Use Case:
DeFi credit score via PSD2
What:
If you’re like most people, there is a good chance that you are living paycheck to paycheck. Even in developed economies, this is likely to be true. Research shows that only 40% of Americans would be able to meet a $100 emergency, for example.
Current financial markets primarily favour extremely affluent individuals, whereby they’re offered billion-dollar loans at very low-interest rates.
Increasingly though, normal people are beginning to have access to loans via Decentralized Finance (DeFi). This network of financial institutions is providing new opportunities for capital formation that have until now been inaccessible for everyday individuals.
However, DeFi is not presently seeking to entirely replace the traditional financial sector. Instead, its mission is to take existing systems and enhance them.
This is done by sharing information with banks via Application Programming Interface (APIs), which were enabled by an EU regulation known as Payment Services Directive (PSD2). Through these PSD2 enabled information streams, DeFi microservices can use all the information that financial institutions have regarding their users and enhance their offerings via Open Banking and bespoke financial products.
Current Situation:
Traditional banks increasingly put stringent restrictions on who can gain access to their services.
On the other hand, the DeFi space has been very willing to accept new customers. However, a lack of knowledge is a major barrier to entry from the user’s perspective. Meanwhile, from the service provider, there’s often not enough financial information available to build risk assessment models.
This means that the collateral requirements for loans, and other financial operations, have been much higher than in the traditional financial world, as trust is lacking on both ends of the system.
Consequently, there is a large portion of people that are considered “underbanked” around the world, as they fail to meet the requirements to participate in mainstream and DeFi financial systems, except in a very limited capacity.
In the US about one in four households is considered underbanked, or even unbanked (which means they don’t have access to financial institutions at all). It bears mentioning that access to capital and having the opportunity to utilize it is considered among one of the most important determinants for economic success.
As such, the present situation is unnecessarily pushing billions of people into poverty, as well as keeping them there without a way out.
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Solution:
With the widespread adoption of PSD2 protocols by banking institutions in the traditional financial world, FinTech companies in the DeFi space can incorporate the already existing information from traditional banks.
As such, FinTech companies can plug the APIs into their systems and incorporate year’s worth of information of potential clients. That means they can compete with banks based on the quality of their services, not on having access to better information.
This comprehensive overview of prospective user’s finances means that crypto-based FinTech applications can serve underbanked/unbanked people. As such, DeFi apps don’t have to build a user database from scratch and can thus create risk profiles for potential customers and thereby offer them products based on their financial capacity.
In other words, while traditional banks often don’t see much value in serving people of lesser means, given the associated costs and risks, DeFi has fewer of these problems.
Given DeFi’s inherently diversified participants and negligible costs of running said infrastructure, it can take on these clients without an issue. The main element that has stopped DeFi institutions until now was the lack of transaction histories or behavioural profiles, which might otherwise take decades to construct.
Hence, PSD2 can bridge the informational asymmetry for DeFi apps and their prospective clients. This way business can be done on fairer terms, without the need for higher collateral requirements for loans, or sky-high interest rates.
Over time, a broader pool of clients and agents will help decrease the risks of loan defaults, or contract breaches and will improve the living standards and life outcomes for billions of people.
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