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 -
Issue 2: Reliance on Delegate / Lead Backer model
Criticism includes Mismanagement of Funds + Lack of Skin in the game
Several protocols work off a model where one of the parties — typically a sophisticated credit investor — assesses the quality of the loans and is considered to be the lead party conducting due diligence. In return, they receive economic benefits and also stand to lose if the loans end up defaulting
In the Maple example, one of the delegates, Maven 11 allowed Orthogonal Trading’s loan to make up 80% of their pool in Dec 2022 (from 14% in Sep 2022). This happened because other borrowers returned funds to the pool which were being withdrawn by lenders. However, this sort of scenario which concentrates this amount of risk on one borrower should have been avoided. One of the criticisms from the incident has been that the stakes aren’t high enough for lending pool managers like M11 which will end up losing <500k on default of over $30m for this incident.
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.
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.
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
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!