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Enabling uncollateralised finance in the metaverse

Anthony Butler
3 min read

In finance today, there are essentially two types of lending: secured and unsecured.

Secured lending is where, in return for lending you some amount, I take as collateral something that is worth the same or more as what I lent.  If someone doesn't pay, then I can sell the asset and get my money back.  As you typically won't want to lose the asset that you used as collateral, you have a strong incentive to pay me back.  

Unsecured lending is where I lend some money to you but I don't take anything from you as a security.  Instead, if you don't return the money, I have the ability to communicate, via credit scores, that you didn't pay your debt or, in some jurisdictions, I can file a criminal case that ultimately puts you in a debtor's prison.

The difference, of course, between the two is that with secured lending I can ultimately get my money back by liquidating whatever I took; whereas in unsecured lending, I won't get anything back – other than seeing the debtor punished in some way.   In secured lending, the borrower is motivated by not wanting to lose whatever they used as security; and in unsecured lending, the borrower is motivated mostly by the societal implications of not paying.  

All of this works quite well in traditional finance ("TradFi") but there are challenges with unsecured lending in the decenteralised, anonymous world of decenteralised finance ("DeFi").  The challenge is that it is, of course, impossible to rely on "social punishment" to enforce repayment in a world that is, by definition, designed to be anonymous, censorship-resistant and where someone can easily just create a new wallet and private/public key pair and resume trading with no link back to their previous defaults or behaviour.   In other words, you can't "punish" a Bitcoin or Ethereum address.

One of the most interesting papers I have read in recent months is "Decenteralised Society: Finding Web3's Soul" authored by E. Glen Weyl, Puja Ohlhaver, and Vitalik Buterin.  The paper outlines a novel idea that I believe could enable decenteralised unsecured lending: non-transferable "soulbound" tokens or SBTs that are digital representations of people's acquired experiences, credentials, and affiliations over the course of their life.  

The paper describes a model where, as person acquires, for example, a university degree, an award, or work experience, a non-transferable token (SBT) is minted and assigned to their wallet (which the authors describe as a "soul").   There is no need for this digital identity to be linked to a person's legal name or real identity; yet it will solve one of the challenges of the contemporary Web3 world and, by extension, metaverse of how to establish and prove reputation in a privacy-preserving way.  For example, if I want to lend to a someone, I can inspect their wallet and see SBTs representing their credentials, work history, prior contractual agreements, and other aspects of their personal and professional history, in order to establish their trustworthiness (since each of the SBTs would be traceable back to the issuing authority).  Based on this, I can make a decision whether to lend.  This would, in some sense, be analogous to credit scoring but in a decenteralised, privacy-preserving way.   Indeed, one can envision new forms of more transparent and innovative credit scoring or risk models based on this SBT data in the open source lending markets that this will emerge.

When a person enters into an unsecured loan contract using DeFi, the lender could issue an SBT representing the loan that is then placed in the borrower's wallet and is visible to everyone.  As their wallet also holds the digital history of their work, education, and so on, if they are to try to escape repaying the loan by creating a new wallet (i.e. "soul"), they would have no prior SBTs and it would be akin to having to start their life with no qualifications, no experience, and no reputation.  When the loan is repaid, the SBT is marked as repaid which will further enhance the reputation of the borrower if they seek another unsecured loan in the future.  If the loan is not repaid, it is marked as such as the person's reputation is adversely impacted which may hamper further attempts to borrow, get employed, rent a house or other commercial or social activities where reputation is important.

It is also possible that loan contracts could be established where, if a debt is not repaid, the borrower's SBTs would be destroyed.   For example, a person could "stake" SBTs representing awards or achievements in return for borrowing some amount; and, if they default, a smart contract would then destroy these SBTs which would create a strong incentive to repay.   Whilst these SBTs are not transferrable and of no value to anyone other than the holder, the fact that they are valuable to the holder – like reputation in unsecured lending systems – as an incentive to motivate repayment and a new form of "collateralisation".

This is, of course, just one example of how this concept of SBTs could be used to unlock new forms of economic value.  The authors of the paper go on to discuss how it could also enable the digitisation of community lending models, similar to the work of Muhammad Yunus with Grameen Bank; as well a variety of other applications across the social stack which they broadly characterise as "decentralised society" or DeSoc.  

Anthony Butler Twitter

Anthony is a Senior Advisor to a G20 Central Bank on emerging technologies and applied research. He was previously Chief Technology Officer for IBM, Middle East and Africa. Lives in Saudi Arabia.

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