Why does the Self-Sovereign Identity provide a guarantee of decentralization for DeFi? – Part 1

In this article, we are going to introduce how Self-Sovereign Identity technology can help DeFi.

Introduction to DeFI and its system

As many of us already know, Decentralized Finance (DeFi) is based on blockchains that support smart contracts. In this sense, Ethereum the largest ecosystem so far.
To get into the topic we want to explain in this article, we should review the role of Smart Contracts in DeFi. And is that these contracts are intended to serve as decentralized implementations, without having a third party to intervene and in an automated way (immediate feature linked to Smart Contracts).

What are the principles of DeFi?

As we have been explaining, DeFi is based on automation and disintermediation/decentralization, through the exploitation of the very important distribute ledger technology and crypto-anarchist ideologies.

It is a fact that interest in DeFi has increased incredibly in the last year and the total value of decentralized applications based on Ethereum (and other networks), has multiplied tremendously. This also means that lending is one of DeF’s main building blocks.

But how do loans work in DeFi?

In principle, what you need to know, is that lending services offer liquidity in exchange for the counterparty’s collateral.

But due to DeFi’s well-known pseudonymous characteristic, this guarantee is limited to just that, a guarantee. This itself is expressed in overcollateralization as a result of the volatility of the cryptocurrency market.

This means that a persistent, unalterable, uniquely identifiable and checkable credit history makes it possible to collateralize the counterparty without liquid collateral.

Unsecured lending lowers a barrier to entry for the widespread adoption of decentralized finance.
What we are going to try to probe and explain in this article, is how the implementation of SSI could facilitate the credit system in DeFi, through credit history linked to a persistent and verifiable self-sovereign identity.

Trust in DeFi

We could say that the world of traditional finance and banking, has lost confidence and support after the various crises, having as one of the major milestones that wreaked havoc in this system, the COVID19, the pandemic and its economic consequences.

It is not surprising that after this, the adoption of decentralized finance systems has grown exponentially.

It was after the 2008 financial crisis that Satoshi Nakamoto proposed a peer-to-peer e-money system based on cryptographic proofs and transactions
blockchains, which propelled the world into cryptocurrency finance.

After Nakamoto’s whitepaper, where he explains Bitcoin, distributed ecosystems have taken off.

DeFi stands on four ideals or principles: non-custodial, permissionless, openly auditable and composable. These characteristics can be seen very clearly in DeFi’s own lending and borrowing systems, through the Loanable Fund Markets.
These fund markets offer two types of loans:

  1. Flash loans are secured as a single atomic transaction that can be reversed in the event of loan default.
  2. Secured loans that span longer terms and are secured by fully collateralizing the loan with cryptoassets.

Given that, traditionally, loans require some form of collateral against counterparty risk, risk management and post-loan monitoring systems were developed to evaluate borrowers to assess their creditworthiness and minimize losses.

At DeFi, this is addressed through the use of collateral on loans, which is liquidated in the event of default or fluctuations in asset value. This collateral requirement makes it difficult for small speculators and non-cryptocurrency holders to adopt.

SSI and DeFi

It is Harwick and Caton (What’s holding back blockchain finance? On the possibilities of decentralized autonomous finance, The Quarterly review of Economics and Finance, 2020) who propose offering an identity link to transparently manage counterparty risk as a solution for unsecured lending.

The financial market is driven to implement more and more Know You Customer or KYC, and anti-money laundering, but they are also trying to find solutions that preserve the user’s identity.

In this sense, a modern digital identity solution that shares many ideological values with DeFi, is the Self-Sovereign Identity (SSI), which we already talked a lot about in Extrimian.

SSI opens up the possibility to storage and enables the presentation of credit history privately through Verifiable Credentials, and bridges the trust gap between lenders and borrowers in the DeFi space.

Decentralized lending protocols

Smart contracts offer an asset exchange format based on the rules set by the code and terms of the contract that is publicly stored on the blockchain and open to community scrutiny.

In turn, they enforce the rules set in the lending protocol, such as interest rate or collateral rate. Thus, traditional intermediaries are replaced by automation and we find ourselves with a decentralized protocol.

DeFi loans have the characteristic that the borrowers and lenders are not obliged to identify themselves.
This is related to the aforementioned permissionless property, where everyone has access to the platform and can borrow money or contribute funds to earn interest.
There are, as we said, two types of marketplace: short-term loans and long-term loans.

a) Short-term loans or flash loans are funded and repaid in a blockchain atomic transaction. If the borrower is unable to repay the loan within the blockchain creation timeframe, the transaction is completely reversed with no collateral damage to the lender. This is why they do not require any collateral. They are mainly used for arbitrage. As these loans are made in a very short time frame, the lender can only interact with the facility through smart contracts.

b) Long-term loans require collateral to cover the loss in case of default. The collateral required is therefore at least as large as the size of the loan plus interest.
Collateral requirements are even higher, starting at 150% of the loan amount and sometimes exceeding 300% (overcollateralization).

c) In the same way, we can consider NFTs as collateral in DeFi: Another means of collateralization is through NFTs. Certain projects allow borrowers to place the NFT as collateral for a loan with a credit limit equivalent to that of the NFT in question.

But…what about SSI? What is its role here?

If you want to know how the Self-Sovereign Identity system can help solve the problems in the guarantee system in Decentralized Finance. Read the second part of this article.

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