Make Frax the first bank of DeFi

This idea is a bit pie in the sky for a FIP at this stage so going to post here instead.

One of the major services TradFi offers that DeFi does not is under-collateralized loans. On DeFi I can earn interest on my savings, borrow against my collateral, trade, invest, take leveraged positions and even to a small extent purchase insurance and options contracts. However one thing I cannot do is take out a loan to buy a house providing only a down payment. I can take out loans, but only if I already have more capital than the size of the loan which is more like a pawn shop model than a bank. I think Frax, at least for some market participants, can become more like a bank.

The reason why banks are able to offer this service is they have an identity to tie to their debtor. With that the debtor has more at stake than just the capital they put up and the bank has more options for recompense if the loan goes badly. As a debtor I want to pay back my loan to avoid damage to my reputation and credit score and the creditor can pursue a variety of debt collection services and may be able to place a lien against other property if need be.

Until some sort of on-chain identity or network of trust solution exists I don’t think under-collateralized loans will be available to individuals. However what might be possible now are another category of loans, business loans, or in the DeFi equivalent, protocol loans.

Here’s a rough model of how it might work:

  1. New protocol is wanting working capital.
  2. The protocol applies to Frax for a loan.
  3. The Frax DAO evaluates the creditor protocol’s creditworthiness. The protocol can submit/evidence documentation and make a case for themselves.
  4. The loan is put to a governance vote, including the terms of the loan (APR, loan size, down payment, repayment schedule, etc)
  5. If the vote passes, the creditor would provide a down payment, possibly in the form of FXS.
  6. The debtor receives the loan in the form of newly printed Frax and makes future repayments in Frax according to the repayment schedule.

An optional feature would be to have a built in debt collection mechanism in the case the debtor fails to repay. This could be in the form of the debtor allowing access to the protocol’s treasury reserves somewhat similar to a TradFi repossession of debtor property. This would require a set of custom contracts but it could be written on chain that the creditor can withdraw a certain amount of the creditor’s treasury tokens contingent on certain conditions, ie loan repayments are not met. These really would be a set of “smart contracts” that different contingencies execute based on behaviors of market participants.

These loan contracts could also be transferable. Debtor protocols would make their repayments to these contracts which then would forward the funds to the creditor, ie whoever owned the contract. Frax then could sell these contracts on the secondary market like any other tradable debt instrument if desired.

A key point is that these loans wouldn’t be permissionless. We obviously can’t allow any random person to create some garbage token, claim to be a protocol and take out a loan, however vetting of protocols should be possible the same way TradFi banks vet their own loans. Theoretically this could also be possible for very high profile individuals with well known wallet address (ex: Vitalik) and maybe this could be something to explore also if there was interest, however it seems like loans for new up-and-coming protocols should be an even bigger market.

Another key point is that the loans would actually be under-collateralized and provide working capital to the debtors. I think this could be another capital funding mechanism similar to existing liquidity mining schemes or Tokemak’s new liquidity direction model but much broader- theoretically these loans could be used not just for liquidity but any type of working capital the protocol required.

Frax is in a unique position to provide this service since with the AMOs and the growing acceptance of Frax as a functioning stablecoin Frax effectively owns a money printer. A money printer with some limits, pushed too far and Frax could theoretically break peg, but a money printer nonetheless. Right now Frax mostly uses its printer to deploy capital to other protocols and earn a return, however Frax could become a key source of capital funding for all of DeFi. This has to scale to Frax’s own size of course, but as Frax’s recognition as a source of funding increases it’s own ability to attract capital should increase in turn allowing it to fund even larger projects and eventually possibly become something like the primary bank of DeFi.