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The Disruptive Potential of On-chain Reputations
Level 3 - Virgin DeFi Analyst
The rise of crypto has led to a paradigm shift in how we conduct online transactions and interact with one another. As the world moves towards on-chain solutions, decentralized identity and reputation systems are becoming increasingly important in establishing trust.
In the first part of our coverage we’ll explore the concepts of on-chain reputation and identity and how they work in decentralized systems. In part two, we’ll highlight notable projects in the field, discuss the potential for multiple winners in this space, and provide a technical overview of on-chain reputation systems. We’ll also share our framework for evaluating investment opportunities in the space.
Concepts: On-chain Reputation and On-chain Identity
On-chain reputation refers to the trustworthiness of an individual or entity within a blockchain ecosystem. It is based on a quantifiable measure that evaluates on-chain activities. A wallet’s reputation score may change as it makes transactions as the system attempts to evaluate the wallet’s reliability and trustworthiness within the network.
On-chain reputation plays a significant role in fostering trust among network participants, as it offers a quantitative assessment of an entity's behavior. In a decentralized system, reputation can serve as an alternative to traditional centralized trust indicators, such as credit scores, and can help facilitate various types of transactions, including lending, borrowing, and e-commerce.
On-chain identity refers to a unique, decentralized digital representation of an individual or entity within a blockchain network. Unlike centralized digital identities, on-chain identities are not issued or controlled by a single authority or organization.
An on-chain identity typically consists of a unique identifier, such as a public key, along with additional attributes or claims that provide more information about the individual or entity. These attributes can include personal information, such as name, age, and contact details, as well as more abstract characteristics, such as reputation scores, affiliations, or certifications.
On-chain identity is a foundational concept that serves as a prerequisite for on-chain reputation. Before an individual or entity can develop a reputation within a blockchain network, they must first establish a unique on-chain identity that can be associated with their transactions.
A basic example of on-chain identity is a wallet address. But. Anyone can create multiple wallet addresses, and it’s hard to determine they are controlled by the same person.
This poses a challenge: an individual can create many identities which don’t appear to be linked, for the sole purpose of exploiting an on-chain reputation system.
Sidebar: Sybil attacks
A Sybil attack refers to a situation where a single malicious actor creates multiple identities within a network to manipulate the system or disrupt its normal functioning. These identities can be used to gain undue influence over consensus mechanisms, manipulate voting systems, or spread false information within the network.
Various countermeasures make it more difficult for a single attacker to gain control over a significant portion of the network by imposing resource constraints, such as computational power or financial investment. Reputation systems could make it more challenging for malicious actors to create and maintain numerous fake identities.
Depending on the economic costs/benefits, it might be profitable to build up sufficient credibility to profitably defect.
Real life social and economic interactions are an iterative Prisoner’s Dilemma. If you develop a reputation for shady behavior, other market participants may be reluctant to trade with you in future. Formal examples include the criminal record system and the norm of verifying references from previous employers.
In the anonymous on-chain world the ability to easily create multiple identities (and to cease using an identity with a damaged reputation) creates a non-iterative Prisoner’s Dilemma. This game has different incentives.
Sidebar: Prisoners Dilemma
A prisoner's dilemma is a game theory scenario in which two players make a decision without knowing the other's choice, and their individual outcomes depend on the combined choices.
In the non-iterative prisoner's dilemma, the one-time nature of the interaction significantly changes the game theory incentives for the players involved. Unlike in an iterative prisoner's dilemma, where players have multiple rounds to interact with each other and can retaliate or adjust their strategies based on previous outcomes, the non-iterative version does not allow for such feedback loops.
The lack of retaliation opportunities in a non-iterative prisoner's dilemma means that players cannot punish others for defecting or failing to cooperate. This inability to retaliate affects the strategic decisions of each player, as they may lean towards defecting to protect their interests, fearing that others might do the same. In other words, the one-time nature of the interaction can make defection the dominant strategy, as players cannot rely on the possibility of retaliation to encourage cooperation.
Real World Example: Airdrops
Airdrops are governance tokens awarded to active crypto users to achieve a degree of decentralization and align incentives. Even if the airdrop receiver sells the tokens, the new owner has an economic incentive to contribute to governance to maximize the token value. (That’s the theory anyway)
And who would make good governors of a protocol? Early adopters and power users (again, in theory). So eligibility for an airdrop is often based on using a protocol. Either a user must pass some threshold of transaction value / transaction frequency to qualify, or passing the threshold results in a greater quantity of tokens airdropped to the user.
In other words, airdrop eligibility is based on on-chain reputation. Unfortunately, as soon as these dynamics were known, participants gamed the system.
