Debt & Debt Tokens
Overview
Premium MORE markets differ from standard markets in how they manage liquidations and debt that may result from such an event. In premium markets, the available liquidity in the protocol may not fully cover lenders if premium borrowers get liquidated, at least immediately. This outcome has been designed purposefully in order to enable higher capital efficiency. The risk of recovering debt from these borrowers is highly mitigated because:
only extremely well-rated borrowers have access to these markets,
a contract between the borrower and the protocol makes legal recourse available,
and in the future, insurance may be enabled on many of these markets.
However, lenders should be aware of that in the most extreme cases such as bankruptcy of the borrower, they may realize a loss.
On Morpho, if a liquidation results in an account having remaining debt with no additional collateral, the loss is socialized, or proportionally shared among all lenders. Since MORE markets are built on the Morpho protocol, the same approach is used to liquidate borrowers in standard markets, where no premium lending terms are available, and standard borrowers in premium markets.
However, for premium borrowers that hold either overcollateralized or undercollateralized positions, liquidations are intentionally triggered at LLTV ratios exceeding market standard LLTVs. In these cases, borrowers have contractually agreed to legal recourse, which is undertaken by the MORE Foundation and the credit attestation service of the market. As a result, the protocol employs a novel mechanism to compensate lenders and reduce the reliance on socialized bad debt.
Introduction to Debt Tokens
To address the potential losses lenders might face in scenarios where liquidations generate recoverable debt, MORE Markets introduces the concept of debt tokens. When a premium MORE market is created, a debt token smart contract is configured automatically for any premium borrower who enters the market.
How Debt Tokens Work
Debt tokens adhere to the ERC-20 token standard. If a premium borrower is liquidated, their entire collateral position is eligible for liquidation. Following the liquidation, the MORE protocol calculates the amount of remaining debt generated by that borrower as well as the proportional share of debt owed to lenders in that market by the borrower.
The debt token smart contract is notified to initialize a new address that serves as the asset recovery address to which the borrower must deposit funds in order to clear their recoverable debt and make lenders whole. In addition, a unique debt token is issued to lenders participating in the market at the time of the liquidation. These tokens can be claimed by lenders. They serve as a claim on recovered assets deposited to the asset recovery address. The vast majority of borrowers will pay back lenders without additional coercion in order to avoid unnecessary fees and a reduction in their creditworthiness. If insurance is enabled for a market, lenders are made whole shortly after the liquidation event.
Any debt token issued by the protocol is specific to a single borrower in a specific market. Debt tokens are always denominated in the loan asset of that market.
Debt Token Nomenclature
Debt tokens adhere to their own specific naming standard that expresses the variables which make them unique:
the qualification of the token (i.e. debt)
the market id,
and the borrower's address.
The resulting name takes this form, debtMarketIdBorrowerAddress.
Using the example above,
Qualification: debt MarketId: 0x384n...623b Borrower Address: 0xbf24...7340
This debt token would be named debt0x384n623b0xbf27340.
Proportional Distribution and Claiming Mechanism
Debt tokens are distributed among lenders using a token-per-share (TPS) model, unique to each market. This ensures that debt tokens are allocated proportionally based on lenders' supply shares.
When a liquidation event occurs, some lenders may be entering the market, while others may be exiting. The debt contract tracks when lenders enter or exit a market to ensure the correct allocations to relevant participants by separating them into two groups. A variable called debtTokenMissed excludes users who join after debt tokens are generated, ensuring they cannot claim tokens. Conversely, debtTokenGained ensures users who withdraw tokens retain the ability to claim tokens generated during their participation.
The formula for calculating the amount of debt tokens a user can claim is:
This mechanism allows users to securely supply and withdraw loan tokens while accurately tracking and storing corresponding debt tokens.
Automated Token Updates
The TPS value is updated regularly to reflect the market's current state. This update occurs before any operation that could affect debt token distribution, such as supply, withdrawal, or claiming debt tokens. The update formula is:
Where generatedDebtTokens is the number of debt tokens generated since the last tps update, and totalSupplyShares represents the total supply shares in the market.
Simple Example of Debt Token Mechanics
For example, let's assume that Borrower A, with address 0xbf24...7340, was awarded a 100% LLTV in a FLOW-USDf market, in which the standard LLTV is 85%. At the time of liquidation, the borrower's collateral position is worth $1,000,000 in FLOW and their loan position is worth $1,001,000 in USDf, representing a LTV of 100.1%, thus making the position eligible for liquidation.
When the borrower is liquidated, their FLOW collateral is fully liquidated. In order to incentivize liquidators, a Liquidator Incentive Factor (LIF) is calculated. Assuming the fees below, as well as the Premium Loan Liquidation Penalty Fee (PLLF), a punitive flat fee of 10% of the collateral (intended to dissuade borrowers from engaging in highly risky borrowing) is immediately levied on the borrower.
Let's further assume that in this example, the price of FLOW is $0.50. The recoverable debt is thus worth 280,000 FLOW.
It should also be noted that bed debt accrues interest at a premium to the prevailing market interest rate, described in the Premium Loan Penalties section. However, for the purposes of this example, the additional interest component on debt is ignored.
The debt token supply, created for this particular liquidation, is then allocated proportionally to all lenders in the market at the time of liquidation. For example, if Lender A's deposit to this market equate to 1% of the market supply, they would be eligible to claim 2800 debt tokens.
When the borrower deposits assets into the asset recovery address, these funds are made available proportionately to all debt token holders. Lenders can then burn debt tokens in order to withdraw funds from this address.
Because a borrower may deposit recovered assets to the address in multiple transactions, claims on tokens are made available on a proportional basis to lenders.
For example, if Borrower A deposits 20,000 FLOW to the asset recovery address, even though Lender A holds 2800 debt tokens, they may only claim 200 FLOW from the address.
Lender and Borrower Benefits
MORE Markets offers significant advantages for both lenders and borrowers by improving risk management and capital efficiency.
For Lenders: The protocol provides an attractive alternative to traditional overcollateralized lending, offering higher yields and a mechanism to manage and recover losses from a premium borrower's liquidation. This is made possible through the use of debt tokens.
For Borrowers: The protocol fills the gap between overcollateralized loans and unsecured lending. It allows for collateralized borrowing through a flexible, semi-permissionless system that considers a borrower's creditworthiness. The integration of debt tokens also enables borrowers to access more capital while providing lenders a clear path to recover funds in case of liquidation and default.
Future Work
While debt tokens can be exchanged between users, the current version of MORE Markets does not yet integrate or support an Automated Market Maker (AMM) providing liquidity for these assets. Future deployments will introduce such markets to facilitate price discovery for debt tokens. Depending on the perceived likelihood of debt recovery, these tokens may trade at a premium or discount.
Furthermore, the rationale for issuing debt tokens on a per market per borrower basis enables the protocol to account for debt at the most granular level. Such a design allows for future flexibility in how debt can be pooled into Collateralized Loan Obligations (CLOs) with regard to a specific market, a specific borrower, a specific token denomination or any other basis for aggregation.
Debt tokens are an exciting new mechanism to speculate on the probability of recovery of liquidated loans that result in debt.
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