Credit is a funny thing. Most of the financial world revolves around it. America’s credit card debt hit a trillion dollars in Q2 this year.
Of course, by definition, credit is underpinned by a notion of trust: trust in your counterparty, trust in the intrinsic value of what you’re borrowing or lending to remain stable for the duration, trust in the legal system to protect lenders when things go wrong.
And yet, when it comes to decentralised finance, trust is considered a weakness. As a subfield within cryptocurrency, we’ve managed to inculcate “don’t trust, verify” as a core way of looking at the world: even though it would appear that several major players in crypto are failing to (although, in fairness, this is a tale as old as time, not unique to us).
In response, Ethereans (and appreciators of every other smart-contract enabled chain out there) built out infrastructure that is overcollateralised as a default — we don’t need to trust anyone or verify anything if it’s impossible to juke your counterparty because you stand to lose more than you gain! The most popular lending markets work this way, and they work well.
Of course, a decentralised lending market that is undercollateralised — or heaven forbid, uncollateralised — loses that assurance, and becomes a de facto credit facility instead. Given that DeFi operates in a pseudonymous, adversarial environment, who would willingly use that?
The thing is, we believe that undercollateralised credit is a great application for DeFi. Lending instruments — as boring as they were next to all of the bubble-mania shitcoinery of the 1700s — made modern finance happen.
Overcollateralisation is desirable when you can’t know your counterparty, but comes with the bladed edge of constraining growth.
But, if you know who you’re dealing with? Then you’re off to the races. Look at the last bull market.
Of course, a counterpoint to that weak justification is that we’ve subsequently learned that that bull market was mostly spurred by a game of pass-the-parcel of loans with an empty box at the end. Most of these loans were off-chain, though: papered up by lawyers for their respective counterparties, then placed into a drawer and forgotten about until the tide rolled out and showed everyone up as swimming in the nude.
What if you could monitor the health and status of a similar arrangement on-chain, though? What if everyone could?
Several solutions for undercollateralised on-chain credit provision exist already, but in our opinion they’re too close to the action.
They certainly provision the infrastructure for credit in terms of smart contracts, and perform the service of connecting risk-seeking capital (lenders) and borrowers to each other, where each party might not otherwise know that the other exists. This is extraordinarily valuable.
With that said, these platforms often also engage third-parties that act as underwriters and credit risk analysts, retain powers such as freezing activity in a given credit pool or liquidating any up-front collateral in the event of default, and go so far as to dictate the interest rates and credit limit of borrowers who are deemed worthy.
In our opinion, this hall-monitor presence is constraining the freedom to contract for parties that are perfectly capable of acting responsibly, and forcing a third-party into an agreement that should otherwise be between a borrower and lender alone.
We believe this is dissuading agreements from forming on-chain that otherwise would. The court system is quite happy to get involved when it comes to loans involving digital assets. That’s the same level of recourse that most parties to a loan agreement receive off-chain.
And so, we arrive at Wildcat.
The extent to which we — in our role of operating Wildcat — are involved in any given credit arrangement between a borrower and their lenders is at the very first stage: deciding which entities are allowed to act as borrowers.
The key question from our perspective is a qualitative one to start, but fundamentally boils down to: is the damage that a borrower would do to themselves by not respecting their lenders while using Wildcat greater than the amount that they could reasonably take out on credit and default on? If so, we’re likely to permit them. We’re not touching Americans though, consider yourselves protected.
Beyond this, we figure that the goings-on between borrowers and lenders in their relationship are none of our business at all. It’s not our place to tell a borrower that they can’t request a credit line for PEPE, or what their response time should be in terms of honouring a request for funds to be returned before they should start paying a penalty.
The demand for credit itself is inelastic, but the circumstances surrounding it very much are: the motivations and requirements behind each credit line are different, and we’d rather leave participants alone while they decide what’s best for them. To that end, we’ve automated as many components as we can, removing the role that third-party oversight plays in the actual day-to-day processes of maintaining a credit line.
With that said, the freedom afforded to borrowers via arbitrary parameter control needs some form of reining in, so in the process of automating everything we’ve provided some guardrails to lenders, who assume the bulk of the risk in a trusted credit relationship:
- There are bounds on the freedom a borrower has: they can’t create a credit facility that is fully uncollateralised, there are minimum penalty rates for borrowers who are tardy in honouring withdrawal requests, and a borrower can’t deploy a market where that penalty only kicks in after a ludicrous amount of time such as a year.
- Withdrawals are handled in such a way that multiple lenders within a single withdrawal cycle are treated identically, and lenders who request a withdrawal in earlier cycles must be attended to before those in later ones. There’s no queue-jumping for preferred lenders.
- A borrower is free to reduce the interest rate of their market at any time, but depending on the degree of the reduction, elevated amounts of reserves may be required to be locked into the market for lenders to withdraw against for a short period of time.
- If the unlikely event that a lender in the same market as you is sanctioned by, e.g. OFAC, markets utilise an efficient mechanism for quickly excising their debt obligations and assets from the wider market, allowing you to continue to use it without fear of being tainted by strict liability.
As we alluded to above, cases involving default on digital assets are already readily handled by the legal system. One of the ‘off-chain’ features of Wildcat is the presence of a master loan agreement that a borrower must pre-sign if utilising Wildcat through the user interface. Lenders can countersign this when first interacting with a market if they wish: it defines conditions of default on the borrowers part, as well as setting out the jurisdiction and process to be followed in the event of general conflict.
Beyond this, our approach is that of Uatu the Watcher: we’re interested, and we’re watching, but we will not and cannot interfere.
We built Wildcat because we trust market participants to engage in agreements that work for them, believe that undercollateralised lending within digital assets needs more freedom than currently exists, and think that there’s only upside for bringing their terms into the light for all to see.
We’re looking forward to seeing its uptake, and the degree to which flexible credit agreements that otherwise wouldn’t exist on-chain start to appear.
If you have any feedback, we’d love to hear from you.