Alone Without Promise — Is There Such Thing as a Loan in DeFi?
Lending platforms perform critical functions in decentralized finance.
Aave, is, of course, the gold standard in decentralized lending protocols, but the platforms which provide lending services are myriad and exists across virtually all networks. On-chain, lending can be approached in several different fashions, however, for the most part, on-chain lending is based on collateral. As is typical for on-chain transactions, the platforms for lending are just that, platforms. They rely on users to both supply liquidity for loans and to borrow those assets.
Almost anyone who has operated on-chain has used a lending protocol
for one reason or another. Superficially, these functions resemble loans off-chain. Collateral is provided, and property is received in exchange. However, substantively, there is little similarity between on-chain loans and traditional loans, begging the question of whether these are truly loans at all.
Loans date back to the earliest agricultural societies, and, arguably,
agriculture itself depends on the practice. Historically, lending as a practice is inextricable from commodity futures for this reason; the capital necessary for agriculture cannot be raised and preserved with promises to pay and collateral.
Options, as a financial instrument, developed in a largely parallel track
to loans. An option is an agreement where the buyer purchases the right, but not the obligation, to buy an underlying asset at an agreed price at a future date. The earliest written records of options date to ancient Greece. Aristotle relays the story of Thales, a philosopher who speculated in the olive oil trade, who would lease olive presses in advance of the olive season. If the olive season was poor, he would lose his deposit on the lease, but if it was good, he could re-let the presses at higher price. As Professor Stephen G. Cecchitti explains:
A critical attribute of Thales’s arrangement was the fact that its
merit did not depend on his forecast for a good harvest being
accurate. The deposit gave him the right but not the obligation to
hire the presses. If the harvest had failed, his losses were limited
to the initial deposit he paid. Thales had purchased an option.
Thales’s olive press option strategy was different from the existing loan
based financing of agriculture because it was not based on a promise to do
anything in particular (such as pay a certain amount at a certain time). Later, this distinction manifest itself in English common law, the predecessor of the American legal system.
Prior the 16th century, the sole fashion in which a debt could be
collected in English courts was known as a writ of debt. Writs of debt were
complicated to enforce, with cumbersome procedural requirements
necessary to demonstrate a debt’s enforceability. In a case known as Slade’s
Case, a cause known as a writ of assumpsit was recognized. Under a writ of
assumpsit, a plaintiff needed to only demonstrate a promise to pay (the
assumpsit) by the defendant. Quickly, assumpsit became the primary cause
of action to recover from a breach of contract.
Assumpsit literally translates to “he has undertaken”. The notion of a
promise underpins the concept. The existence of a loan relies on this concept as well. A loan implies a promise to do something (make a payment) in the future. “In order to have a loan, there must be an agreement, either expressed or implied, whereby one person advances money to the other and the other agrees to repay it upon such terms as to time and rate of interest, or without interest, as the parties may agree.
Secured debt arose much later historically. The concept of security, or
collateral, is that a borrower may pledge his or her property in addition to his or her promise to repay in consideration for a debt. In so doing, a creditor not only has recourse against the borrower, but against the pledged property of the borrower.
Secured debt and options share characteristics. Regardless of the
creditworthiness of a borrower, a lender in secured transaction is guaranteed the value of the collateral pledged. Likewise, in an option, the purchaser of the option is guaranteed the ability to purchase an asset for a known amount. Economically, a secured loan can be expressed as an option. The borrower in a secured loan may repay his or debt in exchange for the property pledged, just as the purchaser of an option may buy the underlying asset.
The key distinction between an option and a secured loan is the
existence of a promise. A secured loan implies the obligation of the borrower to repay the loan. No such obligation exists for the purchaser of an option.
In most American jurisdictions, a promise to repay is, definitionally,
part of any loan. For example, in a California, a “loan for use” is “a contract
by which one gives to another the temporary possession and use of personal property, and the latter agrees to return the same thing to him at a future time, without reward for its use.”2 A loan for exchange is “a contract by which one delivers personal property to another, and the latter agrees to
return to the lender a similar thing at a future time, without reward for its
use. Similarly, Texas law defines a loan as “an advance of money that is
made to or on behalf of an obligor, the principal amount of which the obligor has an obligation to pay the creditor.
Secured loans are governed by the uniform commercial code (the
“UCC”), which has been adopted in all US states and territories, except
Louisiana, Puerto Rico and American Samoa. Under the UCC a security
interest “an interest in personal property or fixtures which secures payment or performance of an obligation.”5 Collateral is the property to which a security interest has attached, and an obligation is an undertaking to repay. Because this notion of a promise is wired into the definition of collateral in the US, a secured loan is only a loan if there is an obligation to repay the principal.
In DeFi, there are no promises. A smart contract creates a series of
events, which may be modified by the choices made by the participants, but any promise to undertake such choice is, definitionally, extraneous to the smart contract. Participants in DeFi lending platforms (such as Aave) may participate in two ways — assets may pledged or exchanged. A depositor is guaranteed a return (characterized as interest) on assets pledged. An exchanger deposits another type of asset in exchange for the assets pledged, and has the right redeem the deposited asset for a return of the pledged asset.
The exchanger pays a fee (also characterized as interest) for the right
to exchange, and (on some platforms), if the value of the exchanged asset
falls below a certain amount relative to the pledged asset, the ability of the
exchanger for redemption is liquidated. However, the exchanger has not
promised to do anything, he or she only has the option of redemption, and
economic incentives, rather than promises, dictate whether and when the
redemption will occur.
An obligation in the law implies a moral choice — there is a right choice
(repayment) and a wrong choice (default). DeFi is based on code, and there
are no obligations in code. Code only has certainties — if a user does “x” then “y” will occur. Therefore, it is arguably whether a loan in DeFi, without recourse to contracts extraneous from the code, can ever exist.
The implications of this definitional issue are far reaching. For example,
under most legal regimes, the licensing of a lender and an options issuer are different. The tax treatment of secured loans varies greatly from that of an option. There are certainly no clear answers on the appropriate treatment of transactions on lending platforms, but given their ubiquity, this is likely to change.
Cal. Civ. Code § 1902
Tex. Fin. Code § 301.002(a)(10).
UCC § 1–201(35)
UCC § 3–103(9)