Product Update Issue 5: Collateralized Debt Obligations (CDOs) and UNION

Protecting DeFi Structured Credit

DeFi’s ascendance this year is often a conundrum. On one side, it’s replete with billions of capital inflows and degenerate memes — billed as the newer, shinier, and carousing financial system. On the other side, even though it moves fast and breaks things, it resembles TradFi in many regards.

DeFi has matured from a fledgling corner of an esoteric cryptocurrency industry to its primary character. To accomplish that, it’s taken a few pages from the world of TradFi and enhanced them with more transparency, speed, and memes.

Lending, the godfather of DeFi, captured prospective DeFi entrepreneurs’ attention once the Total Value Locked (TVL) started ballooning. Entrepreneurs soon began unwinding the potential of a composable financial system. Yield farming, on-chain derivatives, and all the crazy accoutrements of an Internet-native financial community followed suit.

We’re now seeing rapid maturation (and resemblance) of DeFi to the best of TradFi financial sophistication. For example, the exploration of capital efficiency improvements since the vast majority of DeFi lending is based on over-collateralization. Or the implementation of option primitives to protect borrower collateral. Or the introduction of structured risk products.

Structured risk products, especially collateralized debt obligations (CDOs) are often misunderstood, much as “crypto” still is to the general public. So, let’s explore exactly what they entail and the opportunity fit for UNION.

TLDR

Collateralized debt obligations (CDOs) will greatly increase the lending capacity of the maturing DeFi space and create opportunities for purchasers to earn active yield.

UNION’s expertise in valuing and offering protection for protocol risk, strong TradFi pedigree and use of TradFi financial models, and liquidity sourcing framework is uniquely positioned to partner with CDO issuers.

By leveraging products already in our roadmap and our role in offering protection, UNION will play an important role in the evolution of CDOs in DeFi.

Unpacking a CDO

A collateralized debt obligation (CDO) is a structured risk vehicle backed by cashflow-generating debt assets like bonds, mortgages, credit cards, and more. Think of CDOs as portfolios of yield-generating assets. By packaging debt into one larger product, issuers of CDOs offer purchasers diversification of risk given the various smaller loans and provide scalable exposure to higher yield instruments. In return the issuers (lending institutions) are able to free up their own balance sheet so they can meet regulatory standards or issue more loans.

CDOs are frequently, if not always, packaged into tiered “tranches,” which offer different risk profiles to investors:

1. Senior Tranche — (Lower yield, lower risk)
2. Mezzanine Tranche — (Medium yield, medium risk)
3. Equity/Junior Tranche — (Higher yield, higher risk)

Senior tranches are typically the most subscribed in TradFi by financial institutions that prioritize principal protection over yield, such as pension funds. Buyers of senior tranches are the last to be affected by defaults within the CDO portfolio.

The Equity or Junior tranches are subscribed by financial institutions that prioritize yield over principal protection, such as hedge funds. Buyers of these tranches are first in line to absorb defaults within the CDO portfolio.

You can think of the equity/junior tranche acting as a layer of protection for more senior tranches.

In addition to the originators, there are numerous other stakeholders that collaborate to ensure a successful CDO, including: collateral administrators that manage collection and payments, financial guarantors that may provide additional loss protection, and rating agencies that rate the CDO.

As the appetite for returns grew, so did the sophistication of CDOs. CDOs are often billed as one of the villains of the 2008 Financial Crisis because even more complex versions, dubbed CDO-cubed (a CDO compromised of portfolio of CDO tranches comprised of CDOs) encouraged an incentive asymmetry that led to a deluge of sub-prime (that is, very low quality) mortgages being underwritten that did not have parity with the risk profile of the corresponding tranche tiers. The resulting financial crisis saw several institutions experience massive drawdowns as the CDOs they held rapidly deteriorated in value.

From TradFi to DeFi

Applied to DeFi, CDOs can be much safer and more effective:

1. Automated liquidation smart contracts that have successfully protected lender solvency from 30–40% drops in collateral
2. On-chain transparency into the securitized collateral and even holding wallets
3. Close to instant settlement of transactions for distribution
4. DeFi access to a wide diversity of assets

For larger capital players (e.g., institutions) looking to enter DeFi without actively managing positions, porting capital between platforms, and taking on more price volatility risk, CDOs prove appealing even to do so.

