# FTX Fallout Implications for the DeFi Lending Space

In this article, we cover how the recent FTX fallout impacted DeFi lending. More specifically, we call out some of the risks that came to light post-FTX while also providing some ideas/solutions on how these risks can be mitigated in the future. We remain very optimistic about the DeFi lending landscape — it’s time for us to come together and buidl!

### Issue 1: Contagion Risk​

Carapace’s offering for protection sellers includes a diversified pool of loans/loan baskets in order to minimize contagion risk. But is that really possible in times of extreme cycles / black swan events? Some illustrative examples to consider -

#### Potential Solutions​

• Compile data standards around borrower-level data that we will need to collect — especially for one being added to the Carapace pool.
• Include information on backer/loan manager/delegate and specifically the incentives/fee schedule on offer to them. Especially important to get clarity from credit protocols on what happens in the event of default. While the Carapace core team will not take a view on what is good or bad, we should aim to be transparent and capture + pass on this information for our protection sellers.
• Push more borrowers to undertake pool covenants as done by Cauris here

• ### Issue 3: Re-hypothecation Risk​

Sherlock lost >$4m in their ~$10m staking pool as they had invested a large proportion of funds in Maple’s Maven 11 pool. As seen in the case of Sherlock, investment management is a hard job — and a very specialized one too. While Sherlock did communicate to their users about investing in Maple, there was limited information on how this investment would occur, and in which pools. In addition, stakers did not have any control over how these funds were invested so they were only able to make a decision on whether to stake or not stake their funds in the Sherlock pool. Due to not raising the expected amount of capital for their pool, Sherlock ended up in a scenario where funds were invested across 2 protocols despite earlier intentions to invest in 4 protocols.

#### Potential Solutions​

• Re-hypothecation strategies should be geared around choice for the users to make decisions on where their capital is being invested. Where possible, best to get professionals to manage these pools. Early indications suggest that Sherlock will adopt some of these practices going forward.
• Communication is key when it comes to clarifying the risk involved in re-investing customers’ assets.

• ### Issue 4: Borrowers lying/misrepresenting facts​

As alleged by Maple and Maven11, Orthogonal Trading lied about not being impacted by FTX. In fact, Orthogonal Trading did not provide any indication that they would default on their loan until one of their repayment dates on Sunday 4th Dec. There are additional allegations that Orthogonal might have lost more money in riskier trades in an attempt to recover the lost funds (Note: this claim has not been verified).

However, the key concern coming out of this incident is that borrowers can lie/make up data and it is unclear whether this will lead to any legal action against Orthogonal. Maven 11 has stated on Twitter that Orthogonal has breached the contract but it is not clear whether Orthogonal will face penalties as a result of the incident.

#### Potential Solutions​

• Standardization of the liquidation process (if collateral exists)
• Clear litigation frameworks to tackle such scenarios
• Ability to access as much on-chain collateral data as possible.

• ### Issue 5: Borrowers borrowing from multiple protocols​

As seen from the example of Auros, they ended up borrowing on Clearpool as well as Maple. For both protocols, they ended up requiring extensions in December from both protocols to return their loan. There was no requirement for Auros to be transparent about their borrowings across protocols and lenders. Thus, one protocol might never become aware of an entity’s borrowings from another protocol

#### Potential Solutions​

• Building tools that capture a borrower’s credit activity across multiple protocols and ensure that no one borrower makes up a significant concentration within a pool or even the protocol as a whole)
• Communication channels between various protocols to ensure there is transparency across the board regarding an entity’s borrowing activities

• As you can see from some of the examples above, under-collateralized lending is still in its building phase and the industry will need to build these solutions (and more) to tackle some of the challenges in the space.

That’s the only way we’ll see DeFi lending and borrowing go mainstream. We are Carapace remain very bullish on this space and are building protection against default risk for under-collateralized loans. You can visit us at https://www.carapace.finance to learn more!