Problems with Traditional Credit

While traditional credit systems have been the backbone of global finance for centuries, they come with several issues:

Lack of Transparency

The 2008 global financial crisis (that led Satoshi to build Bitcoin) is a stark example of how a lack of transparency in credit systems can lead to catastrophic outcomes. The true extent of subprime mortgage exposure was hidden through complex financial instruments.

When the bubble burst, it revealed that banks had leverage ratios as high as 33:1. The crisis wiped out more than $2 trillion in global economic growth, or about 4% of the world's GDP.

The collapse of Silicon Valley Bank in 2023, with $209 billion in assets, shows that these risks still persist.

Banks conveniently rename bad debt as NPAs. Any loss due to Duration risk or Credit risk is bad debt. This bad debt eventually eats into customer deposits.

Customers remain calm because there is no transparent way for them to see that the bank doesn’t have reserves and assets at market value higher than the deposits.

Limited Accessibility

Traditional credit systems exclude a significant portion of the global population.

As of 2021, approximately 1.4 billion adults (~20% of the global population) remain unbanked, lacking access to basic financial services, including credit. This is particularly critical as these individuals need credit the most to escape poverty.

In developing economies, only 63% of adults have a bank account, compared to 94% in developed economies.

Selective Accessibility

Credit accessibility is often highly selective, leading to systemic inequalities:

• Racial Disparities: In the U.S., Black and Hispanic applicants for home mortgages are denied at much higher rates than white applicants. In 2020, the denial rate for Black applicants was 27.1% compared to 13.6% for white applicants.

• Income-Based Discrimination: Lower-income individuals often face higher interest rates or outright denial of credit, even when controlling for other risk factors. This creates a "poverty premium" where those who can least afford it pay more for financial services.

• Credit History Catch-22: Many individuals, especially young adults and immigrants, struggle to access credit because they lack a credit history, but they can't build a credit history without access to credit.

Poor Adherence to Terms

One of the most persistent issues in traditional credit systems is the failure of parties to adhere to agreed-upon terms. This problem manifests in various ways:

• Late Payments: In the U.S., about 30% of Americans are behind on paying their debt. Late payments not only affect creditors but also damage borrowers' credit scores.

• Contract Violations:

  • Complex credit agreements often lead to unintentional violations or disputes over interpretation.

  • For instance, in 2020, Wells Fargo agreed to pay $3 billion to resolve its fake account scandal, where employees opened millions of accounts without customer consent, violating the terms of their relationship with customers. Case Link.

• Covenant Breaches:

  • In corporate lending, covenant breaches are common leading to renegotiations and increased costs.

Fraud

Fraud in credit systems is a massive and growing problem:

• Identity Theft: In 2020, the FTC received 4.8 million identity theft and fraud reports. Many of these cases involved credit fraud.

• Synthetic Identity Fraud: This sophisticated form of fraud, where criminals create fake identities to access credit, costs U.S. lenders $6 billion annually.

• Application Fraud: It's estimated that 10-15% of credit card applications contain some form of fraud, leading to billions in losses for issuers.

Sub-Par Ability to Reclaim Debt

When borrowers default, the process of reclaiming debt is often inefficient and costly:

• Recovery Rates: According to the World Bank, the average recovery rate for creditors in insolvency proceedings across OECD high-income countries is only 70.2 cents on the dollar, and much lower in developing economies.

• Time and Cost: The process of debt recovery is often lengthy and expensive. In the U.S., it takes an average of 420 days and costs 10% of the estate's value to resolve insolvency.

• Cross-Border Complications: Reclaiming debt across international borders is particularly challenging. The lack of standardized processes and conflicting legal jurisdictions often make it impractical to pursue smaller debts internationally.

Moving credit on-chain is not just an improvement, it's a necessary evolution of our current financial system. On-chain Credit can create a more inclusive and efficient credit system that better serves the needs of a global, interconnected digital economy.