In DeFi, rather than taking a bunch of debt assets like mortgage-backed securities and packaging them together, a CDO would include tokenized representations of a claim on future cash-flows. Examples of these tokenized representations include cTokens on Compound Finance or LP tokens for liquidity providers on Uniswap.

In many cases, cTokens on Compound, which represent a claim to funds deposited and their respective yield from depositors, sit idly in user wallets. But if DeFi is all about making capital more productive, doesn’t it make sense to unlock the fluidity of collateral of cTokens and LP tokens the same way CDOs unlocked the balance sheet of financial institutions?

Enter crypto-native CDOs, which we will explore through the lens of their integration with UNION.

Protection & Design — UNION’s Advantage

Crafting a CDO in DeFi comes with myriad design choices. DeFi has explicit hurdles (and advantages) not characteristic of TradFi, but it also has some distinct similarities. A CDO in DeFi will need to encompass many of the same features of a TradFi CDO, including:

1. Originating and packaging the collateral
2. Pricing and valuing the CDO
3. Underwriting or wrapping the risk
4. Rating the CDO

In TradFi, the above aspects are typically handled by different entities, including securities firms, financial guarantors, and rating agencies, respectively. However, none of these TradFi operators are currently positioned to evaluate the newer risks of DeFi (such as smart contract or project risk) that layer on top of financial considerations or fully take advantage of DeFi composability to efficiently bundle roles in launching and maintaining a CDO.

UNION is ideally suited to partner with CDO issuers to value, rate, and offer protection to purchasers.

Let’s examine the primary areas of expertise required to create a streamlined CDO service in DeFi.

1. Expertise in grading and valuing DeFi risk
2. Expertise in TradFi
3. Financial tooling for pricing
4. DeFi framework for protection liquidity

Expertise in Rating and Valuing DeFi Risk

In DeFi, rating and valuing risk is a unique proposition. Hastily compiled code for innovative DeFi platforms on permissionless blockchain networks induces lending protocol and smart contract risks, layer one settlement risks (e.g., MEV transaction front-running), and crypto-asset price-volatility risk. Compared to TradFi, these risks mirror counterparty credit risk and collateral risk — key considerations of rating and valuing a CDO. However, they encompass entirely new technology with new attack vectors, pricing models, and risk analysis.

UNION’s platform and product suite are ideally suited to evaluate this confluence of financial and technical risk.

As part of UNION properly valuing smart contract risk, we are already working with auditors and developing our own auditing expertise — using outcomes as inputs into our risk models to create project risk ratings. On the financial front, to calculate Minimum Capital Ratio (MCR) for protection pools and price protection contracts across UNION’s suite, we already ingest and analyze market data from respected oracles to calculate financial parameters such as volatilities.

This manifests with C-OP, our first protection product that sources liquidity from a coverage pool and uses market data inputs for collateral asset volatility on lending platforms wrapped in an American-style put option. The idea of persistently examining risk for UNION products will be extended to the multitude of threats facing DeFi.

Expertise in TradFi

Rating and evaluating a TradFi instrument extended to DeFi would be ineffective without leveraging the TradFi models and knowledge.

On this front, UNION benefits from a deep TradFi pedigree, UNION’s project lead, Michael Beck led software architecture and development at a 14 + billion hedge fund. Our CPO, John Liu, spent 2004–2013 trading and pricing structured credit and credit derivatives at hedge funds, including a $20+ billion structured credit hedge fund.

With team leadership that has accomplished significant milestones in both structured risk modeling and risk management, that’s a boon for imbuing DeFi CDOs with robust TradFi strategies.

Financial Tooling for Pricing

UNION is already well on its way in melding financial instruments with DeFi, as laid out in our whitepaper. This includes credit default swaps (CDS) for measuring event risk and non-linear outcomes — a concept imbued into C-OP and a vital part of calculating downside volatility risk for protection pools underwriting smart contract risk.

