On-Chain Lending — with Tezos

Borrowing and earning USDtz, BTCtz, XTZ and more

There are many ways for individuals to profit from the USD Tez ecosystem. I’ve previously described an On-Chain Savings account smart-contract that operates like a Savings account that generates returns of 3% APY. This article will present a few new instruments that will be available in Year 1 of USD Tez. First, we’ll take a look at one of the building blocks of many instruments to come — On-Chain Lending.

Soon you’ll be able to take out a loan in USD Tez, either by collateralizing your USD Tez On-Chain Savings position or by collateralizing your Tezos non-fungible tokens (NFTs). You’ll also have a new way to make profits, by buying and flipping seized NFTs from borrowers that had permanently defaulted on their loans.

Scenario: Say you’ve invested in a bunch of non-fungible real-estate tokens (perhaps issued by Elevated Returns), and most of your remaining cash is locked in your crypto-trading portfolio. Your funds are all locked up.

Now let’s say you need some free cash; maybe you need liquid cash to pay your rent or utility bill, or maybe you want to buy more XTZ because you believe it will have a big bull-run this weekend.

How can one borrow money in the Tezos ecosystem? The answer to this is especially important to cryptocurrency traders who spend day and night keeping the veins and arteries of the Tezos financial ecosystem aflow. For traders especially, borrowing in the Tezos ecosystem opens the door to margin trading; enabling traders to take larger positions on their choice investments than they otherwise could with their own available liquid cash alone.

Long-term, these are the building blocks for many other financial instrument possibilities in the Tezos ecosystem. This article will touch on those topics later on as well.

What On-Chain Lending offers are, in principle, are 2 main things:

Lender repayment is guaranteed — By the end of the smart-contract, lenders will get paid the money they are owed one way or another Borrowers have no need to complete a credit check—The liquid net value of the collateral pledged by the lender is given a formally verified appraisal through a binding on-chain pre-loan auction

In accordance with our values, we want lending to be free and easy, but we want to avoid the tricky-practices of predatory lending that lead to the subprime mortgage crisis and nearly collapsed the global economy, as well as avoid any magnifications of debt through nebulous investment vehicles that leverage debt and speculation to afford more debt that’s covered by more speculation. (Phew!)

Nay, rather we want a healthy Tezos financial ecosystem built on solid ground, in which the terms of lending practices are publicly readable and in which remittance is guaranteed in arithmetic terms that can be formally verified on the blockchain.

One thing we need to make sure never happens is this:

So, how do we do it?

Introducing: On-Chain Lending

On-Chain Lending enables users to borrow money without a central trusted intermediary nor with an invasive underwriting process; all the terms of the loan are covered/collateralized for automated remittance triggered by contingency mechanisms written into the smart-contract, and thus all risks are hedged no matter who the borrower is. This works even better than the traditional bank method since a bank can only presume remittance, not guarantee it, despite their invasive and expensive underwriting processes.

There are two collateralization methods (and thus, two different smart-contract types) enabling ways to borrow USDtz with On-Chain Lending:

Borrower Collateralization Decentralized Collateralization

Either collateralization method can refer to On-Chain Lending since all end-to-end borrowing and lending contingencies are covered within the smart-contract. Borrower Collateralization is the simpler of the two methods and will probably be the most common; it is simply a smart-contract between two parties — the lender and the borrower.

Type 1: Borrower Collateralization

Alice (the ‘Borrower) needs a loan of USDtz from USD Tez Foundation. USD Tez Foundation (the ‘Lender’) sets the terms of the loan, which requires interest payments to make it worthwhile. The Lender also requires Alice to pledge collateral for the loan, to be included in the smart-contract, in case Alice defaults on the loan.

Alice has a Savings bond with USD Tez

Alice happens to have a USD Tez Savings Bond/smart-contract, which she established the day prior. She decides to pledge the Savings Bond as collateral for her loan.

