Background:
As we enter another crypto bull market, the supply of crypto-native lending has radically transformed following the demise of Genesis, Celsius, BlockFi, Babel, Voyager, et al. Lending to crypto trading firms previously accounted for >90% of crypto lending volumes and based on our estimates still accounts for >95% of volumes even when including the recent $800m+ in T-Bills on chain as “lending”. Nascent market infrastructure creates market fragmentation, which drives inefficiency and the demand for credit to equilibrate exceedingly profitable arbitrage opportunities. This results in very high demand for capital efficient funding solutions that TrueFi was historically able to provide to Lenders at scale. Unfortunately, while this vertical proved to be one of the most profitable, without proper risk controls it was fateful, with various recoveries still pending.
The days of reputation-based DeFi lending have lamentably damaged what, by our proprietary data, has been a particularly accretive lending vertical (albeit at times radically mis-priced) with an attractive mix of market depth, high yields, and high liquidity for on-chain investors. In the ashes of Genesis, Cicada was created as an on-chain credit risk manager to service this market, promote transparency and efficiency in crypto lending.
Credit, staking rewards (the usage-based kind), funding rates, and arbitrage are the only REAL yields in crypto. TrueFi’s battle-tested smart contracts, decentralized governance, and modular infrastructure are well positioned to recapture what we expect will be a multi-billion-dollar TVL opportunity over the next year.
Proposal: Protocol Credit Risk Manager
The purpose of this proposal is to establish the role of Credit Risk Manager and to facilitate non-custodial lending services for market neutral trading firms and funds on top of TrueFi infrastructure. The Credit Risk Manager will support the DAO by structuring and underwriting non-custodial lending deals, supporting the pricing and creation of vaults for market neutral borrowers to drive TVL growth.
In particular, the Credit Risk Manager will source, filter, underwrite, onboard, and manage borrower credit risks on behalf of the DAO. As needed, the Credit Risk Manager will also provide industry market analysis and research to support the DAOs efforts to drive improved value accrual to TRU without taking undo credit/macro risks.
Finally, in structuring deals for the DAO, it is the Credit Risk manager’s responsibility to prepare and administer off-chain legal documentation.
Why Lend to Crypto-Natives?
Some market participants are quick to argue that the last cycle proved unsecured lending to crypto-natives is simply unworkable due to the perceived credit risk involved. We believe this to be an emotion-driven reaction to the fraud and capital misallocation of the prior cycle and we have extensive research and data to back up these claims that we are happy to share with the community over time.
Our data-driven approach yields the following conclusions: (1) Aggregate industry probabilities of default are not dissimilar to unsecured single-B rated default rates. Secondly, (2) when adjusting for simple improvements in due diligence, probabilities of default radically improve given the severity of loss at a few previously “reputable” firms. Lastly, (3) using conservative ‘21/’22 loss rates as a long-term indicator of industry risk, the current supply gap of crypto-native financing yields an estimated 300-400bps spread over a fair value risk-adjusted yield based on our ‘21/’22 estimates for loss given default (“LGD”) and traditional credit valuation-adjustment modeling.
Problems with Existing Lines of Credit
Reputational lending is fraught with danger, particularly within crypto where negative selection is particularly perverse due to generally low barriers to entry. Price rarely equals value and the number of Twitter followers has no bearing on character, capacity to pay, or conditions of a loan. During ‘21/’22, our team repeatedly witnessed a massive disconnect between credit risk and yield paid by “reputable” firms. This includes but is in no way limited to Alameda and the existing market for lines of credit is no different. With borrowers able to anchor pricing at chosen levels and investors left in a black box on true underlying credit risk, a DAO representative is needed to arrange the responsible growth and use of Lines of Credit.
Next, utilization curves don’t really work for both borrowers or lenders. Yields based on utilization curves are exceedingly volatile, reducing cost of capital visibility and requiring operational maintenance on a near daily basis. This poor borrower experience can be extended to non-volatile rate environments where borrowers have the opposite problem—access to too much capital when they need it least—and lenders earn exceedingly poor returns on capital for the credit risk.
Secondly, a curve with a utilization kink at 85% creates an immediate, material performance drag for any experienced credit manager, and generally results in a remarkable underpricing of credit risk. This is a cost borne by all parties, but particularly lenders.
As a hypothetical example, if 10% is a fair risk-adjusted yield for single-B credit risk of 500 basis points (bps) over a 5% discount rate, borrowers would need to pay 11.8% (10%/85%) to adequately compensate lenders for uninvested capital. But at 10% yield, lenders would only receive an 8.5% return, resulting in 30% (150bps/500bps) of the credit risk premium being eaten away by the utilization curve before even accounting for fees or transaction costs. Equally troubling, the higher fair risk-adjusted yields, the higher the potential performance drag and the greater the potential to misprice credit risk.
