RociFi’s Immunity to Bank Runs

Jul 13, 2022

Terra and Celsius meltdowns provide another datapoint to showcase DeFi’s superiority to TradFi and CeFi approaches to under-collateralized lending and risk management.

Currently, CeFi is struggling to flush the system of bad loans, leading to bank runs and liquidity crises. Both being driven by wildly over-leveraged speculative bets and CeFi lenders’ belief that reputation and KYC-only, uncollateralized loans were a good idea.

RociFi addresses these risks in its protocol design.

We have talked ad nauseam about how reputation-only, under-collateralized lending does NOT work. They fail when your borrower goes insolvent, e.g. 3AC. Additionally, the legal recourse provided by KYC is only effective when your borrower is solvent or senior debt lien has priority. When the aforementioned does not occur, the legal recourse isn’t worth the paper that it’s printed on and has identical recovery rates as ‘social recourse’ loans in the event of default.

Thus, RociFi’s social recourse is identical to reputation-only/KYC lending in both good times and bad, i.e. borrower distress, especially when uncollateralized. Actually, social recourse is superior given it damages a borrower’s reputation onchain, and bans them from participating in RociFi
and eventually all of DeFi and Web3, forever. This becomes incredibly powerful as onchain reputation becomes more valuable in the future.

RociFi’s on-chain scoring, i.e. credit risk score is from 1 to 10 with 1 being the lowest and 10 the highest. The score is generated by an intuitive credit model of the wallet’s historical on-chain behavior and decentralized identity (DID) credentials to generate an expected probability of default. The platform further insulates risk by having a robust rate strategy and common sense credit limits per unique borrower.

Since stablecoins cannot be easily spent (a core function of USD) in the real-world, they are typically reinvested in crypto which creates a self-reinforcing build up of deadwood loans and speculative bets on the collateral which underpins those loans. This cycle of build ups and burndowns will continue if it’s not addressed in protocol designs.

The Terra and Celsius meltdowns highlight the dangers of operating pseudo-central banks and pseudo-retail banks incorrectly. These two very different approaches effectively led to the same outcome: bank runs.

Let’s call Terra bank run Scenario A andCelsius Scenario B.

1. Terra was a very experimental complex system from the beginning which few people knew how it worked out in the wild (the Terra team even resorted to turning the blockchain on and off on several occasions).
2. Celsius started with a simple traditional ‘loanable funds’ retail model but it rehypothecated investors’ deposits into highly speculative DeFi and CeFi strategies creating massive balance sheet complexity which tripped it up.

A bank run is a classic example of Prisoner’s Dilemma. It would be best for the system if every individual depositor didn’t withdraw their funds but as trust, transparency and, also, understanding breaks down, herd mentality takes over and bank runs accelerate.

To avoid Scenario A bank run where the system is so complex that not even the core team can fix it, RociFi’s protocol has circuit breakers to avoid multiple system failures happening at once

• The RociFi smart contract architecture is a set of loosely coupled internal components with the minimum of hard dependencies between them. This allows for RociFi’s various smart contracts to connect with those of external DeFi protocols and primitives without being reliant upon any one of them.
• We aren’t trying to ‘stabilize the system’ with price pegs and issuing a stablecoin.
• Every asset-storing contract is equipped with circuit breakers which allow protocol admin or DAO to pause it and disable any money transfers.
• To mitigate attacks on funds we have abstracted the code of the bond contract (a critical component) away from any one owner.

To avoid Scenario B where customers’ funds are reinvested in products so complex that risk compounds on the protocol’s balance sheet leading to a system collapse, we have taken a leaf out of the TradFi manual.

In TradFi, banks flush big loans such as mortgages from their balance sheet on a regular basis. In other words, they bundle them into tranches based on risk and maturity, securitize and sell them on secondary markets. One such example is mortgage-backed securities.

The primary tool RociFi uses to avoid a Scenario B bank run is its debt token. The innovation of RociFi debt tokens is that they enable the co-mingling of loans of the same risk profile into one pool (or portfolio), i.e. bundled loans with different maturities, interest rates and collateral but with the same credit risk score, which can be sold on a secondary market AMM. The aforementioned describes a “decentralized bond market” which is the first ever in DeFi.

The debt token bond market allows RociFi to offer depositors no-lockup period on capital without introducing bank run risk. Furthermore, as secondary trading of debt tokens becomes more liquid, it will provide a free-market signal of expected lending pool default rates by trading behavior of debt tokens, i.e. price fluctuations, which will be used to decentralize the credit scoring over time.

Celsius’ speculation using customers’ deposits without having any of the TradFi circuit breakers in place or clearing any of those loans, quickly turned them from an asset to a liability on their balance sheet.

RociFi debt tokens allow lenders (and liquidators) to periodically clear the RociFi system and their individual balance sheet by selling their loans on AMMs outside of RociFi (decentralized bond market). Debt tokens give users control over their loanable funds, thus transferring responsibility and risk to the individual rather than threatening the system as a whole.

Other ways RociFi mitigates balance sheet points of failure:

• There is a global borrowing limit across assets which caps the amount of borrowing per day, as well as per user, on RociFi.
• Debt tokens are tokenized (tradeable) loans which have secondary market liquidity outside of RociFi. This allows lenders if they wish to ‘cash out’ of their loans earlier than the maturity date or are nervous about market conditions.
• Our smart contracts and debt conditions are open source, so anyone can call out fraudulent users and risky over-leveraged borrowers, or investigate the solvency of the system.
• Our fraud engine which contributes to the Non-Fungible Credit Score (NFCS) has been trained by a database of millions of transactions from hundreds of thousands of wallets to detect spurious users.
• The value of under-collateralized loans issued will never exceed the reserves deposited for that particular asset.

The best way to avoid cascade effects from internal and external market shocks is to educate our community on how the system works, provide onchain verifiable solvency, and continue to build a robust credit system that ultimately becomes antifragile.

This is the ongoing purpose of our technical articles. Join us on this continuous journey of iteration and education. After launch, RociFi’s debt token trading will be supported by AMMs across Polygon.

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RociFi: Under-Collateralized Credit Protocol on Polygon