Borrower proposes a loan and pledges her Savings bond as collateral for that loan

However, for Alice’s loan request to be approved and then issued as a smart-contract, the Savings bond must be large enough (mathematically) to cover Alice’s potential debt in case Alice default’s on her payments — that is, the Savings bond Alice pledges, if seized by the Lender, must be large enough to cover the principal loan amount, plus the maximum interest Alice owes, assuming the worst-case scenario (in which Alice takes the money and runs).

Assuming Alice’s pledged Savings bond is large enough, Alice’s loan request will be accepted and the Lending smart-contract will be issued.

The pledged collateral would cover Alice’s default and so the Loan proposal is accepted

If Alice returns the borrowed sum with interest to the lender, then the smart-contract completes its duration with all desired conditions satisfied; Alice keeping her Savings bond, and everybody wins.

The smart-contract is in effect for the set period of duration

If, however, Alice defaults on her loan beyond repair, then the lender (USD Tez Foundation) would seize the Savings Bond that Alice pledged as collateral, thereby getting repaid in another way. Pretty simple.

Type 2: Decentralized Collateralization

The simpler form of decentralized collateralization is for the borrower to get the agreement of a 3rd party (friend, or family member) to underwrite the loan in a formal fashion — that is, to lock-in a collateralizing deposit in the same smart-contract; that is, a smart-contract guarantor. The 3rd party would do this based on trust and could end up losing money in the process.

Assuming the borrower does not have a Savings Bond to pledge as collateral (or doesn’t have one that’s large enough to cover the requested loan terms), and has no one to formally underwrite them based on personal trust, a loan can still be issued from the lender to the borrower, through a process requiring another form of on-chain collateral (e.g. a non-fungible-token).

This is where on-chain lending truly starts to demonstrate a revolutionary improvement over prior off-chain practices, which stretch back through the entire history of banking.

The lender still needs assurance from the smart-contract that the lent amount plus interest will be paid in full.

If the lender were to follow traditional (off-chain) banking practices, they would be setting themselves up for an attack. Under a mere ‘blockchain-ified’ version of the old system, to profitably attack the lender, all a borrower would need to do is coordinate an inflated price for an NFT, collateralize that NFT, borrow against it, and intentionally default on their loan. Even though the lender would end up seizing the NFT, the NFT may sell on the open market for even less than the amount lent (and lost). Under this open-ended method, recovery for the lender is not certain, let alone formally-verifiable.

For this reason, even if the lender accepts the NFT of the would-be borrower, the lender must not be the one to collateralize the NFT, because the lender cannot trust the face value of that NFT.

Rather, the borrower would turn to a decentralized collateralization method, in which the NFT is given a formal appraisal, and contingency purchase agreement; free-market-competing 3rd parties collateralize the presumed future seizure of a non-fungible-token. Here’s how it works:

3rd party participants would compete with one another as bidders in a pre-loan auction of the NFT. The winner of the pre-loan auction becomes the Guarantor and commits to purchasing the NFT at the winning price, but only if and when the borrower irreparably defaults on the terms of their loan. This way, not only is the NFT given a fair appraisal, but the lender can have formal verification of their exact amount and timing of repayment before the loan smart-contract is issued. The 3rd party Guarantor is paid a small yet incentivizing monthly fee for their services, even if the Borrower never defaults.

Couldn’t an attacker just scam the 3rd parties? An attacker could try to do so. However, the free-market competitive nature of these auctions will foster an ecosystem of support, resources, and knowledge that will appraise NFT values far more accurately and discerningly than a single party (the lender) ever could. The bidders are financially incentivized to accurately determine good collateralized NFT assets from bad ones, protecting themselves and the ecosystem along with it. In fact, the Guarantor activities of Decentralized Collateralization of on-chain-loans will likely become a large industry sub-sector in and of itself, which will spur capital resources and talented professionals to innovate an ever more competitive arsenal NFT evaluation.