A Practical Tale of Decentralized Finance — Part 2 — Debt
This article is not in any way to be taken as financial advice. It is simply my opinion of how financial systems may work in the near future.
Also, I am not a computer scientist, technologist, programmer, etc. The following is my assessment from a practical standpoint…how I think the system will work. If the current technology does not allow for the exact narrative I play out, please understand this is where I think it can go.
If you’ll remember from Part 1, our investor, Alice had invested in a real estate fund called JREF. Instead of receiving only the standard stack of paperwork, she had her ownership denoted in Security Tokens. Instead of the investment being highly illiquid, she was able to list some of her tokens on a Decentralized Exchange when she needed some cash to pay for her daughter’s wedding.
Maybe, instead of selling some of her shares to pay for her daughter’s wedding, Alice wants to try to take out a loan. She has very nicely performing assets, and doesn’t want to lose their potential.
If she goes to a bank to get a loan, they might charge a high interest rate since she is now less liquid than she used to be. They see her real estate investments, but know that those won’t work as collateral since it would be costly for them to take those assets if she were to default.
Again, Alice can go to a DeFi company such as Bloqboard, which is built using the Dharma Protocol for lending. Dharma protocol stipulates the manner in which loans can be entered into, paid, collateralized, etc. on the Ethereum Blockchain.
Alice determines that she wants a loan of $50,000 (currently it would most likely be denoted in Dai). An underwriter might determine that her JREF tokens are pretty stable and have some value, and that she would have to put up 50,000 tokens, valued at $1 each, as collateral. That underwriter would send the information — amount of loan requested, interest rate, collateral being pledged — to Bloqboard, and state his/her reputation as an underwriter on the ability of Alice to repay the loan.
Brian, now looking to lend instead of purchase, determines that he is ready to make a little interest on his liquid funds. Traditionally, there are several ways to earn interest rather than just growth on investing in an asset. Brian could put his money in a savings account at a bank, and currently earn far less than 1% annually. He could put his money in a Certificate of Deposit (CD), to earn a bit more, depending on the length of time his money is locked up. Of course, as he does this, the bank is going to take his money, pool it with others’, and make loans, earning far more interest than they are paying.
Brian can also buy bonds — US, Municipal, corporate, junk — and get paid interest based on the amount of risk he is taking. The higher the chance of default, the higher the interest rate. The nice part of investing in bonds is that they do have liquidity. Brian can buy the bonds to earn the interest, and he can later sell the bonds if he needs the cash, or if they have gone up in value and he wishes to capitalize on them.
Since Brian is an accredited investor, he can invest in a BDC — Business Development Company — that specializes in offering debt. In this investment, the BDC accepts Brian’s money, along with thousands of others. The BDC then makes or buys loans according to their Investment Policy Statement. They may issues loans in developing countries, buy mortgages, etc. Brian and the other investors receive a regular distribution based on the profitability of the company.
The BDC investment is good for Brian because professional managers will have potentially hundreds of millions of dollars at their disposal, and probably have a great history of profitable loans. The downside for Brian is the illiquidity of the investment.
Brian could also pool his money with others in a newer type of arrangement. LendingClub, Prosper, and others have become centralized companies that allow individuals to offer their funds for loans, and allow those seeking loans to apply. LendingClub takes care of the underwriting and collection of the loans, as well as all the marketing for finding the borrowers.
Brian decides finally that he wants to try being a lender in a decentralized platform like Bloqboard. He agrees to lend up to $50,000 worth of a cryptocurrency, in this case DAI since it is a stablecoin attempting to maintain the value of $1. Brian is approved as a lender, and offers his loan.
Now, on Bloqboard, Brian has agreed to lend up to $50,000, and Alice has requested to borrow $50,000. Her terms are 6% interest, paid monthly, for 60 months, with her JREF tokens offered as collateral. The software matches Brian and Alice, and the loan agreement is finalized. Brian and Alice haven’t met, don’t know about each other, never have to talk. Brian has simply entered that he is a willing lender, and the terms he would like. Alice has asked to borrow, and the underwriter has taken her terms to Bloqboard. The software essentially takes care of everything else.
This debt contract now creates its own token known as a debt token. It is basically a non-fungible ERC token — a Smart Contract. It stipulates that Alice’s wallet will pay Brian’s wallet 6% monthly, and the remaining principal at the end of 60 months. If at any point there are not enough funds in the wallet to pay, the underwriter will force the income she receives from her JREF token to pay the interest. At the end of the 60 months, if there is not sufficient DAI in the wallet to pay back the principle, the underwriter will enact a transaction to transfer the JREF tokens from Alice to Brian.
Just as with any loan, there are fees to be paid. The underwriter is receiving a small fee for assessing Alice’s collateral, putting the terms together, holding the collateral, and making certain the loan is repaid. The underwriter is also pledging his reputation, which is part of the immutable Blockchain ledger. If an underwriter has a poor history of underwriting loans that are not repaid, the reputation may keep him from pursuing further transactions.
The relayer or market — in this case, Bloqboard — receives a small fee for providing the market that allows Alice’s request and Brian’s offer to find each other. In the future, different relayers may specialize in different markets.
An important feature to note is that Alice does not know the loan is from Brian, and Brian doesn’t know he is lending to Alice. Actually, the Smart Contract that denotes the agreement doesn’t note their names either. It simply notes wallets that they each control (hopefully).
So now, this could be the end of our story…Alice has her investment in JREF, and has borrowed $50,000 to pay for her daughter’s wedding. She is going to pay interest at a stated amount each month, and the principal in full at the end of the 60 month term.
Brian is making 6% from his $50,000 investment, and will be completely repaid in 60 months. He knows that there is collateral to back up the loan, and that, if interest rates move up, he will have his principal back to make another loan at higher rates.
Keep in mind that this has all happened, in theory, without the need of a bank or many of the other expensive, high-priced players that traditionally would be needed to facilitate the transactions.
Now we will add some additional players, and see where we end up. Check out Part 3 — Multiplying, Funds, and Derivatives.
