Summary
Goldfinch is a decentralized credit platform that enables loans without requiring on-chain collateral. This novel approach increases access to capital and expands the crypto lending market to users that otherwise would not have sufficient on-chain assets to qualify for a loan. Goldfinch’s “trust through consensus” mechanism allows lenders to directly evaluate the creditworthiness of potential borrowers, supporting but removing the need for on-chain collateral. Ultimately, this creates a permissionless framework that connects users with surplus capital to users in need of capital, expanding the number of potential borrowers and opening access to lending in more equitable ways.
Problem: Determining Creditworthiness of Borrowers - Expensive Collateral or Subjective Attributes
Decentralized lending is difficult, especially when designing a system that is permissionless. Part of the challenge is determining the creditworthiness of potential borrowers to mitigate default risk. In many instances, lending protocol design requires borrowers to overcollateralize their debt position with on-chain assets. So borrowers typically must provide large sums of capital collateral in order to qualify for a loan, and in some cases this could amount to 150% of the amount being borrowed. This generally makes sense for hedging against default risk in highly speculative markets such as leveraged trading. However, it is not efficient with other more conventional areas. It also places significant limitations on borrowers that have insufficient access to capital.
Another approach to decentralized lending is to build a mechanism that determines creditworthiness based on other factors such as on-chain reputation and repayment history. This shifts the focus away from on-chain borrower collateral. However, the parameters used to determine creditworthiness beyond capital tend to be quite subjective and can often induce risk if the lender chooses the wrong factors or the borrower is able to game their on-chain behavior.
Solution: Decentralized Approval Process of Loan Applications
Goldfinch introduces a novel mechanism which removes the explicit need for collateral and builds on the idea of loans through a more robust way of determining creditworthiness. The protocol’s “trust through consensus” acts as a guide to determining creditworthiness by shifting towards a model that requires lenders to examine each potential borrower and determine whether or not their loan application ought to be approved. So applicants create a loan proposal, outline the terms, and submit through the protocol. A panel of lenders examines each proposal, looking at parameters such as an applicant’s on- and off-chain history and the terms of the loan, and use these factors to determine whether or not they want to provide capital towards the loan. So creditworthiness is determined by the collective assessment of stakeholders in the ecosystem rather than the sole presence of on-chain collateral.
One of the main advantages of this approach is that it not only opens up access to credit, but it enables the protocol to permissionlessly approve (or deny) loans. This helps to improve the speed and efficacy of the lending process and moves towards a truly decentralized method of distributing loans.
Goldfinch’s approach also opens a new layer of capital demand, since more participants are able to borrow assets that otherwise would not have been priced out. So both the pool of potential borrowers as well as potential lenders expands under this model, creating a new dynamic in decentralized lending and borrowing markets.
Collectively, these actors allow efficient capital distribution in a distributed way. This design expands the user base in DeFi, further infuses the Web3 space with more capital and liquidity, and creates a real world service that improves upon existing infrastructure, such as traditional bank loans. It also creates a more equitable distribution of capital to underserved markets like India and Vietnam, where potential borrowers have solid performance histories, but struggle to raise additional capital, are unable to access traditional loans, or want to access DeFi’s liquidity for off-chain uses but are unable to overcollateralize with on-chain assets.
Deeper Dive
The core functionality of Goldfinch is centered on two key players: Borrowers, who propose deal terms and access capital, and Investors, who supply capital to the protocol. Backers are investors who evaluate and lend to specific deals, while Liquidity Providers are investors who supply surplus capital to a shared pool that is automatically distributed across the protocol according to the actions of Backers. Borrowers that are seeking a loan can then propose a deal and its terms on the protocol.. Each deal and its terms are then vetted by Backers who determine whether or not they will lend capital to the Borrower as is proposed. As Backers invest, the shared pool (Senior Pool) automatically provides Liquidity Providers' capital in alignment with the amount lent directly by Backers, according to the protocol's leverage ratio. The Borrower can then withdraw the capital from the protocol.
The way this works in practice on Goldfinch is a bit more technical. The process begins through Borrowers. These agents seek financing and propose Borrower Pools which contain the terms of lending that they seek, such as interest rates and repayment schedules. The Borrower Pool smart contract encodes these terms and broadcasts them to the network. This smart contract also enables Borrowers to directly borrow and repay capital. Any Borrower can create a Borrower Pool and define the terms they want. Backers are essentially capital providers that evaluate Borrower Pools and decide whether or not to lend to the Pool. These agents supply first-loss capital (Junior Tranche) and as such, take on more risk and earn more yield.
