Under-Collateralized Loan

Under-collateralized lending introduces counterparty risk and default risk. Protocols mitigate this through layered structures:

• First-Loss Capital: Junior tranches or stakers absorb initial losses (e.g., TrueFi's TRU stakers, Maple's Pool Delegate capital).
• Legal Recourse: Enforceable off-chain agreements and entity formation.
• Progressive Decentralization: Starting with permissioned borrowers and moving to open underwriting as systems mature.
• Transparent On-Chain History: Immutable repayment records build borrower reputation.

This method assesses creditworthiness by analyzing a user's persistent on-chain history. Key metrics include:

• Transaction history and wallet age
• Protocol interactions and governance participation
• Soulbound Tokens (SBTs) representing credentials
• Sybil-resistance to prevent identity fraud Platforms like ArcX and Spectral generate on-chain credit scores by aggregating this data, allowing lenders to evaluate long-term behavior instead of just collateral value.

Credit assessment leverages a borrower's connections within decentralized social networks or communities. The core principle is that trust and reputation are embedded in social links. Methods include:

• Analyzing followership and endorsements on platforms like Farcaster or Lens Protocol
• Evaluating standing within DAO memberships or contributor roles
• Using peer-to-peer attestations and vouches This creates a web-of-trust model, where a user's social capital can supplement or replace financial collateral.

This approach evaluates a borrower's ability to repay based on verifiable, on-chain income streams. It is particularly relevant for Decentralized Autonomous Organizations (DAOs), NFT projects, and deployer wallets. Assessment focuses on:

• Recurring revenue from protocol fees or royalties
• Treasury management and outflow patterns
• Smart contract-based revenue splits By analyzing these cash flows, lenders can underwrite loans similar to traditional business revenue financing, using future earnings as a basis for credit.

Unlike over-collateralized loans (e.g., 150% collateralization), under-collateralized loans operate with a Loan-to-Value (LTV) ratio greater than 100%. The exact ratio is dynamically determined by the credit assessment method.

• Example: A user with a strong on-chain reputation score might secure a loan worth 120% of their posted collateral.
• Risk-based pricing: Interest rates and LTV limits are directly tied to the computed credit score. This flexibility unlocks greater capital efficiency but introduces new models for default risk management.

Since collateral value is insufficient to cover the loan, protocols employ alternative enforcement mechanisms. Common strategies include:

• Social recourse: Default damages the borrower's on-chain reputation score, limiting future access to credit.
• Future cash flow interception: Agreements can automatically divert a portion of the borrower's verifiable future revenue to the lender.
• Legal wrapper integration: Some protocols use off-chain legal agreements (like a promissory note) that can be enforced in traditional courts, bridging DeFi with real-world law.

Several pioneering DeFi protocols are building infrastructure for under-collateralized lending.

• Goldfinch: Uses off-chain credit assessment via pool delegates and legal agreements to finance real-world businesses.
• Maple Finance: Employs pool delegates to perform due diligence on institutional borrowers for on-chain capital pools.
• TrueFi: Utilizes a staked-based credit model where borrowers are approved based on stakeholder votes and their locked capital. These models demonstrate the spectrum from hybrid to fully on-chain credit evaluation.

A loan where the borrower must deposit collateral worth significantly more than the loan value, typically 150% or higher. This is the standard model in DeFi (e.g., MakerDAO, Aave) to protect lenders against asset volatility and liquidation risk. Key features include:

• Liquidation Thresholds: Automated triggers to sell collateral if its value falls.
• Stability Fees/Interest: Paid by the borrower on the loan.
• Capital Inefficiency: Ties up more value than is borrowed.

A mechanism that allows a depositor (delegator) to delegate their credit line to a trusted borrower without transferring funds. Platforms like Aave V2/V3 enable this. The delegator earns a yield, while the borrower accesses under-collateralized loans based on the delegator's deposited collateral and risk assessment. This introduces trusted counterparty risk into an otherwise trustless system.

Protocols that establish on-chain identity and creditworthiness to facilitate underwriting. These systems aim to reduce anonymity as a barrier to credit. Examples include:

• Soulbound Tokens (SBTs): Non-transferable tokens representing credentials or history.
• Credit Scoring Oracles: Off-chain credit data (e.g., traditional FICO scores) brought on-chain via oracles.
• Sybil Resistance: Techniques to prevent fake identity creation.

The forced sale of a borrower's collateral to repay a loan when its value falls below a required threshold. For under-collateralized loans, liquidation mechanisms are more complex and may involve:

• Recourse to Future Cash Flows: Claiming future income or assets.
• Legal Enforcement: Relying on off-chain legal agreements.
• Liquidation Triggers: Based on specific covenant breaches, not just collateral value.

Uncollateralized loans that must be borrowed and repaid within a single blockchain transaction. They are a unique DeFi primitive for arbitrage, collateral swapping, and self-liquidation. Unlike under-collateralized loans, they carry zero default risk for the lender due to atomic transaction execution, but require sophisticated smart contract logic to utilize.

The process of evaluating a borrower's ability to repay. In DeFi, this is evolving from purely algorithmic (collateral ratios) to hybrid models. Key components include:

• On-chain Analytics: Analysis of wallet history, transaction patterns, and DeFi activity.
• Covenants: Contractual terms that trigger default if breached.
• Underwriting Pools: Groups (often DAOs) that collectively assess and assume borrower risk.