DeFi Lending Replaces Credit Scores with Overcollateralization

On-chain lending has disrupted traditional credit systems by eliminating the need for banks, scores, and loan officers. Instead of relying on credit history and income, lenders use overcollateralization, where borrowers deposit crypto worth more than what they borrow.

This system works without trust due to mechanical enforcement rules encoded in smart contracts. If a borrower's collateral value drops below a threshold, an automated liquidation mechanism sells part of it to repay the loan, protecting lenders from losses.

Protocols like Aave, Compound, and Zest Protocol on Bitcoin (BTC) have extended this model across multiple chains, with total value locked in DeFi lending exceeding $40 billion as of mid-2026.