Mitigating Risk & TrueFi’s Loan Default Process

What happens in the event of a loan default on TrueFi?

All investments carry risk. The best investments typically offer the highest returns at the lowest possible, best understood risks. In the case of crypto investing, certain risks are common across every DeFi protocol, and others are unique to each platform.

This post will briefly explain TrustToken’s approach to common DeFi risk vectors, then go deep on the primary risk to lender & staker funds on TrueFi: borrower default.

It assumes familiarity with TrueFi, the unsecured lending protocol: read our litepaper or watch our intro video to get started, then join our Discord to discuss your questions and feedback on this piece.

Standard DeFi Technical Risk

One of the most common threats to any DeFi protocol is hacking. Whether through a code exploit or using flash loans, a particularly aggressive hack can drain the majority or even all of a protocol’s stored funds.

TrueFi Audits

The most common prevention is rigorous code audits. TrueFi has undergone two deep audits:

• By Slowmist of TrueFi V1 completed on November 21st, 2020
• By ETHworks of TrueFi V2 completed on February 17th, 2021

In both cases, the TrueFi core team received the audit results and solved any major threat vectors in advance of the code going into production, as is our standard. TrustToken is also recruiting an auditor to work on retainer through the launch of V3 and V4.

Limiting Vulnerable Capital

TrueFi is also designed in such a way that only a small minority of the protocol’s assets are ever at risk of attack: when the lending pool’s assets are successfully utilized for loans to borrowers or earning on Curve, they cannot be drained from TrueFi in a direct attack targeting the lending pool.

Generally, the pool aims for a 70% utilization rate, meaning only 30% of TrueFi’s pool assets are possibly at risk of a hack. It should be noted, however, that relying on Curve for boosting returns on unloaned capital exposes TrueFi lenders to vulnerabilities in Curve, specifically on TUSD-supporting pools.

TrueFi Platform Risk: Borrower Fails to Repay Loan

In an effort to prevent loan default, the TrustToken core team and TRU holders work hard to select the most reputable borrowers, vet them deeply alongside a robust community of TRU holders, and ratchet up loan size or length conservatively. Once completing KYC and now also undergoing a financial review, borrowers sign an enforceable loan agreement and have their wallet address whitelisted.

In case of default, TrueFi’s planned response is public and legal. In the case of a confirmed loan default, the TrueFi community will be alerted of the default across all community channels. Simultaneously, legal action will be initiated against the delinquent borrower, aimed at collecting on the loaned capital and interest. The delinquent borrower suffers immediate reputational damage, and possible legal damages for breach of contract, on top of collections action.

Preventing Loan Defaults

To date, prevention of default has been extremely successful: TrueFi has processed almost $100m of uncollateralized loans with prompt repayment and a 0% default rate. Here is how TrueFi approaches prevention of defaults today:

Restricting Borrower Type

At present, TrueFi’s borrowers are among the most public and sizable institutions in crypto.

This is by design: large, long-standing institutional borrowers with public profiles are likely to be the safest and largest borrowers, while simultaneously incurring the greatest reputational cost in case of default.

Though TrueFi is exploring retail and even protocol-to-protocol lending, we believe that institutional borrowers are the safest beachhead market with which to start offering unsecured loans. This is especially true in terms of amount borrowed vs borrower risk: while a single institutional loan on TrueFi starts around $1m at arguably low risk (based on historical repayment rate), it may take dozens or hundreds of retail borrowers to reach this amount of borrowed capital at an acceptable risk profile.

Examples of current borrowers include crypto hedge funds like Alameda Research and exchanges like Poloniex, though we expect other types of institutions and non-crypto players to participate in the medium term.

Borrower Due Diligence & Loan Requirements

Receiving a TrueFi loan demands a number of steps, with unique checks and balances, including a regulatory review, a community feedback phase, signing an enforceable loan agreement, and finally submitting a loan requested that will be voted on by TRU holders. The steps are outlined in detail here and explained below.