Liquidity Providers also contribute to capital provision, but in a less risky way. In short, they provide capital to a “Senior Pool.” This pool then utilizes a leverage model to automatically allocate capital to different Borrower Pools (e.g. based on the number of Backers participating in a given pool). Liquidity Providers receive passive yield in return and a portion of their interest earned is sent to the Backers. This increases the Backers’ effective yield, which incentivizes them to both provide the higher-risk first-loss capital and do the work of assessing Borrower Pools. Finally, Auditors effectively serve as network watchers and ensure the integrity of the protocol. These agents stake a predetermined amount of $GFI (the protocol’s native token) and are randomly chosen to check for fraud and vote to approve Borrowers.
Tokenomics & Mechanism Design
$GFI is the native token of the Goldfinch network that is used for governance. Token holders can vote on updates to the protocol and changes to different parameters, such as the rewards and distribution of $GFI or pausing protocol activity in the event of an emergency.
Moreover, $GFI serves as an incentive mechanism for participants in a variety of different ways. All active participants, including Backers, Liquidity Providers, and Auditors receive ongoing token distributions to incentivize their participation. Backers receive $GFI rewards to incentivize to provision first-loss capital to Borrower Pools. Backers can receive both early Backer rewards and higher effective yields based on the Senior Pool leverage. They also have an incentive to stake $GFI on other Backers because they can earn additional rewards when that Backer supplies to Borrower Pools. Liquidity Providers are incentivized to supply to the Senior Pool through passive yield rewards. Finally, auditors are incentivized to participate and vote honestly in order to earn $GFI rewards. In addition, by requiring that auditors stake $GFI in order to participate, they are both incentivized to avoid having their stake slashed and are naturally aligned with the long term success of the protocol.
Goldfinch has implemented a few interesting mechanisms to shore up the lending and borrowing process. To begin, in order for a Borrow to initiate a Borrower Pool, they are required to stake an amount of $GFI equal to double the cost of an Auditor approval. Half of this goes towards paying for the Auditor approval, the other half is held as a bond that is fully returned to the Borrower once they’ve repaid their loan. This mitigates spam, signals commitment to the network, and provides $GFI to pay for the first Auditor approval. To incentivize capital provision, Goldfinch has designed an early rewards program in which Backers earn additional $GFI rewards for allocating capital early, with the reward amount decreasing over time as the Borrower Pool reaches its limit. This helps to initiate initial capital creation as well as mitigate free rider problems, since it’s riskier to be the first one in a Borrower Pool.
In terms of repayment, Goldfinch has created a system designed around NFTs that track different capital allocations. So when Backers and the Senior Pool disburse a loan, they also receive an NFT which tracks the amount that was supplied and how much of it has been redeemed. A Backer or the Senior Pool can use their NFT to redeem their specific portion of the available repayments in the pool. Using an NFT (rather than token) ensures that no one redeems more than their proportional share of the total repayments as they come in. For instance, if two Backers each supply $500 for a total of $1,000 borrowed, and the Borrower has made repayments in the sum of $300, then the NFTs ensure each Backer can only redeem up to $150. This is their portion of the repayments so far, and prevents one Backer racing to redeem the full $300 for themselves. To encourage timely payments on the Borrower side, Borrowers that are late on a payment are immediately unable to further borrow. Borrower repayment history is tracked on the network so Backers will be less likely to supply capital to a Borrower with poor repayment history.
In terms of network security, Goldfinch has developed a system of Auditors that help manage risk and filter loan applications, although the role is not yet live on the protocol. In short, Borrowers need an approval vote from Auditors in order to borrow from the protocol. Anyone can be an Auditor by staking a specific amount of $GFI and going through a verification process. Once verified, Auditors stake $GFI in order to be selected for votes, and they earn $GFI rewards when they vote with the majority of other Auditors. When a vote is requested, the protocol selects 9 Auditors on a random basis weighted by the amount of $GFI they have staked.
Conclusion
Ultimately, Goldfinch has the opportunity to expand the crypto lending market beyond just niche Web3 applications and into real world use cases. The protocol's mechanism design carefully aligns all participant incentives and provides considerable protection against fraud and default. Lenders are incentivized to provide capital and to provide it early on, despite increased risk associated with early provision. Borrowers are incentivized to create robust proposals and to make timely repayments on their loans. Moreover, Goldfinch’s novel approach to NFT credentialing is a framework that helps facilitate a truly decentralized way of credit evaluation and also serves as a method of ensuring that lenders are only entitled to their specific portion of a loan repayment at any given time. This latter part helps to keep downward pressure away from $GFI tokens; if lenders simply had to exchange $GFI to retrieve their portion of a loan repayment, this could lead to constant, even accelerated selling of the token. Goldfinch’s NFT approach removes this factor from impacting token price.