Collateralized Debt Obligations Make Their Way Into DeFi Lending

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25 January 2021

Opium Finance has released collateralized debt obligation products (CDOs) for Compound Finance’s automated lending markets, Opium Protocol founder Andrey Belyakov told CoinDesk in a phone interview Friday.

Investors can put up the Compound debt token cDai – and soon Uniswap LP tokens – to diversify exposure to DeFi lending markets. Opium’s product pays out structured returns to both a senior and junior risk tranche in exchange. The former tranche offers a 7% fixed return on dai (a collateral-backed stablecoin) at maturity, while the latter pool offers a variable rate paid out after filling up the senior tranche’s return, a blog post shared with CoinDesk states.

As depicted in Michael Lewis’ “The Big Short,” CDOs are infamous for their role in monetizing the subprime mortgage crisis that spurred the 2008 financial crisis. Warren Buffet even went as far to call CDOs and other derivatives “financial weapons of mass destruction” years before the financial downturn. CDO holders lost out on expected payments when mortgage holders defaulted en masse. Banks that were over leveraged on the then-worthless debt obligations began to default themselves, such as failed financial giant Bear Stearns.

CDO: Risk tranches monetize debt by paying out returns to instrument holders.
(Opium Finance)

It’s thought the transparent nature of blockchain-based financial applications could limit the downside of using these complex derivatives. Moreover, the risk profile of the average DeFi lending app is vastly different than the reasons CDOs became a household name over a decade ago. DeFi apps have little chance of becoming insolvent due to programmatic liquidation settings. Rather, the risk mostly comes down to software exploits which many poorly put-together DeFi apps experienced this past year. 

Belyakov said risk tranching increases the efficiency of capital on lending markets – a poorly understood problem in young DeFi markets he thinks derivatives can help address.

Risk tranching with crypto CDOs

It works as follows: A protocol issues a debt token representing a claim to funds deposited or “locked” on a DeFi app, such as cDai. These debt tokens allow those same deposits to gain exposure again on other markets. However, most DeFi investors let these debt tokens sit idle in wallets, re-invest them as collateral for other loans or put them up for yield farming. The problem is these bets often move in the same direction. Placing debt tokens into Opium’s CDO, on the other hand, acts as a categorical alternative to other forms of capital exposure, Belyakov said.

“What we did was look at the lowest-hanging fruit,” Belyakov said. “And we found that Uniswap LP tokens, Compound cDai and some others are just stored on a wallet; they are not being used as collateral or farming – you don’t utilize this capital.”

The DeFi lending market mostly consists of three protocols: Compound Finance, MakerDAO and Aave.
(DeBank)

The derivative joins other early attempts to protect lenders from the software risks associated with decentralized finance (DeFi). For example, Saffron Finance launched its unaudited protocol in November while little-known protocol Barn Bridge continues to build out an offering similar to Opium’s. The protocol also released a credit default swap (CDS) product for the tether stablecoin in September.

Opium is also jumping on the governance token bandwagon. The protocol released its opium (OPIUM) token Monday for decentralizing the protocol’s governance structure. The launch was preceded by a premine and a $3.5 million private sale including participation from venture capitalist Mike Novogratz, Galaxy Digital, QCP Soteria, HashKey and Alameda Research, among others.

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