Decentralized Undercollateralized Credit Markets

      Introduction

      Credit markets are critical to any economy, including the crypto economy. DeFi borrowing and lending is more efficient, accessible, and transparent than traditional lending markets, but it lacks real-world use cases as most platforms offer overcollateralized loans. It is more efficient since it is code-based and does not rely on the human mistakes and slow processes. It is more accessible because it is available 24 hours a day, seven days a week to everyone. And it is transparent because the information is stored publicly on the blockchain and can be audited by anybody.

      TrueFi is an undercollateralized loan protocol for institutions. The first undercollateralized loan was issued in November 2020, shortly after being launched in Ethereum. However, TrueFi lenders encountered some scalability issues because transaction fees were sometimes higher than the loan’s expected annual yield during network congestion. As a result, in July 2022, TrueFi launched on Optimism to provide a faster and cheaper experience to the community, thereby improving capital efficiency in lending and borrowing.

      Overcollateralized vs Undercollateralized Loans in DeFi

      Before granting you a loan, the lender will want to know that the borrower can repay it. As a result, many of them require some form of security, and any monetary asset accepted as security by the lender is referred to as collateral.

      The majority of the DeFi ecosystem is anonymous and permissionless. As a result, lenders face significant issues in pricing and managing risk, as they must ensure repayment without depending on credit scores and prior due diligence on the borrower, as is the case with traditional finance.

      This issue was first addressed by DeFi lending protocols, which required strict overcollateralization, often ranging from 1.25 to 3 times the loan amount depending on the underlying volatility. Excess collateral has several significant drawbacks, including the fact that credit is only available to those who already have capital; it doesn’t care about credit borrowers’ financial health or reputation since users, institutions, or DAOs with a lot of money and a good reputation can borrow on the same terms as anyone else; and locking up such a large amount of value is an inefficient allocation of capital.

      Over-collateralization protects the lenders, whereas a low collateral ratio improves the borrower’s borrowing ability and, as a result, the system’s overall usability. Undercollateralized loans provide borrowers access to a larger pool of capital, while lenders gain access to a pool of debt-based yield with a higher annual percentage yield (APY) than other sources. The obvious issue here is that DeFi wallets are anonymous and have the ability to steal borrowed funds at any time.

      What is the Use Case for TrueFi?

      TrueFi’s lending protocol is designed for institutions. As previously stated, having access to debt is not harmful if used wisely, and institutions can use debt to expand their operations or investments.  

      Assuming a company is looking for a $100,000 loan, it has two options: overcollaterization or undercollaterization. 

      In the first scenario, if the collateral ratio is 1.5 times the loan value, the business owner must provide $150,000 of collateral to be granted a $100,000 loan, for example. This company could borrow $100,000 without putting up any collateral in the second scenario, which is the scenario for a TrueFi borrower. This is possible due to the protocol’s credit assessment mechanisms, which we will investigate further below.

      How does TrueFi work? 

      TrueFi Participants

      TrueFi ecosystem has five key participants: lenders, borrowers, TRU stakers, the TrustToken team and independent portfolio managers.

      Similar to any other loan, there is a lender who loans the money and a borrower who receives it. In the case of TrueFi, lenders have access to private credit as an asset class, allowing users to generate yield while being confident that credit managers are undertaking due diligence, and borrowers have more efficient access to capital after passing the KYC procedure.

      TRU stakers are the first ones to be liquidated in case of default and in exchange are rewarded with TRU tokens and fees generated by the protocol. They can also vote on loan requests, indicating their creditworthiness on TrueFi’s credit prediction market. 

      How does TrueFi work
      Image link: https://truefi.io/static/TrueFiSalesDeck-c2f891499335c955778b643ae04159bb.pdf

      There are two types of portfolio managers that are in charge of all underwriting decisions in their pools. TrueTrading is the team managing the DAO lending pools and is responsible for conducting a borrower analysis to determine credit quality and ensuring adequate credit support exists for the protocol’s lenders. Portfolio managers are independent portfolio managers that configure their lending pools.

      Lending Pools 

      TrueFi lending pools connect lenders and borrowers. The APY will vary based on the pool’s use; pools with more significant usage earn higher interest rates, resulting in greater yields.

      DAO-managed Pools —> The pools are permissionless and managed by TrueTrading, who act as pool delegates with credit expertise.