KYB Compliance: To become whitelisted as a borrower on TrueFi, every applicant must complete a Know Your Business review, which simultaneously removes the borrower’s veil of anonymity and guarantees the protocol and borrower alike remain compliant. Though KYB is currently carried out by TrustToken, Inc, TrueFi is built to allow other KYB providers to eventually service this step in the onboarding process.

Credit Committee: Upon receiving approval from Compliance, the Borrower will be asked to provide certain diligence items for financial review by TrueFi’s internal Credit Committee. The purpose of this analysis is to ensure the borrower meets the protocol’s minimum financial standards including adequate collateral coverage, asset liquidity and allocation. Additionally, the credit review process includes a high-level wallet analysis and risk profiling with respect to their trading behavior and interaction with third-party protocols. This committee is intended to pave the way for an on-chain credit model and full community governance, which may make the Credit Committee obsolete.

Community Feedback: Once approved by KYB and our Credit Committee, the borrower must persuade the TrueFi community of their creditworthiness with a forum post, in which they outline their business, historical and financial record, and plans for the funds. Community members may ask for more details before submitting a vote in favor or in opposition to whitelisting the new borrower. Borrowers with a majority “Approve” vote move to the next phase.

Enforceable Loan Agreement: As a condition of the Master Loan Agreement that each borrower signs before any loan is approved, the borrower agrees to the settlement of all disputes related to the loan will be settled via binding arbitration governed by the laws of the State of California. In addition, as part of the borrower onboarding process, the Credit Committee assesses the place of incorporation of each borrower and rejects loans to borrowers located in jurisdictions where the Credit Committee believes enforcement of the terms of the Master Loan Agreement would be impossible.

Wallet Whitelist: Once approved by a community vote, the borrower’s wallet is whitelisted to begin making loans. Only one wallet is whitelisted per borrower at a time.

Loan Request Requirements & Vote: At this time, borrowers must place loan requests one at a time, each subject to community approval. To be eligible, the loan must meet the lending pools criteria for size, length, minimum APY, and risk profile — which would be modifiable by governance in future — and also attain enough votes from TRU holders who are in favor of the loan requests.

It’s only after completing all of these steps that a new borrower is allowed to withdraw their requested capital from the lending pool.

A robust credit model is being developed for launch with V3 that will offer voters much more detail on a borrower’s risk profile and creditworthiness, which may allow any redundant elements of the process to be eliminated.

Restricting Loan Scale-Up

TrueFi allows borrowers to increase their loan size in a slow, deliberate fashion, at approximately 1.5x of the previous loan size.

In addition to limiting the growth in size and time, TrueFi also requires borrowers to repay any pre-existing loans before being able to receive the next loan.

Growing the Number of Borrowers & Outstanding Loans:

Finally, TrueFi also reduces concentration risk to the portfolio by steadily increasing the number of borrowers active on the platform. Through borrower diversification, each active loan makes up an ever smaller proportion of the lending pool, meaning any default represents a smaller net loss for the pool.

Responding to Loan Defaults

In the end, while TrueFi takes precautions against loan default — to date, with 100% success rate of repayment — it is wise to prepare for a default well ahead of it happening.

In case of default, TrueFi will follow this protocol:

Liquidating TRU Assurance to Repay Lenders

By staking TRU, stakers assume the risk of partial liquidation in case of loan default, currently capped at 10% of the total staked TRU.

At the time of default, at most 10% of staked TRU is liquidated to refill the affected lending pool. The liquidation price of TRU is set through Chainlink price oracles, guaranteeing the fairest possible outcome for lenders and stakers alike.

The value of the liquidated TRU is transferred into the lending pool affected by the default, in the asset that is delinquent (i.e. denominated in TUSD, for the TUSD Lending Pool).

Absorbing Lending Pool Losses

Following TRU liquidation, the value of the delinquent borrower’s loaned capital (denominated in a loan token originally priced at “loan principal” + “interest to date”) is set to 0. This adjustment negatively impacts the value of the lending pool and is reflected in the respective pool token.

