Challenges of Delegated Credit

The challenge of such relationships is they must be based on specific lines of trust. The lender must conduct their own due diligence on the borrower, and ascertain whether the borrower can be trusted to repay. Furthermore, the lender may lack access to financial intelligence about the borrower’s ongoing behavior, and be blind to indications of deteriorating credit worthiness.

This model may be effective on a small scale, and between parties who are well known to each other. But as decentralized markets for delegated credit scale up in size, the overhead of individual due diligence for each lending relationship is bound to become burdensome. Beyond that, the relationship-based trust model is unlikely to be economically sound in the long run. Extrapolating that a large-scale decentralized economy can operate from an informal “I’ll get the next round of beers” form of mutualism is bound to result in error and loss.

This implies a need for trusted sources of credit information in order to preserve a scalable, liquid market for under collateralized lending. Traditional credit scores rely on the fact that repayment schemes are, in reality, more flexible than their legal terms admit. Credit scores take in data points such as late or partial repayment to compile the score.

In a world of atomic transactions, where transactions are automatically executed on schedule by smart contract, that signal of impending default is absent. Unless there is pre-existing or validated trust, the lender can’t rely on prior performance as an indicator of future behavior. Thus some level of trust intermediation, through a third party or service, is essential if rational allocation of lending at understood levels of risk is to occur.