      Lenders can join lending pools by depositing stablecoins and are free to leave at any time as long as sufficient liquidity supports the transaction. To assure pool liquidity in the absence of a lockup period, an exit fee proportionate to the number of stablecoins in the pool is charged.

      TrueFi Capital Markets —> third parties, such as portfolio managers or borrowers, can use TrueFi Capital Markets to launch pools tailored to their specific needs. On TrueFi Capital Markets, there are currently two types of Capital Markets pools available: 

      • Managed Portfolios—> lending pools that can be configured and managed by third-party managers. Managers are responsible for developing the portfolio’s strategy and controlling loan terms (such as interest rates) and other factors such as pool size, maturity date, portfolio fee and lender restrictions.
      • Single-Borrower Pools —> portfolios with a single borrower and an interest rate determined by a programmable curve.

      The Process 

      The loan application process can be broken down into four steps:

      • Onboarding —> Borrowers in TrueFi must be white-listed institutions with at least $10 million in assets under management to be accepted. To achieve this status, borrowers must complete KYC, a financial review, and sign a master loan agreement. 
      • Loan Terms —> Loan terms must be defined by portfolio managers based on metrics such as the borrowers’ credit score.
      • Approval —> The borrower’s loan application must be approved by the community through voting.
      • Funding —> Once approved, the borrower can make a funding request and must repay the loan through the app at the end of the term.

      The flow used by TrueFi to issue loans is depicted in the image below:

      TrueFi Process
      Image link: https://truefi.io

      What happens in case of Default? 

      If the borrower defaults on an overcollateralized loan, the lender can sell the collateral and use the proceeds to pay off the portion of the loan that was lost. This, however, is not possible with an uncollateralized loan like TrueFi.

      TrueFi automated the default process by relying on a default-handling SAFU (Secure Asset Fund for Users) mechanism. This SAFU smart contract is in charge of dealing with all bad debt accumulated by the protocol, and it was initially funded by TrustToken team (10 percent of company tokens), and all funds will go towards covering defaults. 

      When triggered, the SAFU smart contract will reduce staked TRU tokens by up to 10 percent of the default amount. If the slashed tokens’ value is insufficient to cover the default, the SAFU will use its funds to help repay the affected lending pool for lost funds. Lenders will be at risk if the value from SAFU is insufficient to cover the remaining default value. 

      TrueFi’s Performance

      TrueFi has currently issued a total of $1.68 billion in loans and a total value locked at the time of writing equal to $326 million.

      TrueFi Performance
      Image link: https://app.truefi.io/loans

      We can glean some interest insights from the list of active loans: 

      • Amber Group received the oldest active loan in February 2022, with a value of $38.44 million and a term of 180 days. 
      • The most recent active loan was issued to Nibbio in July 2022 for $5.28 million with a term of 60 days. 
      • There are currently 11 active borrowers who have borrowed a total of $279.62 million. 
      • Wintermute Trading is the most active borrower, having lent $92.05 million at 8.73 percent.
      • Amber Group is the second largest borrower, borrowing $65.86 million at interest rates ranging from 9.23 percent to 9.35 percent.
      • Alameda Research is the third largest borrower, borrowing $51.27 million at interest rates ranging from 7.02 percent to 7.15 percent.
      • The first three largest borrowers account for nearly 75 percent (74.8 percent) of all loans.

      On the liquidity side, 85.8 percent of the deposits have been borrowed, leaving $46.38 million in cash available for loans.

      TrueFi’s TVL

      TrueFi TVL, as shown in the image below, increased until the end of 2021, when the overall crypto market began to experience a bearish sentiment. It is currently facing a contraction due to the global economic situation.

      The ATH was in August last year, with the TVL hitting over 1 billion dollars. Currently, it is around $300 million.

      Image link: https://defillama.com/protocol/truefi hideMcapChart=true&hideEvents=false

      TrueFi’s Value Accrual 

      TrueFi does not accrue any value with DAO-managed pools since all interest rates are shared with lenders and TRU stakers and there are no protocol fees. 

      TrueFi creates value by charging various fees based on the pool type: 

      • Managed Portfolios —> Whenever a lender funds a pool, the protocol levies an annual fee of 0.50 percent. 
      • Single-Borrower Pools —> When a lender withdraws, the TrueFi protocol’s treasury receives 0.05 percent of the withdrawal amount.

