QuiD Protocol
Credit Protection
Accounting for Borrower Defaults
Borrowing carries a cost in the form of protection fees, whose purpose is to protect Debtors from ever owing more to the protocol than what they borrowed if their collateral falls drastically in value, while also offsetting the aforementioned net losses borne by Creditors. Debtors are charged a dynamic rate which is paid into the Dead Pool, deducted from their available QD balance, canceling out defaulted debt awaiting distribution to Creditors, or (in the absence of either) from their pledged collateral up to the trigger point of default. A Guarantee Fund is provisioned to stand in as a backstop (similar to a lender of last resort) in “Black Swan” scenarios that would otherwise permanently crush QD’s dollar peg. This fund retains a small cut of all protection fees that is left “untouchable” (AKA Protocol-Controlled Value). Protection pricing is modelled after a far out-of-the-money, perpetual knock-in put. A put is the option to sell, in this case a Debtor’s collateral priced at the value of their debt. An option is out-of-the-money when it doesn’t make sense for the holder to exercise the option (moneyness is how far the option is from being in-the-money, when exercising will yield gains). A knock-in option becomes exercisable (“knocks in") only once a certain price level is reached, in this case when the option is in-the-money and the Pledge’s collateral is worth less than its debt, at any time in the future (perpetual).
This protective (married) put is synthetic because unlike a real put, which is a fungible contract that can change hands, it merely replicates the state where an option buyer gains the right to sell, while an option underwriter becomes obligated to satisfy said right if it’s exercised. It’s worth pointing out that Debtors could achieve similar protection by buying and holding real puts on their collateral with a defined strike and expiry. However, this adds the chore of choosing those parameters, especially having to predict the liquidity of different strikes, and then deciding to keep or sell the option while it’s out-of-the-money throughout its lifetime. The extent of a Debtor's over-collateralisation relative to their debt represents the moneyness of their synthetic put (pricing the premiums cheaper the higher the collateralisation). The Debtor’s collateral is the strike asset, the strike price is up to 10% less than its value, and the time value of the protection varies based on its volatility. Protection fees will increase in proportion to collateral price volatility, and inversely proportional to moneyness levels both systemically and individually. By acting together as a single seller the Creditors are a unified underwriter of risk and counterparty for all borrowing, serving to make a relatively homogeneous options market out of what would otherwise be extremely fragmented and heterogeneous. Each synthetic put on individual Pledges is bound together into a pool, and protection is sold on notional amounts of collateral in the pool, yielding Creditors an aggregated premium on a book of short positions in those options.
Being long on Debtors’ default risks, the Creditors are not naked short, as they have have staked collateral in advance for covering the fact of defaulted Debtors’ liabilities exceeding their assets, thus the pool of Solvency Providers is both funded and physically settled (there is an actual delivery of Debtors’ collateral).
Last modified 4mo ago
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