Noted with Interest: DeFi and Potential Lender Liability | Quinn Emanuel Urquhart & Sullivan, LLP

What is DeFi?

DeFi is the abbreviation for “decentralized finance”. It refers to financial services for cryptocurrencies which are built on distributed blockchain networks without central intermediaries. Since cryptocurrencies are decentralized in nature, financial services for cryptocurrencies are also referred to as “decentralized finance” or “DeFi” to reflect the same decentralized concept. Data shows that tens of billions of US dollars worth of cryptocurrencies are used in DeFi transactions every week. DeFi covers many sub-sectors, including lending, trading, derivatives, and payments. This article focuses on the lending industry.

While DeFi is new and constantly evolving, lending is one of the largest and most mature DeFi industries. Most DeFi loans are secured by the assets of the borrowers. Thus, the size of the DeFi loan market can be measured by the value of assets deposited on DeFi platforms by lenders (the cryptocurrency to be borrowed) and borrowers (the cryptocurrency acting as collateral), which is sometimes referred to as Total Value Locked (or “TVL”). Recent reports place TVL in the tens of billions of dollars in DeFi loan market. Major players in the DeFi lending industry include Aave, Maker, Compound, InstaDApp, and Liquity, each of which is said to have over TVL 1 billion on loan on its platform.

Leverage – the use of borrowed funds to make investments – is popular in DeFi due to the volatility of cryptocurrency prices. For example, suppose one owns Crypto A and thinks that the value will increase, but also wants to buy Crypto B because she thinks that the value of Crypto B will also increase. Instead of selling Crypto A to buy Crypto B, she could borrow the funds with her Crypto A as collateral and then buy Crypto B with the borrowed funds. This leverage is similar to margin trading, which offers greater profit potential than traditional trading but also amplifies the effects of losses. The combination of price volatility and the practice of leverage creates risk in the DeFi loan market.

The difference between DeFi and traditional finance – Smart Contract

Leverage transactions and collateral assets are not new. What differentiates DeFi from traditional financial services is the use of “smart contracts” to facilitate transactions. Cryptocurrency is a computer code carried over decentralized computer networks (blockchain networks). So people can embed this code to provide instructions to the blockchain network. For example, the embed code can automatically transfer the cryptocurrency subject to a condition precedent. This type of self-executing contract whose terms and conditions are written directly in lines of code is called a “smart contract”. The contractual code exists on a distributed and decentralized blockchain network. Code, not humans, controls contract execution and transactions are automatic, minimizing the risk of arbitrary intervention and manipulation. So the contract is “smart”. Smart contracts are the backbone of DeFi systems.

However, due to their technical nature, smart contracts can lead to unintended consequences. For example, during times of high volatility, smart contracts can liquidate collateral assets unexpectedly by borrowers due to their lack of understanding of technical liquidation conditions. Additionally, if the smart contract code contains bugs, it may inadvertently execute or fail transactions. If borrowers believe that smart contracts are harming their interests, they can sue the lender for liability.

Who are the lenders?

The threshold question for a lender liability lawsuit is: who is the lender? In traditional lending operations, this is an easy question because “[t]The material terms of a loan include the identity of the lender and the borrower. Peterson Development Co. v. Torrey Pines Bank (1991) 233 Cal. App. 3d 103, 115. However, in DeFi transactions, the borrowing process may omit lender information as funds may come from decentralized sources. Lenders deposit digital assets into pools, from which the assets are taken for loans obtained through the DeFi platform. Specific lenders are not identified for borrowers, who received borrowed cryptocurrency in their digital wallets.

The borrowers could argue that the lending platforms are the lenders because the loans are obtained on the platforms and the lending platforms usually program the smart loan contracts. However, the platforms could argue that the ultimate sources of funds are the decentralized owners of cryptocurrency, and the platforms only fill supply and demand when both agree to loan terms. And many platforms include disclaimers on their “Terms of Service” pages stating that they are not parties to smart contracts and have no control over transactions. The effect of such disclaimers has yet to be examined by the courts. Indeed, while the term “decentralized finance” may give the impression that there is no centralized lender in DeFi loans, the identity of the lender could be a very factual issue.

What are the loan conditions?

The loan process is relatively straightforward compared to a traditional loan application. Borrowers do not need to fill out a loan application form. Lending platform websites may simply display a few critical numbers, such as interest rate and liquidation penalties, without detailed explanations. A borrower could complete the transaction by clicking a few buttons without seeing the explanations for these critical numbers. For example, the lending platform may display a “10% liquidation penalty” when a borrower fails to meet a margin call. However, there may not be any explanation of what a “10% liquidation penalty” means in the lending process. Does this mean 10% of borrowed assets or 10% of guaranteed assets? From what time are assets valued? What exchange platform price governs the value of assets? To find the answers, a borrower may need to read the lending platform’s technical white papers or even read the source code of smart contracts, and the platform may warn the borrower of such a need. If the borrower does not refer to these documents, there may be a gap between borrowers’ understanding of the loan agreement and the actual loan agreement programmed into the smart contract code.

When interpreting the contract, “[t]The whole of a contract should be taken together, so as to give effect to each part, if reasonably possible, each clause helping to interpret the other. Cal. Civil Code § 1641. It could be argued that white papers and source code are part of the loan contract or should be taken into account in the interpretation of the contract. Thus, parties may need to carefully examine the source code to support their legal positions in a dispute.

What are the obligations of the lender in question?

Common lender liability claims include breach of contract and fraud. DeFi borrowers can rely on one or more of them in a dispute. For example, when a borrower thinks that a certain code in the smart contract is important but it is not disclosed during the loan process, they may claim that it is a fraud because the lender fraudulently induced her to enter into a loan agreement. When liquidation is triggered, DeFi borrowers may argue that the lender inappropriately sold the secured assets. The courts have relied on the Uniform Commercial Code and have held that the method, manner, time, place and terms of the incidental sale must be “commercially reasonable”. See, for example, Caterpillar Fin. Serves. Corp. vs. Wells, 278 NJ Super. 481, 651 A.2d 507 (Law Division 1994). But whether the Uniform Commercial Code applies to Defi transactions and what is commercially reasonable in the context of DeFi transactions are currently unexplored waters. The coming years are likely to see a growth in high-stakes DeFi litigation involving unique and new legal issues, especially as crypto markets evolve in a way that results in significant losses for DeFi loan participants.

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