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.

Bob uses the DIVA App to create a credit insurance product with the following configuration:

Notes:

  1. The Reference Asset is the on-chain bond address.

  2. The Expiry Time is equal to the maturity/grace period end of the bond.

  3. Given the on-chain nature of the loan, the repayment amount information is stored on-chain providing a fully trustless oracle for settlement.

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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