Further, while instant liquidity is helpful in normal times, during periods of market stress, when liquidity is most required, utilization curves have time locks at 99%. So, while probabilistically low, the time when lenders need liquidity most will be the time when utilization curves will disappoint lenders. Conversely, the time when you’ll want to lend least to a borrower will be the time when utilization spikes and liquidity dries up.
In short, lenders misprice credit risk and pay an onerous premium in normal times for liquidity they’re unlikely to have when they really need it because when liquidity dries up, default risk spikes.
Finally, Lines of Credit suffers from a cold start problem. Lenders require a representative to negotiate attractive rates or borrowers will launch unrealistically priced vaults that are never filled.
Solution for Lines of Credit
The Credit Risk Manager will play an integral role in bringing borrowers to TrueFi, negotiating terms on behalf of lenders, restructuring the utilization curve to provide a better borrower-lender experience, and actively manage borrower credit risk to optimize for zero defaults and high risk-adjusted returns for lenders.
First, we will leverage our expertise in pricing unsecured lending risk, using our CCR Pricing Model that blends two underlying data sets: (1) a historic, stress-tested loss given default model for comparable credit risk and (2) an empirical or relative valuation approach based on corporate credit spread data, adjusted for liquidity and duration. The estimated credit risk is imputed into a credit spread and then added to the 4-Week trailing average DeFi Risk Free Rate, which we aggregate and publish here.
We propose to have a flat interest rate model (illustrated in the ALOC graphic) that optimizes a fixed risk-adjusted yield, over 30-180-day facility tenors.
Lenders will benefit knowing there is a DAO representative with expertise in evaluating and pricing credit risk, and recommending tenors. Lenders will no longer rely on reputational lending, and returns will be less susceptible to short-term fluctuations in the supply of stablecoins.
Borrowers will benefit from greater visibility into their cost of capital and reduced onboarding frictions.
Why Cicada?
Cicada is an on-chain credit risk management company. We facilitate the growth of institutional lending on public blockchains by managing credit risk for non-custodial lenders. We will add value to the TrueFi ecosystem via the following:
Differentiated Experience: The team has extensive crypto-native lending expertise, having underwritten >$850m in loans on Maple and Atlendis since ’21 to an industry-leading 1.2% default rate.
Strong Track Record of Risk Management: During ‘21/’22 our pool on Maple finance demonstrated exceptional performance in a challenging market environment with a >5 Sharpe Ratio and >9 Information Ratio when benchmarked vs. Treasuries and the BB-Credit Index (and excluding MPL rewards). Further, despite a lucrative underwriting relationship, we pushed and persuaded Maple leadership to close the single-borrower Alameda credit pool, against lender wishes, with no skin in the game, and leaving profits on the table.
Pre-Screened Pipeline of Borrowers: We have identified >$300m in high quality credit demand across 20+ borrowers at attractive 13-15% real yields.
Amplify Business Development Efforts to Drive TVL: Cicada’s initial go-to-market strategy will support re-purposing the Lines of Credit product to better serve borrower adoption. We will bring seed capital to vaults and will plan to work closely with Wallfacer on an L2 partnership push.
Remuneration Model
Cicada requests a 1/3rd base grant and 2/3rds performance grant from the DAO to drive the launch of multiple Lines of Credit on TrueFi as follows:
- Base Grant: 3M TRU tokens, 30% front-loaded, remainder vested over 6 months.
- TVL-Based Performance Grant: We recommend three tiers of TVL-based performance compensation. If aggregate TVL across Cicada underwritten vaults exceeds $10/25/75M as outlined below, TRU rewards step up by 1/2/3M, respectfully.
- Vaults Underwritten: Additionally, we recommend three tiers of underwriting-based performance compensation.
- To align incentives, but lock in a reasonable range of TRU-based pay for both sides, we’d request to get paid in a fixed amount of TRU tokens between $0.025 and $0.1 per TRU, with TRU amounts increasing (decreasing) to match the floor (ceiling) below (above) $0.025 per TRU token ($0.10).
Final Thoughts
The founding team at Cicada has watched from the other side of the bleachers as TrueFi infrastructure has been built out modularly, to the needs of Asset Managers. While other protocols have taken radically different architectural, governance, and marketing approaches to scaling open-source software, we have been particularly impressed with the community’s ability to execute and deliver on the vision throughout the bear market. From the development of Asset Vaults to Index Vaults, the ecosystem provides additional tooling we look forward to integrating into our core business, but for the sake of this proposal and solving TrueFi’s cold-start problem, we propose a targeted strategy focused on Lines of Credit, with a plan to expand the scope of engagement to Index Vaults over time.
Sincerely,
Cicada Partners
