Part II: Building Better Asset-Backed Line of Credit Products
Ways to eliminate margin call risk and make asset-backed line of credit products more appealing
In the previous post, I explained why asset-backed line of credit products will go mainstream this decade. One major drawback of existing asset-backed line of credit products is they introduce margin call risk. That is, if the collateral’s value drops and the loan-to-value (LTV) required by the lender is exceeded, the lender may sell the collateral to maintain the required LTV. Without addressing the margin call risk, the popularity of these products will be muted. I will outline two strategies to remove margin call risk and make asset-back line of credit products more appealing to mainstream users.
Make the Loan and Collateral of Same Type to Maintain the LTV ratio
One way to remove margin call risk is to make the loan and collateral of the same type to maintain the LTV ratio. This way, even if the collateral’s value decreases, the expected loan repayment also falls in tandem, maintaining the LTV ratio.
Let’s use a concrete example to better illustrate this. Suppose, you have 1 BTC worth 100k USD. You want a loan of 50k USD. Now, the lender would give loan you 0.5 Bitcoin or 50k USD. To repay the loan, you’d have to pay back 0.5 BTC at the prevailing price then. Even if Bitcoin’s value plunges 50%, both the loan and collateral move lock-step thus the LTV ration remains constant.
While this approach solves the margin call risk, it introduces uncertainty about loan repayment costs. If the underlying asset appreciates, the amount you need to repay will also increase. Extending the previous example, suppose Bitcoin’s price doubled to 200k USD. The 0.5 BTC you need to repay will now be worth 100k USD even though when you borrowed it was 50k USD.
However, there are built-in mechanisms to deal with this risk. So long you are taking on an over-collateralized loan, you’d be able to repay the loan with collateral that has now also increased in value. In this case, where Bitcoin doubled, your collateral of 1 BTC initially worth 100k USD would be worth 200k USD. You can use that to close your 0.5 BTC loan and regain 0.5 BTC.
Additionally, if the user is willing to take some risk, the lender could use the underlying collateral to sell out-of-the-money covered call options to generate premiums. The downside here is that your upside gets capped as in exchange of receiving premiums you are now obligated to sell at a specific price. Yet, this also will make the loan self-repaying - probably making it a worthwhile tradeoff.
By using this strategy, one is in effect going short on an asset as they have to buy it back later to repay the loan. It would make the most sense in the later part of the market cycle when one thinks an asset’s price has peaked. This strategy enables one to lock in some gains without triggering capital gains tax.
Buy a Put Option to Ensure the Collateral is Sufficient to Meet Loan Obligations
Alternatively, the lender could buy a put option at the strike price matching the amount loaned. This ensures the collateral's value will always be enough to close out the loan if necessary.
So how would this work in practice? Imagine once again, that you hold 1 BTC, which is worth 100k USD. You use that collateral to take a loan for a year for 25k USD. The loan provider would then simultaneously buy a put option expiring in a year at a strike price of 25k for one BTC. Suppose in a year, BTC drops to 20k and the loan isn't repaid. The collateral is worth less than loan amount. But, through the put the lender has a guarantee that they can sell it for 25k to close out the loan without incurring any losses.
This approach will raise the cost of borrowing. Lenders would pass the cost of the put in the form of higher loan interest rates or as higher loan origination fees. There are some ways to offset the costs. Just as with the first strategy outlined above, the loan provider could earn premiums from the selling covered calls using the collateral.
Buying European options which can only be exercised at expiry will also reduce costs. Unlike, American options, which can be exercised at any time between the purchase and expiry, European options can only be exercised at expiry. This makes European options cheaper.
Another limitation of this approach is that it requires deep options markets. While this condition is satisfied for many blue-chip stocks, it doesn’t hold for many crypto assets currently. For example, I checked FTX's options market. The markets for out-of-money puts is very thin. For a 25k BTC put expiring in 8 months, the bid was 1.2k and ask was 2.4k. The wide spread between the bid and ask prices suggest a shallow market. To implement this strategy, the lender might need to set up a separate fund to underwrite put options. More risk for sure, but it could also become a meaningful moat for the lender.
With this strategy, one can lever up and go long on asset. This strategy would make more sense earlier in the market cycle when you believes the asset is under-priced.
Implications for DeFi
Almost all existing DeFi line of credit products don’t address the margin call risk.1 There are a few explanations for this. First, I suspect many have erroneously assumed margin call risk is an inevitable component of asset-backed line of credit products. Second, there hasn’t been any need because current DeFi users don’t mind the margin call risk as they have higher risk appetites and have sufficient financial buffers.
But moving forward, the margin call risk has to be addressed for these products to go mainstream. New users being onboarded into DeFi have lower risk appetites. The crypto-markets continues to remain volatile making the risk of a margin call imminent.
Many users have an aversion to selling their assets to meet their liquidity needs. But existing line of credit products aren’t appealing because they introduce margin call risk. Further, especially in TradFi, accessibility of these products is limited. These products are mainly pitched to wealthy clients.
New asset-backed line of credit products in DeFi which address the margin call risk and provide a frictionless experience will unlock new markets. The space is still wide open. Some great businesses will be built here.
Disclaimer: Nothing here is financial advice. Always do your own research