The case for something new in the crypto credit space

DeFi was developed to make credit markets more transparent in the crypto space, but its drawbacks, high-fees and high impact security vulnerabilities, are quite severe. This is the beginning of a proposal for a transparent-yet-centralized credit platform.

The case for something new in the crypto credit space
Photo by Dmytro Demidko / Unsplash

One of the biggest misconceptions I see in the public in general is how the money supply is managed. To be precise, there is a lack of understanding on how the money supply is so intertwined with the credit markets.
I seriously recommend reading this Macro Compass Post (thanks Alf for putting these important concepts in a plain language!).
Central Banks don't print real economy money; governments expand it by running deficits and contract it with surplus budgets and, most importantly, commercial banks create money out of thin air when issuing loans and money gets destroyed when deleveraging happens.

Because of this, it is argued that today we live in a credit-based monetary system and, by definition, money supply is elastic.
I believe that BTC and the rest of crypto thereafter have come up as a response to this; an effort to bring us closer to a commodity-based monetary system.
In this type of monetary system credit works in a completely different way, money is not issued when a loan is created. Rather the lender needs to cede a currency unit to the borrower, thus it does not increase the claims available. This is how peer-to-peer lending works in the credit-based system, but in crypto this is enforced across all credit markets because no party can issue units when extending loans.

There's been a lot of activity in the crypto finance space lately. But most of the initiatives fall into primarily two categories: CeFi or DeFi.
But neither category is able to expand the money supply of any of the cryptos they manage.

Without going too deep into what either category is, we can summarize CeFi as something pretty similar to traditional finance but on the crypto space.
What these entities do with the assets they hold is pretty much unknown to their depositors. There's complete opacity in regards how the funds are managed; it can even be argued that this is even worse than in traditional banking as the regulations in the latter provide some transparency.
There's no way to tell how they are generating, even if they are generating, enough income to sustain the yields they pay. It's impossible to know what their liquidity situation is or whether the loans they issued are properly collateralized. Overall, you get a centralized system with no public accountability, no transparency and no oversight from any entity.

On the other hand, DeFi goes to the opposite end of the spectrum. Everything is on-chain and the transactions happen on-chain. This brings a lot of the needed transparency into the crypto credit-scene. But this comes with drawbacks too.
Having the code on-chain means that the entities have little control in  regards to how or when the code is executed, it increases the criticality of any bug present in the code. Any exploit is pretty much unstoppable. If the contracts are written in a way that allows the owner full control over this, then you just end up with a centralized distributed system with pretty much all the cons and none of the pros; just the hype.
Another downside of DeFi, is that computational throughput is limited to the blockchain design and not the available computational resources in the network, making it really inefficient which ends up making computation costs skyrocket as the smart contract platforms start being heavily used.
And finally, like it or not, regulation is something that will always be present in the financial sector. DeFi platforms by their intrinsic properties have a harder or even impossible task of aligning with financial regulations. This not only creates potential liabilities on the platform owners but also on their clients too.

I think there's a place in crypto for a credit platform that combines the best of both worlds. That is, centralized management and operations but using a public ledger as the settlement layer and accounting system.

By having an on-chain accounting system, we can get the public benefits that come from DeFi. A platform that can be audited 24/7 by anyone who wants to do it, with interest rates calculated algorithmically based on supply and demand. Where the revenue generated by it can be tracked too as well as the collateralization of the loans.
Having the state in a public distributed ledger as the ultimate source of truth provides the transparency while it is not necessary to have the operations themselves run on-chain too.

By centralizing the operations and management, it is possible to get benefits in several dimensions. It allows for faster iteration on the features as the code is handled in a traditional fashion and doesn't require updating or changing on-chain contracts. From the security standpoint it allows for a faster response and it allows the platform to control and reduce the attack surface in ways that a truly decentralized on-chain approach do not allow. And last, but not least, it allows for an easier integration and compliance to financial regulation, reducing legal liabilities to all parties.

In my opinion, the Stellar blockchain is the perfect candidate to use as the backend for the accounting system as its properties align closely to what one needs and expects to carryout an endeavor of this type.

First, it allows the easy creation of custom assets. This is a key requirement to implement an open accounting system to track the state of the platform.

Second, it has a high transaction throughput with really low transaction fees and short settling time. This blockchain is able to do so due to the type of consensus mechanism it has and by narrowing the type of operations and state the public ledger needs to maintain. But none of this is an impediment for the type of operations that need to be handled to manage an accounting system of the type I am proposing.

Lastly, Stellar is financially oriented and the type of consensus mechanism it has guarantees immutability. If a transaction gets included in a ledger it is guaranteed to never be rolled back. This is in contrast to most PoW blockchains where there are no guarantees that this is the case; there's always the possibility of a longer chain being published and the chain being reorged (yes, it is extremely unlikely but not impossible). This is a critical property for a financial system.

If you managed to get here, thanks for reading the article! I will be deep diving on how I'm designing the system envisioned here in follow up articles. Stay tuned!

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