In the case of the TUSD pool, the loss would be reflected in a decrease of the value of the tfTUSD lending pool token, proportional to the value of the delinquent loan. The loss would be felt evenly across all tfTUSD holders.

You can learn more about the slashing process on our Github.

Announcement & Legal Action

Defaults on TrueFi are public events: if a loan is not repaid at the end of its term, it is clearly represented as past due in the TrueFi dashboard. Loans past due are considered delinquent, triggering losses and liquidation on the platform, but also kicking off a community and legal process to make the TrueFi community aware of the default and to attempt collections through the enforcement of the signed loan agreement.

At present, the communication and legal enforcement function are largely handled by the TrustToken core team. In the future, these functions may be provided by a nonprofit foundation acting on behalf of TRU holders. Also planned is a process for putting the loan agreement on-chain, making it simultaneously transparent and immutable.

The borrower’s wallet address may also be blacklisted from TrueFi, preventing any further loan requests from being made.

In Case of Successful Collections against Delinquent Borrower

Under the current design, if the platform successfully collects funds from delinquent borrowers both lenders and stakers can be made whole in case of default, though in different ways:

Lenders are made whole by Stakers: up to 10% of staked TRU will be liquidated to compensate lenders for losses suffered due to a loan default.

Stakers receive the collection of the defaulted loan: the defaulted loan tokens are transferred to stakers after liquidation, and upon successful legal action against the delinquent borrower, the collected funds are used to pay back the delinquent loan tokens.

As an example:

1. Let’s say the TrueFi-TUSD lending pool makes a loan of $5m to a borrower that defaults (the “Lenders” are owed money)
2. Up to 10% of TRU from the staking pool (the “Stakers” assets) will be liquidated to make the TrueFi-TUSD lending pool whole.
3. The tokens representing the defaulted loan are transferred to the stakers liquidated in step 2. These tokens are now worth less than they would be if the loan did not default.
4. The legal process to recover the delinquent funds commences. Let’s assume that the delinquent borrower pays back the whole $5m plus interest. That money is used to compensate the defaulting loan tokens that are held by the TRUstakers who made the TrueFi-TUSD lending pool whole during liquidation. If the legal process recovers less than the amount of the defaulted loan, TRU stakers could suffer a loss.

Securing the Future: Safeguards being Developed

While today’s risk assessment and response has been successful for TrueFi so far, two major additions to the protocol and its governance are certain to make TrueFi an even more robust, safer place to lend and borrow.

The TrueFi Credit Model

Building a more robust, composable credit model — one that simultaneously achieves a borrower’s desire for privacy and speed, a lender’s desire for a deep review of creditworthiness and risk, and is diversified enough in its data and providers to be consistently reliable — is not an easy job.

That said, TrueFi is already making progress on this front with its Credit Committee that actively reviews borrowers and loans, while also developing a standalone model fed by diverse on and off-chain data streams — likely without exposing the underlying inputs (i.e. token holdings, leverage exposure, self custodied and exchange wallets) to the public.

The TrueFi credit model is expected to arrive in V3, but early elements of the model are already being used to assess incoming loans.

Loss Protection through the TrueFi SAFU Fund

Originally proposed by a TRU holder, a SAFU Fund would offer some protection against unexpected losses incurred by TrueFi users. Beyond offering practical assurance against outsized damages, the TrueFi community believes a sort of “community insurance fund” would grow trust and lower loss anxiety for new TrueFi users.

As of writing, the SAFU Fund is partly funded (through a company token grant from TrustToken), but is only just being designed, and we welcome your input in the TrueFi forum.

In Conclusion

Once more: every investment that offers return, also carries risk. The best type of risk to take on is risk one both understands well, and can ideally mitigate. We hope this post helps all TrueFi users and TRU holders understand their exposure — and hopefully, invites them to make suggestions on how to make TrueFi even safer, more lucrative, and appealing for new lenders and borrowers.

Tell us what you think about the risks and returns of TrueFi on Twitter or our Discord today — we’re looking forward to your ideas!