      Trade-offs 

      TrueFi’s yields are higher than those of the majority of other lending protocols, reflecting the greater risk associated with providing undercollateralized loans as opposed to overcollateralized loans, as well as the need for trust that the borrower will not default and that credit managers are accurately assessing risk.

      TrueFi seeks to limit this risk by whitelisting respectable institutions with at least $10 million in assets under management and more than 10 to 15 times the requested amount, and by allowing the community to “veto” loan terms determined by credit managers before funding a loan.

      Credit managers attempt to mitigate these trust issues by conducting extensive due diligence prior to loan approval; however, these borrowers must complete a KYC and provide financial documentation in order to do so. 

      A further trade-off is the exit fee, which ensures sufficient liquidity in the lending pools and allows lenders to withdraw their funds whenever they desire or require, as opposed to a predetermined locking period. It usually performs well, but in severe bear markets, most liquidity gets removed.

      Finally, In undercollateralized loans, the credit score is an essential factor that aids credit managers in establishing loan terms and penalizes defaulting borrowers. Nevertheless, it should ideally allow the community to vote on a borrower’s ability to repay the loan and aid in reputation management, but it is now run and stored off-chain.

      Comparing Undercollateralized Lending Protocols 

      TrueFi, Maple Finance, and Clearpool Finance are all KYC-required institutional undercollateralized lending protocols, with TrueFi and Maple offering fixed interest rates and Clearpool offering variable interest rates.

      The credit risk analysis processes used by the three protocols differ. TrueFi utilizes community-based voting. Maple relies on professional credit analysts to assess and approve loans. Clearpool requires approved borrowers to stake a percentage in order to be considered for a loan.

      It is also important to note how each of these protocols ensures that the pools have adequate liquidity. TrueFi and Clearpool do not have a lock-up period, whereas Maple requires a 90 days locking period. TrueFi accomplishes this by, as previously stated, charging an exit fee.  

      Finally, Maple does not charge interest on loans, only Loan Establishment Fees, whereas TrueFi charges 10 percent of the interest generated by the protocol’s lending activity to share with stakers and charge a protocol fee of 0.5 percent to managed portfolios and Clearpool charges 5 percent.

      Tokenomics 

      TRU, TrueFi’s native token, is used to perform three main functions: 

      1. Earn staking return —> 10 percent of interest rates
      2. Governance —> TRU stakeholders evaluate new Borrowers for creditworthiness and vote on loan approval. TRU holders also have a say in the overall direction of the TrueFi platform. 
      3. Assure TrueFi against default —> provide loan coverage in the event of default (up to 10 percent of all staked TRU) 

      TRU is an ERC20 token with an initial supply of 1.45 billion. It has a yearly inflation rate of around 26 percent used to pay out rewards. It is currently trading at $0.09, has a market capitalisation of $48.03 million, and has a circulating supply of around 770 million.

      At the launch, the TRU token allocation was the following:

      Given that a significant portion of tokens are allocated to parties other than the general public, the continuous inflow of tokens upon completion of the respective vesting schedule can threaten to keep TRU sell pressures high.

      Final Thoughts

      TrueFi is committed to providing credit markets to institutions, even though undercollateralized loans are still in the experimental phase and are continuously evolving for the better. Lenders have access to private credit as an asset class, while borrowers have access to capital more efficiently. 

      Moving to an Ethereum rollup to provide users with a cheaper and faster experience while leveraging the mainnet’s strong security guarantees was a wise decision. This will increase the transaction volume and attract more lenders with limited capital who cannot afford mainnet fees. Optimism is the second layer two by TVL and the first in terms of fees generated.

      Every day, the blockchain space evolves, and new competitors appear out of nowhere. There are numerous new DeFi undercollateralized loan protocols, and this is a race worth following.

      About The Author

      Catarina Urgueira

      loves doing technical research about crypto and spread knowledge about it. She has a Master Degree in Computer Science, and has been involved in the crypto space since 2018 by working as a blockchain developer for Vodafone Group. She recently joined Three Sigma, an engineering, research, and investment company focused on improving Web3. Catarina has a strong interest around the infrastructure side of the crypto space, you can follow her on twitter: @cate_urgs