TLDR: Default risk is one of the biggest problems in lending, and DeFi loans are not exempted. At Umoja, we use effective strategies like tokenized RWAs to handle default risks and protect lenders. We discuss these strategies in this piece.
When a lender provides financing to a borrower, they face the possibility of the borrower not repaying the loan. This is called the default risk, a situation in which a borrower defaults on a loan.
According to the Federal Reserve Bank of St. Louis, the default rate on U.S. commercial and industrial loans peaked at 5.5% in February 2021, up from 1.7% in February 2020.
What if the borrower decides or cannot meet the repayment terms? How can you protect your investment?
These are valid questions that every lender should want answers to providing liquidity. This article will delve into default risk, how it works, and how we handle it at Umoja Protocol.
Default risk (default probability) is the probability that a borrower will fail to promptly and fully pay the principal and interest of a loan according to the loan terms. It is one of the credit risks lenders face when they provide financing; default and loss severity are the two components of credit risk.
According to a report by the Federal Reserve Board, credit risk is one of the financial institutions’ most significant risks. Credit risk is the potential for a lender to lose money when financing a borrower; it is the probability that the borrower will fail on their obligation.
According to the International Finance Corporation’s (IFC) report on Private Sector Credit in Sub-Saharan Africa, default rates on loans in the region vary widely depending on the country and sector. The report also notes that “default rates tend to be higher in sectors that are more exposed to economic shocks, such as agriculture and small and medium-sized enterprises.”
However, measuring default risk is complex, as it involves predicting the borrower’s future actions using present factors. The question remains, “How can we determine what a borrower intends to do in the future?”
Note that the measurement of default risk is usually probabilistic; it involves using present factors to forecast what will happen in the future. That said, the level of default risk depends mainly on the borrower’s capacity.
Borrower’s capacity refers to the borrower’s ability to make timely and complete debt payments. It is one of the five Cs of credit analysis that financial institutions use to assess a borrower’s creditworthiness.
The other four Cs include character or credit history, capital, collateral, and loan conditions.
Character or Credit history: the borrower’s reputation based on record for repaying debts
Capacity: the ability to refund debt payment
Capital: the borrower’s overall financial strength
Collateral: asset pledged to the lender as security against credit exposure
Conditions: the general conditions of the loan, including interest rates and principal amount
The borrower’s capacity is influenced by many factors, which are the significant factors that contribute to default risk.
Borrower’s financial health: Generally, borrowers with a lower amount of cash flows, cash reserves, or assets relative to debt are less creditworthy
Economic cycle and industry conditions: External economic conditions can affect a borrower’s performance. Inflations and macroeconomic downturns can cause an increase in their default risk.
Currency risk: High volatility within the currency market can cause a significant impact on a borrower’s creditworthiness
Political factors: political issues like war, corruption, or regime change can make it difficult for borrowers to meet their obligation
Sector-specific risk: Certain sectors, such as agriculture and small businesses, may be more vulnerable to economic shocks, leading to higher default rates.
These factors are compounded in emerging markets because of the following:
Economic instability: Emerging markets may experience more volatile economic conditions, which can make it difficult for borrowers to meet their debt obligations
Political instability
Weak legal systems: Weak legal systems can make it difficult for lenders to enforce contracts and recover assets in the event of default.
Currency devaluation: Emerging markets experience currency devaluation more often than developed countries introducing another factor that can lead to default risk
Umoja aims to democratize loan financing for MSMEs in Africa by providing affordable financing for borrowers and low-risk and flexible investment opportunities for lenders. We understand that traditional DeFi lending methods like overcollateralized loans are not sustainable in emerging markets like Africa.
Apart from raising the cost of loan financing, overcollateralized loans increase the barrier to entry. But, traditional DeFi lending platforms use methods like over-collateralization to mitigate default risks. Therefore, a major question a lender might have is, “How does Umoja defend against default risk?”
In this section, we’ll cover our approach toward default risk and all the strategies in place to help us manage credit risk.
Umoja depends on several stakeholders, including lenders, collateral providers, insurers, and borrowers, to maintain a hyper-crowdsourced financing model. What this means for lenders is more collateral securing their capital against default risk — simply put, more security.
Our lending process has five stakeholders instead of the traditional two.
Learn more about how the Umoja Protocol work here. Liquidity providers are the least exposed to default risk because their capital is protected by the loan collateral and the Junior Tranche investor’s capital. On the other hand, backers limit their risk exposure with the Collateral Pool. The Collateral Pool offers optional loan protection that Backers can rent to reduce risk exposure and protect their capital.
Stakers provide default insurance to protect collateral providers by limiting their risk exposure. The Default Insurance pool crowdsource staked tokens.
The rule is that if the protocol’s default percentage exceeds 14%, the Default Insurance Pool will reimburse Collateral Providers for all capital they have lost until the protocol-wide default rate is back to (or lower than) 14%.
The Borrower’s KYC (Know-Your-Customers) and KYB (Know-Your-Business) provide loan underwriters with the necessary information to approve loans.
Umoja employs UID (Unique Identification) as the identification method for borrowers. The UID is an NFT that represents each borrower’s KYC and KYB.
Umoja’s IOU tokens are tokenized RWAs that offer investors high investment flexibility. As an investor, you can invest in RWA tokens with the risk exposure you’re comfortable with.
For example, if you prefer a low-risk position, $uLP tokens are low-risk RWA tokens protected against default risk. On the other hand, $uBP tokens are variable risk RWA tokens; their risk exposure is higher than $uLP. But that also means that they get more APYs than $uLP.
By bootstrapping liquidity with high-quality RWAs, Umoja provides more secure loan financing for lenders. Note that tokenized loans are more protected against credit risks. The image below compares how effective Umoja’s tokenized loans are against industry standards.
To counter FX fluctuation and settlement risk, Umoja is introducing the first DeFi FX AMM (Automated Market Marker).
With the FX AMM, Borrowers can get loans directly in their local currency and avoid FX fluctuation and devaluation. Therefore, borrowers don’t pay more on loans because of the extra cost due to FX devaluation. In turn, lenders experience lower settlement and default risk caused by FX devaluation.
Junior Tranche or Approvers can decide to rent collateral for their Borrower pool to adjust their risk exposure at any time. An Approver changes the risk level of their $uBP tokens by renting collateral from the Collateral Pool.
This feature offers lenders with higher default risk exposure a way to level the field. When lenders rent collateral, they further de-risk their debt position and reduce their risk exposure.
Umoja offers borrowers affordable loan options with flexible loan terms. Borrowers propose their terms for loan financing, including their repayment plan for approval.
Umoja understands that a borrower’s financial condition can change during a loan cycle. This can be due to several reasons — economic instability and sector-specific risk. Umoja introduces a renegotiation plan for borrowers to deal with this factor.
With renegotiation, a borrower can renegotiate their terms during the course of the loan. If a borrower thinks they can’t meet up with repaying their loan, they can submit a renegotiation request. They can change the loan period and repayment plan in the renegotiation request.
Learn more about lending on Umoja in this article. Read our whitepaper for a more comprehensive look at the Umoja Protocol and how we work.
Umoja offers lenders and borrowers flexible credit structuring options. For lenders, this means more secure and flexible debt investment opportunities.
But, Umoja can only meet its vision of providing over $100 billion in MSME financing through partnership and community participation. Join the Umoja DAO and become a Shujaa (warrior in Swahili)