is essential not to indirectly reveal the identity, location, or size of any single lender or borrower's holdings. This leads us to our final thoughts on where on-chain AI protocols can intersect with credit-scoring blockchain projects.

The Future of AI-Enable Blockchain Credit Scores

We have seen how blockchains can reimagine credit scores by redefining creditworthiness and creating access to open lending and borrowing markets across DeFi protocols like Teller Finance.

Where AI can further enhance these protocols is through AI-powered privacy solutions like zero-knowledge homomorphic encryption models like the ones outlined in our previous entry. Additionally, AI can enhance the cross-bridge security of layer zero interoperable blockchains, thereby connecting lending and borrowing protocols across chains and further enhancing the availability of marketplace access.

The advancements in AI chatbots and UI can also lead to the broader adoption of the DeFi industry. Where the DeFi space previously seemed technologically intimidating for non-crypto users to enter, the use of a simple chatbot could unlock a tsunami of capital from retail and institutional investments and flood the lending marketplace with liquidity. This could make lending and borrowing extremely accessible and the issuance of credit score building loans open to everyone.