Dharma Protocol: Tokenized Debt and Funding Through Decentralized S...

Image Source: Dharma on GitHub

The biggest problem of the modern era is receiving funding for a project or company. The market has become almost too efficient. Investors are able to leverage that to their advantage. The scrutiny in investment process for equity has become a barrier to efficient capital allocation. So while some people consider ‘debt’ to be evil, it may be a necessary evil to keep our world thriving.

The modern start-up is open to debt funding. At some level, the risk is higher considering the constant cash outflow throughout the loan tenure, but it leads to long term rewards as the founders/company hold a larger ownership stake. At a seed stage, start-up funding is still majorly equity-driven given the lack of cash flows. But if a company has product revenue or some other form of cash flow, debt makes sense given the long term incentive it holds.

Why Debt Funding?

The venture debt market in the US is pegged at $2-3 billion annually. It serves as a financing link between two rounds of valuation and fundraising. Despite putting strain on company cash flows, it gives startups access to funds without diluting equity and it gives VC’s and Angels the ability to keep the ship alive before figuring out if this company is worth sinking more equity capital into. Considering debt investors have recourse to their money before equity investors, it is actually a safer alternative for investors.

The problem with debt is extensive paper work in a bureaucratic process that takes week or months to go through. The paradox is that companies issue debt or take loans when they are in need of immediate liquidity. But the loan-issuing entity cannot be completely blamed for the inefficiency of the process. The governance angle plays a huge role in slowing it down. Firstly, all loans must be handled and disbursed as per the law. The background checks are extensive yet they are done at a much slower pace than necessary. This boils down to the fact that the third parties who verify data and run background screens take their own time to do so. Moreover, the people they get their data from also take their own sweet time. The countless middlemen and reporting to federal agencies is what creates the inefficiencies.

Dharma as a Solution

ERC-20 is the standard for developing a decentralized network today. It is one of the most effective ways to build decentralized applications over a blockchain. But this tokens standard has its own drawbacks. It cannot retrieve payments or machine readable meta-data (interest rates, investment amount, etc) and it doesn’t allow you to factor external risks and events into the pricing of the ERC-20 token. Despite these drawbacks, it is still the best option currently in play. More dApp platforms are being developed so Ethereum will see a mob of competition if it fails to scale.

Dharma works on the same notion of crowd-funding. What ICO’s are to stocks, IDO’s (Initial Debt Offering) are to bonds. They work on the principles of making markets more efficient, transparent, and accessible. The bureaucracy in loan processing is evaded by instilling underwriters who are incentivized and penalized based on the loans they’ve written.

For people unfamiliar with the concept of an ‘underwriter’, it’s a person or entity who determines the risk profile for a loan and sets the terms according to that risk. Underwriters are an important part of traditional markets as they serve as the basis for risk management in loan issues. Morgan Stanley, Goldman Sachs, J.P. Morgan, and Jeffries are few examples of underwriters in the current system. Dharma would introduce underwriters that are effectively incentivized to accurately assess loans and their possibility of default.

Why Do We Need Efficient Debt Markets and Transparency?

As of today, global equities are valued at approximately $87 trillion while global debt is at nearly $270 trillion. Given the market is roughly 3 times larger, it makes up an incredibly significant portion of the world economy. Credit Suisse’ global wealth report estimates global wealth to be $317 trillion. That means debt is nearly 85% of total global wealth. With a vast amount of money in the world being debt, it goes without saying it is an important component of the financial system, despite how risky it is.

Equity tokens have several dimensions of risk (regulatory, market, liquidity, technology, and platform risk) but debt tokens have all these plus 3 more: credit, default, and transparency risks.

The need for transparency comes from the sheer size of this market. Today, most people are oblivious to the role of debt in functioning the entire world. Yet, the market is relatively opaque as not much information regarding issues are shared publicly. Other than the debt covenants (the contract between issuer and lender that states what the issuer can and cannot do during the life of the bond), nothing about the issue or use of the debt is given to the public eye. Many large institutions release reports and data regarding the state of debt markets and the parties involved. But coming from within the system, from a member of the financial cartel, are the reports and data truly trustworthy?

This is where the need for a more transparent debt market stems from. Rather than relying on a third or fourth party to tell us how the market us, what if we built a decentralized debt platform that bypassed the bureaucracy and invoked transparency? That is exactly what the Dharma Protocol aims to create.

Features of the Dharma Protocol

First and foremost, Dharma runs on the 0x protocol, putting it on par with any decentralized exchange (DEx) in terms of decentralization. It is a platform to issue, fund, administer, and trade non fungible debt tokens. Don’t misinterpret fungible here – it doesn’t mean it cannot be exchanged easily, it means it cannot be redeemed for another token or asset until it matures.

There are 4 main agents that operate the network: Borrowers, Lenders, Underwriters, and Relayers. Borrowers and Lenders are simple operators, so I’ll briefly explain the other two.

• Underwriters: As mentioned earlier, these are the agents who identify the possibility of default and structure the terms of the debt issue. Their job is solely to accurately identify the potential for default and liquidity risk and issue an approval or denial for a loan. Additionally, they enforce the contract after it comes into play. They ensure repayment and distribution of interest payments as well as collect on collateral for defaulted loans

• Relayers: The agent(s) that relays orders and aggregates all approved debt issues are relayers. Their job is to host the order book for potential lenders to browse through. They provide lenders with all meta-data associated with the potential loan.

Handshake Dharma.png

(Source: Dharma Protocol Whitepaper)

The underwriter is free to create terms and collateral necessity as per their will. They can choose to get off-chain, legally binding contracts that are enforceable through courts or they can demand on-chain collateral. It’s important to note, Dharma is agnostic to this entire process; the entire underwriting process is strictly between the underwriter and borrower (and any necessary parties from either side such as lawyers and consultants). Responsibility to resist Sybil attacks and to gain the trust of potential lenders is solely on the underwriter.

Advantages of Dharma

• Low cost and transparent debt issues
• Eliminate inefficiencies of the current loan processing system
• Trade tokenized debt with ease on the same platform it is issued on
• Lend and borrow money at risk defined interest rates

Disadvantages of Dharma

• No guarantee of underwriter expertise is estimating risk of loans
• Lack of reputation integration for lenders and borrowers
• Unsecured loans are highly risky for underwriters and lenders as there is no legal recourse. Borrowers must have some collateral they put up for the lender to have a degree of confidence.

End-Game

Dharma can change the way debt is issued and traded. It can create a transparent ecosystem that drastically cuts shady practices and corruption. But all said and done, it does have its own flaws.

The lack of a reputational system is a big negative for Dharma. If they were to implement a reputation protocol that created an identity for each underwriter and carried all their information and the experience lenders and borrowers had with the particular underwriter (ease of cooperation, straightforwardness, efficiency, etc), it would help future lenders take more specific actions with regard to ascertaining the trustworthiness of the underwriter and their process.

Luckily, Sid Ramesh and Nadav Hollander have addressed this issue and see implementation for such a reputational system in the future. It’s important to note that Dharma is incredibly young and have done fantastic work so far despite being in a nascent stage and challenging the very competitive financial system that exists today.