On-Chain Securitization
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When you think about consumer credit, you probably think about personal loans, student loans, or even credit cards. These financial products are unsecured credit agreements, meaning they don’t have any collateral backing them. In the event a borrower defaults, there isn’t a physical asset to seize and liquidate, unlike with auto loans or mortgages. Additionally, these loans often have long maturities, extending up to several years, which makes them fairly illiquid assets.
This combination of factors makes managing consumer loans quite challenging, especially at low volumes. Imagine you had lent money to just one person; the probability of that borrower defaulting is fairly high.
One way to solve this issue is by pooling multiple consumer loans together. Instead of financiers owning individual loans, they can own a portion of the entire pool. This process is called securitization and is a well-established concept in traditional financial markets. With a sufficiently large portfolio of loans, the default rate converges to a predictable average, significantly reducing risk. Additionally, pooling individual loans creates a steady stream of cash flows, much like bonds.
One challenge with pooling loans together is that not all financiers have the same risk-return appetite. In traditional finance, this is usually addressed by creating a tiered structure called tranches. This approach allows financiers to participate in the same pool of assets through various classes of debt, each offering distinct risk and return profiles. A standard example of this structure is shown below.
The most common securitizations feature a junior and a senior tranche. The junior tranche absorbs losses first, while the senior tranche, which offers a lower yield, is protected from losses by the junior tranche.
This is the model Zivoe follows, except both the senior and junior tranches are on-chain, and depositors receive tranche tokens that represent their positions within the securitization.
Traditionally, most securitizations are fixed: the issuer raises capital from financiers, lends it to borrowers, and then borrowers repay interest and principal as the loans mature. However, this structure creates unnecessary overhead because financiers have to continuously reallocate funds to new securitizations as the existing ones mature. In DeFi, this is particularly problematic as it complicates integrations with other DeFi protocols, requiring developers to continue adding support for new pools.
To solve this, Zivoe’s tranches are perpetual. Financiers can freely deposit capital into the protocol, thereby increasing the size of the senior or junior tranche. This new capital is then used to issue new consumers loans. If financiers wish to exit the tranches, they can submit a withdrawal request to get their funds out. This perpetual structure offers several advantages:
Zivoe can finance new consumer loans at any time given there is sufficient liquidity in the tranches.
Financiers, including DeFi protocols, can deposit to either tranche without having to constantly reallocate funds to new pools.
The overhead of setting up and operating the underlying legal structure multiple times is removed.
Financing real-world assets requires a robust legal structure. Unlike platforms that support multiple issuers and pools, Zivoe offers a single perpetual securitization with one senior tranche and one junior tranche. When users deposit into the senior or junior tranche, their capital is used to originate new consumer loans. These loans are placed into a bankruptcy-remote Special Purpose Vehicle (SPV), which secures the tranches. In return, depositors receive tranche tokens representing their ownership in the respective tranche.
An Operating Agreement strictly defines the operations of the SPV, and the legal ownership of the assets is transferred from the loan originator to the SPV to ensure the tranches remain in a secured position to collect from the underlying consumer loans.
