Lending Product with Option-like Risk Control

The crude schemes used in the prevailing DeFi lending protocols do not address default risk properly. A unique reward-driven and option-like risk control is introduced for collateral-backed lending.

The unique risk management tool offered by the INK Products Module is likely the most innovative risk management scheme in the asset-backed DeFi lending domain.

Every original pledger is stressed when the price of their collateral drops sharply, and the tendency is to default on the obligation of making up the shortfall. The goal of INK’s shortfall auction mechanism, part of the Products Module, is to encourage others to fulfill the obligation with a significant potential reward, by activating a collateral shortfall auction before triggering the liquidation process. This avoids delinquency instead of forcing one, which liquidations tend to do.

The winner of such auctions shall deposit enough collateral to make up for the shortfall to restore the original pledge ratio. The winner is then granted the right of control of the collateral vault. When the collateral price recovers enough to make a risk-free profit, the winner can buy back the outstanding debt with interest and take possession of the original collateral plus their own shortfall maintenance collateral.

This auction is similar to the bidding of a call option on the collateral, except in INK’s mechanism, the premium is not spent when the option is exercised because the collateral vault includes it.

In addition to this dynamic credit enhancement scheme, INK Products Module also introduces a game-like tranching mechanism to provide market-driven risk/reward distribution at the initial auction. Any investor can choose to take a senior or junior position in the financing deal, and the Module's formula automatically adjusts the risk/reward of the two different positions as they are being taken by different investors, allowing them to express their different levels of risk tolerance for the expected return.

The following diagram illustrates how to use the INK Products Module to issue such a collateralized loan (a note or bond) with two tranches (token A and B):

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