For pricing CDOs, one approach is to use intensity-based models for simulating default risk, which is a key factor in tranche pricing. Intensity-based models are the same underlying framework as CDS models, which naturally translates to an optimal model for pricing more volatile crypto assets within a DeFi CDO.

DeFi Framework for Protection Liquidity

To protect against risk, you need capital. DeFi’s most successful avenue for sourcing capital deployment is via the pooled “lazy capital” model consistent with popular DEX’s (Uniswap), on-chain derivatives (Hegic), insurance platforms (Nexus), money markets (Aave), and more.

UNION protection pools are perfect for sourcing liquidity from willing risk-takers. When paired with robust risk controls to protect pool solvency that meets stringent TradFi insurance standards, UNION’s protection pools provide peace of mind for purchasers of CDOs. Throw in the transparency of pool economics, transaction flows, solvency parameters, and automated liquidation of collateral, and the argument for injecting cash-flowing collateral into CDOs within DeFi begins to crystallize.

UNION’s Value Proposition for the CDO Lifecycle

With its distinctive advantages and natural fit for supporting CDO issuers, UNION can play an active role throughout the CDO lifecycle. The potential avenues of application for UNION are:

1. Collateral: Assets being borrowed themselves have embedded protocol risk, which UNION evaluates and protects against.
2. Lending/Liquidity Platforms: While lending and liquidity platforms have their own risk measures, UNION goes one level further and protects against smart contract risk, flash loan risk, and more.
3. Issuer/ Special Purpose Vehicle (SPV): More likely than not, the issuer of the CDO and SPV that manages the CDO would be encapsulated by smart contracts, which UNION would protect against. Furthermore, with deep understanding of risks in collateral and origination platforms, UNION is well positioned to offer enhanced protection for the CDO, increasing the financial strength of the CDO.
4. CDO Tranches: With intimate understanding of the CDO, UNION can provide a grading of the offering tranches based on financial risk and technological risk of the various components laid out in the previous 3 steps. Furthermore, utilizing its financial models for providing protection, UNION can derive an expected value for each tranche. Finally, through its liquidity pools, UNION can source purchasers of the Junior tranche, which acts as partial protection against defaults for the higher tranches.

Roadmap Congruency

As you can see, it was only natural that UNION would offer a DeFi-specific CDO since we were already building all of the necessary ingredients anyway. Our builds to grading and offering protection on CDOs can be easily accommodated into our existing roadmap. Rather than targeting DeFi CDO creation with a siloed toolset and expertise, we have compiled a suite of products, risk modeling, capital pricing, and DeFi-centric governance that accounts for all the vital components of creating and maintaining structured risk products like a CDO.

Critically, we do not need to approach the problem piecemeal via multiple third-parties, only convoluting the process. Instead, we can streamline the process for any prospective CDO issuer.

Our roadmap to providing a comprehensive CDO service for DeFi includes:

1. Engaging with CDO issuers to identify a properly sized CDO, the amount of underwriting needed, and how to integrate.
2. Continue to buildout CDS models (originally intended for pricing smart contract defaults), and expand intensity models for CDO tranching.
3. Assign a growing team of in-house auditors to review CDO issuers as well as projects of the assets being borrowed themselves.
4. Prepare liquidity pool and pricing, from 3rd-party protection (purchasers of CDO independently or those with a view on the success of CDO to buy protection on CDO exposure) to integrated underwriting — work with CDO issuers and include the protection as part of CDO pricing to purchasers.

For DeFi to reach its true potential, it doesn’t (nor should it) need to run antithetical to TradFi at every turn. Yes, the underlying technology is better, the memes are cooler, the innovation is faster, and the atmosphere is livelier, but a melding of both TradFi and DeFi is the optimal path forward.

We look forward to releasing more details about UNION’s CDO Service in the future.

For more info, follow us at:

Twitter: https://twitter.com/unnfinance

Telegram: https://t.me/UNNFinance

Telegram ANN: https://t.me/UNNFinanceANN

Disclaimer: UNION is not an insurance company and UNION does not sell policies of insurance. UNION is not an issuer of of CDOs.