Credit default protection
A product that offers default protection to lenders in an undercollateralized loan
Bob has provided an undercollateralized loan to a DAO using a DeFi protocol. He is concerned that the DAO may not repay the loan in full and he will lose money. Bob would like to protect himself against a (partial) default by purchasing a position whose payout increases as the repayment amount decreases.
⚙️ Pool configuration
Bob uses the DIVA App to create a credit insurance product with the following configuration:
Notes:
The Reference Asset is the on-chain bond address.
The Expiry Time is equal to the maturity/grace period end of the bond.
Given the on-chain nature of the loan, the repayment amount information is stored on-chain providing a fully trustless oracle for settlement.
🤝 Sell long position tokens
After creating the pool, Bob puts all long position tokens for sale (1'000'000 in total in our example), for a price of USDC 0.95 each. Alice purchases all long position tokens for a total of USDC 950'000. After the trade, the two parties end up with the following positions:
Bob's net contribution / premium paid for the credit default insurance (short position) after the sale is USDC 1'000'000 - 950'000 = USDC 50'000.
💵 Payoff scenarios
1) DAO has repaid the full loan amount (USDC 1'000'000):
Bob paid a premium of USDC 50'000 but doesn't receive any payout from the short position as the loan was fully repaid: -> net loss for Bob: USDC 50'000 -> net gain for Alice: USDC 50'000 (5.26% on USDC 950'000)
2) DAO has repaid 50% of the loan (USDC 500'000):
Bob paid a premium of USDC 50'000 and receives USDC 500'000 as payout due to partial repayment of the loan: -> net gain for Bob: USDC 450'000 -> net loss for Alice: USDC 450'000
3) DAO doesn't repay the loan (USDC 0):
Bob paid a premium of USDC 50'000 and receives USDC 1'000'000 as payout due to a full default: -> net gain for Bob: USDC 950'000 -> net loss for Alice: USDC 950'000
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