Why Ethereum Can’t Help You Get a Small-business Loan: Part 1 - Identity

For all the spectacular growth in DeFi lending, most of the borrowing is done by crypto traders. To buy more cryptocurrencies.

And while DeFi enthusiasts can’t stop talking about its revolutionary potential to disintermediate banks, most of them ignore an obvious fact - there is not much of conventional lending happening in DeFi. If you are a small business looking to expand or a thin-file borrower looking for a short-term loan, chances are that you will not be able to use a typical DApp on Ethereum (or Polygon, Solana etc.) to borrow say $10,000 for a year.

There are severe limitations to the current DeFi systems that keep this from happening, it is certainly not that the fertile minds in crypto space haven’t thought about it. This article is 1st in a series of 4 that explore these limitations and possible solutions to them.

Identify me!

Ethereum (like bitcoin, algorand, polygon and others) is an infrastructure for pseudonymous payments. Other than an address (something like 0x12de3434b813c23239) you don’t need much to transact on it. This includes borrowing and lending.

How does one protect against default then, you might wonder. The short answer is that all lending in DeFi space currently is secured lending where the collateral is some cryptocurrency or token. If a borrower defaults, the lender simply takes the collateral coin and keeps/sells it.

You may ask, “What if I do not have cryptocurrencies to borrow against?”. Well, in that case, you are out of luck, kindly write to your friendly neighbourhood bank or a web2.0 fintech lender!

You may continue asking, “What about my creditworthiness, my credit score and those good things?”. Sorry! In the crypto world, we do not know who you are; you are just an address and addresses do not have credit scores.

What if you were a lender? Is it enough to simply have the algorithmic certainty that your loan would be repaid in the event of default? What about the instances where you know the borrower and are happy to lend based on your assessment of them? And if you are a formal lending business, what about the regulations around knowing your borrowers?

Lack of identity is one of the key reasons why DeFi is yet to go mainstream.

What’s in a name?

In a discussion with a fintech lending platform, I realized identity fraud is one of the major problems for lenders - offline and online. Conventional identity systems rely on a government provided number and document. The latter is open to forgery. The former is open to identity theft. It seems there are troubles in the conventional systems as well!

Blockchain is a promising technology in the context of identity. However, simply moving a government record of who is who to a distributed ledger will still not solve the problem of identity theft.

Why not also rely on the community?

What if individuals could vouch for each other’s identity to complement the conventional identity documentation?

If I need a small business loan, I go to a lender and submit the usual docs but I also give them my identification number on a public blockchain, through a cryptographically signed request sent to them from that id and referring to this loan application. The lender then looks into the connections of this borrower on this blockchain. Let us say, there are 50 others that are connected to me there and all of them have decent standing in the community. As a lender that should satisfy me further that this is quite unlikely to be identity theft.

Trust as a collective good

I referred to something called the ‘community’ and something else called ‘decent standing’. These are concepts drawn from informal social networks and are routinely employed in informal transactions between members of a community. However, to date, there has not been a good platform to collate this information reliably for ‘outsiders’ to use. That is where a public blockchain could help.

If others’ vouching for me is not a one-time reference check (which is time-consuming, and also open to fraud) but a persistent record of my standing in a community, a lender can refer to it reliably. What’s even better, if I repay the lender, this standing of mine can go beyond the community since this good behaviour is now recorded immutably. A generalized credit bureau of sorts.

Using decentralized identity in DeFi

Whether the lending is secured or unsecured, incorporating decentralized identity in DeFi can go a long way in enabling non-crypto users to get access to credit using the potentially inclusive DeFi technology.

Why Ethereum and other current mainstream blockchains are unlikely to be useful in this context is that anonymity is not a bug of these platforms, but a feature! It is like asking the gun-enthusiasts in the USA to give up guns. For better or worse, anonymity is now like a constitutional right in crypto space. And it would be a dark day for the anonymity proponents if identity were to be brought to the centrestage in DeFi!

There are projects like brightid that enable decentralized identity. The problem with these solutions is that they are patches that work in their respective silos - not all that different from a web2.0 application.?

We need identity at the protocol layer in a blockchain to reliably create a network that serves mainstream needs. Watch this space!