In simple terms, if a project wishes to reward a user who makes a few low value transactions with a wallet containing a few thousand dollars, any whale with a few million dollars can create 1,000 decoy wallets masquerading as small users and receive 1,000x the airdrop value. There have also been examples of “insider trading” where the qualifications for an airdrop were leaked to investors, allowing them to profit by ‘gaming’ an airdrop at the cost of their portfolio company.
In a financial context, especially an anonymous one (low perceived risk), expect participants to ruthlessly follow incentives. See our recent post on Navigating Shark-Infested Waters. As long as the reward for defecting in a non-iterative game exceeds the cost, it will be rational for participants to exploit on-chain reputation. This is a key challenge to be solved before on-chain reputation is a useful metric for e.g. deciding whether to make an under-collateralized loan.
Identity Establishes Uniqueness, Reputation Determines Trustworthiness
There are some solutions to the Sybil problem. One is to require proof of a government-issued identity to create an on-chain identity. Zero-knowledge proofs make it feasible to prove that the government issued ID
has not been used to verify another on-chain identity
without revealing the information on the government-issued document (name, date of birth, identity number). This makes it more difficult/expensive to perform a Sybil attack - but not impossible as a whale could simply pay people who have no interest in that crypto platform to create and sell their account.
It is worth emphasizing that while on-chain identity establishes the uniqueness of an individual or entity, it does not necessarily reveal their real-world identity. This feature allows users to maintain a certain level of privacy while still participating in the network and building their on-chain reputation.
While on-chain identity is concerned with establishing the uniqueness of an individual or entity within a blockchain network, on-chain reputation focuses on determining their trustworthiness based on their on-chain activities.
An on-chain identity serves as the foundation upon which a user’s reputation is built. As they engage in transactions and interactions within the network, their actions are recorded and assessed, contributing to the development of their on-chain reputation.
In this way, on-chain identity and reputation work together to create a comprehensive picture of an entity's behavior within the digital realm, providing a basis for determining their trustworthiness or suitability for certain transactions.
Some financial products today carry customer suitability requirements based on income, net worth, or product experience. Examples include investment funds which can be marketed only to Accredited Investors, and brokerages which require X years experience investing in stocks (or Y number of trades) before allowing a user to trade riskier stock options. In the future, on-chain reputation can validate that the user meets the qualifications.
Consider also a decentralized lending platform that uses on-chain reputation to evaluate the creditworthiness of borrowers. In this scenario, each borrower's unique on-chain identity allows the platform to track their lending history and payment behavior, while their reputation score reflects their overall trustworthiness as a borrower. By combining these two pieces of information, the platform can make informed decisions about whether to approve loan applications and set appropriate interest rates, ultimately fostering a more secure and transparent lending environment.
We’re a long way from this becoming reality, but in the future it might be sufficiently difficult/expensive (or illegal) to obtain another on-chain identity that it’s simply not worth wrecking your FICO 2.0 by defaulting on a small DeFi loan.
Reputation and Identity in Decentralized Systems
As the world continues to shift towards decentralized solutions, on-chain reputation and identity play an increasingly critical role.
In the absence of traditional centralized trust indicators, such as credit scores or online reviews, on-chain reputation and identity serve as a potentially unbiased, transparent, and tamper-resistant alternative for assessing an entity's trustworthiness.
By providing a quantifiable measure of reliability and trustworthiness based on on-chain activities and interactions, these systems can help create a more secure and transparent environment for various types of transactions, including peer-to-peer lending, e-commerce, and sharing economy platforms.
DeFi borrow/lend has been hamstrung by the need to overcollateralize loans which is capital inefficient. Hybrid solutions have emerged where large borrowers who are judged trustworthy can be whitelisted for undercollateralized (or uncollatearlized) loans, backed by legally enforcable agreements off-chain. Ironically, these borrowers were mostly crypto trading companies, many defaulted in 2022 due to systemic risks: “Past Performance Is No Guarantee Of Future Results”.
Despite these drawbacks, making automated decisions based on on-chain reputation can advance one of the key goals of DeFi: providing financial services to unbanked people around the world. Centralized trust and credit facilities are too expensive to run in some parts of the world relative to the average profitability of a bank customer in that region. Technology can drive down these costs allowing poorer participants to access the financial system.
Individuals with limited credit history or those from underbanked communities may struggle to access traditional financial services due to a lack of established trust. By leveraging on-chain reputation and identity, these individuals can build trust within decentralized networks and gain access to a broader range of financial products and services, ultimately promoting greater financial inclusion and social mobility.
We’ll dive deeper on this topic in our next post for paid subscribers covering:
Current market landscape
The future of on-chain reputation and identity
If you’re interested in learning more about the disruptive potential of on-chain identities, try out a paid subscription.
Disclaimer: None of this is to be deemed legal or financial advice of any kind. These are opinions from an anonymous group of cartoon animals with Wall Street and Software backgrounds.