TrueFi’s $4M Bad Debt in Limbo Shows the Risk of Unsecured Crypto Lending

The Crypto Bear Market Teaches Still-Fedgling Decentralized Finance (Challenge) that banking can be a tough business.

On October 9, TrueFi, a DeFi protocol where institutional investors can take out collateral-free loans, Posted a “notice of default” for the first time since its launch in 2020. The borrower was Blockwater, a Korean crypto investment firm, which allegedly defaulted on a $3.4 million loan payment.

And that’s not the only troublesome loan on the protocol’s balance sheet. On the same day, TrueFi officials warned in a Twitter post that another borrower, Invictus Capital, may default on $1 million loan due Oct. 30; Invictus filed for voluntary liquidation earlier this summer.

TrueFi is already dealing with the fallout from news last month that crypto market maker Wintermute fell into dire financial straits after this lost $160 million in a hack. Wintermute is the largest borrower on TrueFi with $92 million in debt at press time, due to mature Oct. 15. On Sept. 21, TrueFi said its “credit team has had several constructive discussions” with Wintermute, and that it may to find a short-term loan if necessary.

Unlike DeFi protocols like Aave or Maker – where loans are collateralized by more assets than the value of the loan and default results in automatic liquidation of collateral – lenders on TrueFi have no choice but to trust due diligence protocol on borrowers who take out unsecured loans. loans, because there is no collateral to seize in the event of default.

“It’s not too different from the centralized model,” Dustin Teander, analyst at crypto-intelligence platform Messari, told CoinDesk. “You kind of have to trust people.”

TrueFi said its credit group “believes that the loan portfolio continues to remain in a good position”. But the recent revelations call into question the sustainability of the under-collateralized crypto lending business model and its level of decentralization. Borrowers and loans once deemed safe may be riskier than previously thought.

Bad Crypto Loans

Decentralized finance is a new concept – made possible by rapidly developing blockchain technology – which attempts to create a banking system without the need for bureaucracy and trust in intermediaries by deploying computer-coded smart contracts.

This year, automated DeFi lending protocols, including Maker and Aave, have stood out by weathering the crypto market crash – although several centralized crypto lenders, such as Celsius Network and Voyager Digital, became insolvent after making risky loans with customer deposits to crypto companies. DeFi platforms’ requirement for sufficient collateral has proven crucial in their ability to avoid losses.

TrueFi is one of the most prominent practitioners of under-collateralized lending in DeFi. The protocol, backed by major crypto investors like Andreessen Horowitz (a16z) and Alameda Research, creates lending pools where any investor can deposit crypto to earn yield; professional investors – seemingly reputable crypto firms – make up the bulk of borrowers; they can contract loans, at interest.

These loans are unsecured, meaning borrowers do not pledge any of their own assets to secure the loan. The likelihood of the loan being repaid is based on protocol review of borrowers’ creditworthiness – essentially an article of faith.

Therefore, potential borrowers must go through TrueFi’s credit and know-your-customer (KYC) checks and meet capital requirements to apply for a loan. Those who hold TRUthe platform’s governance token, vote to approve or deny the application.

“Defaults are the normal course for this asset class and are critically important in refining risk parameters and pricing over time,” contributor Roshan Dharia, head of lending at Archblock, told CoinDesk. principal of TrueFi who oversees borrower relations on the protocol. “We have historically focused on borrower counterparty risk, asset mix and liquidity profile. These elements of due diligence remain the highest priority as we face continued macro headwinds and a extended bear market.”

TRU’s price has fallen 15% in digital asset markets since Blockwater’s default, although the decline was mostly in sync with a pullback in broader crypto markets. Currently, the token is trading at 4.4 cents, near an all-time low and down 90% in the past year, according to Data by crypto price tracker CoinGecko.

One-stop solutions for DeFi issues

Under-collateralized lenders like TrueFi provided loans when crypto prices and yields were high; it’s a bit like when subprime mortgage lenders issued heaps of loans during the house price boom of the mid-2000s – just before the housing market crashed.

Borrowing has declined on TrueFi over the past year. (Token Terminal)

Knowing the bear market for the first time, these crypto lenders have had to adapt to a new reality, where returns are lower but with greater perceived risks. Returns in Crypto Lending depend on trading volumes rather than central bank-set risks and interest rates, and trading volumes on exchanges declined after many traders exited the market.

“It’s really hard to make long-term loans in a volatile market and expect constant repayment,” said Teander de Messari. “I think the under-collateralized lending model is going to stay,” but “people need to improve risk pricing.”

TrueFi, in anticipation of a non-zero amount of defaults, has incorporated “Default Protection” as backup insurance for lenders. The protocol slashes up to 10% of all staked (locked) TRU tokens to compensate affected lenders.

Default protection, however, currently stands at $1.36 million, TrueFi’s dashboard shows. This is only about a third of the bad debt outstanding on the platform, which is not enough to reassure lenders.

The process isn’t automatic, and the Blockwater loan resolution is “working its way through internal checks,” Michael Bland, Archblock’s senior counsel, told CoinDesk.

Lenders seeking to fully recover their assets are left with a traditional, not at all automated, remedy – hoping that the protocol can negotiate with borrowers to restructure and pay off the bad debt or go to court to liquidate the assets in order to recover them. Legal fees can add up.

According to a TrueFi blog post on Blockwater’s debt default notice, “a possible court-supervised administrative proceeding would lead to a better outcome for stakeholders given the complexity of the sudden insolvency.”

Possible loan losses

If history is any indication, depositors in the TrueFi lending pool could face losses.

Maple Finance, a rival under-collateralized DeFi lending protocol, had signaled on June 21 that it may face short-term liquidity issues and have insufficient cash after Babel Finance, a crypto credit company, became insolvent and defaulted on a $10 million loan. After liquidate the loandepositors in the loan pool suffered losses of $7.9 million, representing a 3.2% discount on the pool’s total deposits of $244 million.

TrueFi’s bad debt of $4 million represents a fraction of outstanding loans of $117 million. What may worry lenders is that the bad debts of Blockwater and Invictus both come from the same loan pool potentially non-performing loans represent almost half of the pool’s $8.4 million in assets.

The TrueFi credit team has been added in a Tweeter that “following active negotiations, the expected recovery value will be maximized on these distressed loans”.

What comes next is that the TRU token holders, who govern the protocol, discuss and vote on how to proceed with asset recovery to mitigate the blow to lenders affected by the default.

How long that might take and how many assets might be recovered remains an open question.

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