Centralized vs. Decentralized Credit Scoring System: Advantages and Drawbacks

There are many reasons why forward-thinking financial service providers and credit savvy individuals are excited about the potential of decentralized credit systems utilizing distributed ledger technology.

Let’s examine why by comparing a centralized credit scoring system with a decentralized one. We will focus particularly on differences in the authentication of data, the protection of data, and access to credit information.

What is Decentralization?

From a simple technology standpoint, the process of decentralization involves storing data in multiple locations rather than a centralized location, preventing single point of failure.

The traditional credit scoring system can be defined as a centralized process. In order to decentralize the system, it means that no one single entity collects, compiles, and assesses your financial history. In addition, your financial data and credit histories are recorded in more than one location.

Centralized Authentication of Data

Credit bureaus are expected to have a system of checks and balances to verify the massive amount of incoming data.

Advantage

A long-standing relationship of trust already exists between the chief credit bureaus and the major debt holders such as banks and credit card companies.

Drawback

Centralized credit data bureaus exist by maintaining a level of trust. For example, lenders are not required to submit legal paperwork establishing that a debt exists.

Decentralized Authentication of Data

Decentralized data collection is a trustless enterprise.

Advantage

A decentralized system does not require any party to have unquestioned faith in the accuracy of another party’s record keeping.  All alterations to the blockchain ledger are forced to undergo validation procedures.

Drawback

The data appearing on the blockchain can be corrupt information if initially entered incorrectly. Mistakes can occur, for instance, when migrating a credit history from the traditional system to a distributed ledger.

Conversely, the accuracy of blockchain data increases if the data is created on the blockchain. In other words, the financial transaction such as extending and receiving credit began on the blockchain.

Rigorous authentication of data requires the participation of multiple computers functioning as mining nodes. Performing the necessary computations requires computers to consume large amounts of electricity. As a result, verifying data on the blockchain can be more costly than the traditional method.

Centralized Protection of Your Financial Data

Equifax, Experian, and TransUnion, collectively known as The Big Three, are the primary centralized rating agencies which catalog consumer financial history in the United States. Therefore, the agencies face the challenge of protecting that data from unauthorized personnel.

Advantage

Credit bureaus offer tools such as fraud alerts to warn creditors that they should attempt to verify your identification before extending lines of credit in your name.

Drawback

It stands to reason that any central party housing the names, social security numbers, date of birth, and addresses of millions of Americans would be the target of hackers.

Therefore, it wasn’t surprising when hackers breached security at Equifax in 2017. They assessed the private information of over 145 million people.

Experian experienced its data breach in 2015.

Decentralized Protection of Your Financial Data

However, a similar attack would be useless upon blockchain data that uses a layer of proven privacy protocol.

Advantage

Decentralization separates your identity data into smaller encrypted chunks. For example, decentralization doesn’t blatantly link your name to your social security number.

A thief would have to gather together far more bits of information about you to steal your identity and sabotage your financial history.

Drawback

There is the common misconception that blockchain data is completely hack-proof. Unfortunately, that’s not the case.

Data on the blockchain is vulnerable to sophisticated hacking if a privacy protocol is not in place to protect it. That protocol is only as capable as the company that administers it.

Centralized Access to Your Credit Score

Your credit record improves only if your creditor reports your activity to one of the credit bureaus.

Advantage

Credit bureaus have instituted simple methods for people to request a copy of their credit report now that each person is legally entitled to one free yearly report from each of The Big Three.

You can file a request online but obtaining the report doesn’t require any specialized computer skill. Alternatively,  you can also order the report by telephone.

Drawback

Any mistakes made by the lender or the reporting agency can negatively impact your credit status and negate your progress. A crucial error may appear on a credit report for months or years before the average consumer becomes aware of it.

Interestingly, credit lenders aren’t required to report your activity to the Big Three. Therefore, there’s no guarantee that your good financial conduct is improving your credit score.

Decentralized Access to Your Credit Score

Decentralized credit scoring removes the traditional credit bureaus from the picture.

Advantage

Credit records are more dynamic on the blockchain than at the traditional credit bureau. Updates propagate comparatively quickly throughout the ledger.

It takes the vote of more than one entity to change your credit history, lessening the chance of bad data entering the ledger.

Drawback

The ledger of a blockchain is only as accurate as the data entered.

Data that originates off-chain and then moves onto the blockchain carries more risk of containing errors than similar data created specifically for the blockchain.

The Future of Centralized Versus Decentralized Credit Scoring

Both centralized and decentralized credit scoring systems will maintain their most loyal adherents.

Naturally, centralized systems will continue to dwarf decentralized systems in size as blockchain-based credit scoring platforms must gain the trust of more institutions and the general public.

Not only will the two systems continue to operate simultaneously, but the unique advantages of both could appear together in hybrid systems.

For example, The Big Three could migrate their existing data to distributed ledger systems, maintaining credit information in both centralized and decentralized environments.

Building with NUTS

To ensure security for all traders in the open OTC market, NUTS provides an accessible, distributed ledger that secures non-standardized trading and provides the transparency needed to safeguard every transaction.

We integrate essential financial capabilities into smart contracts to create diversified technology modules, and enable open, inclusive financial processes that serve the changing needs of a digital asset class.

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