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Noted with Interest: DeFi and Potential Lender Liability

October 07, 2021

What Is DeFi?

DeFi is short for “decentralized finance.”  It refers to financial services for cryptocurrencies that are built on top of distributed blockchain networks with no central intermediaries.  Because cryptocurrencies are decentralized in nature, the financial services for cryptocurrencies are also called “decentralized finance” or “DeFi” to reflect the same decentralized concept.  Data shows that tens of billions of U.S. dollars’ worth of cryptocurrencies are being used in DeFi transactions every week.  DeFi spans numerous subsectors, including lending, exchanges, derivatives, and payments.  This article focuses on the lending sector.

While DeFi is new and ever-changing, lending is one of the largest and most mature DeFi sectors.  Most DeFi lending is backed by borrowers’ assets.  Thus, the DeFi lending market size can be measured by the value of assets deposited into DeFi platforms by both the lenders (the cryptocurrency to be borrowed) and the borrowers (the cryptocurrency acting as security), which is sometimes called Total Value Locked (or “TVL”).  Recent reporting puts TVL in the DeFi lending market at several tens of billions of dollars.  Significant players in the DeFi lending sector include Aave, Maker, Compound, InstaDApp, and Liquity, each of which reportedly has over one billion TVL in lending on its platform.  

Leverage – the use of borrowed funds to make investments – is popular in DeFi because of cryptocurrencies’ price volatility.  For example, assume one has Crypto A and believes the value will increase, but she also wants to buy Crypto B because she believes Crypto B’s value 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 trading on margin, which offers greater profit potential than traditional trading but also amplifies the effects of losses.  The combination of price volatility and leverage practice creates risks in the DeFi lending market.


The Difference Between DeFi and Traditional Finance – Smart Contract

Leveraged trades and collateral assets are not new.  What makes DeFi different from traditional financial services is the use of “smart contracts” to facilitate transactions.  Cryptocurrency is computer code carried on decentralized computer networks (blockchain networks).  Thus, people can embed that code to provide instructions to the blockchain network.  For example, the embedded code can automatically transfer cryptocurrency subject to a condition precedent.  This type of self-executing contract with the terms of the conditions directly written into lines of code is called a “smart contract.”  The contractual code exists across a distributed and decentralized blockchain network.  The code, not humans, controls the contract execution, and transactions are automatic, which minimizes the risk of arbitrary intervention and manipulation.  Thus, the contract is “smart.”  Smart contracts are the backbone of DeFi systems.  

However, due to their technical nature, smart contracts may cause unintended consequences.  For example, during high volatility periods, smart contracts may liquidate collateral assets in a way unexpected by borrowers due to their lack of understanding of the technical liquidation conditions.  In addition, if the smart contract code has bugs, it may execute or fail to execute transactions inadvertently.  If borrowers believe the smart contracts harm their interest, they may pursue lender liability actions.


Who Are the Lenders?

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

Borrowers might argue that the lending platforms are the lenders because the loans are obtained on the platforms, and the lending platforms usually program the smart lending contracts.  However, the platforms could argue that the ultimate sources of the funds are decentralized cryptocurrency owners, and the platforms merely bridge the supply and the demand when both accept the lending terms.  And many platforms include disclaimers on their “Term of Use” pages stating that they are not parties to the smart contracts and have no control over any transactions.  The effect of such disclaimers remains to be examined by courts.  Indeed, while the term “decentralized finance” may create an impression that there is no centralized lender in DeFi lending, the lender’s identity could be a highly fact-intensive issue.


What Are the Lending Terms?

The lending process is relatively simple compared to a traditional loan application.  Borrowers do not need to fill in any loan application forms.  The lending platform websites may merely show some critical numbers, such as the interest rate and liquidation penalties, without detailed explanations.  A borrower could finish the transaction by clicking a few buttons without seeing the explanations of those critical numbers.  For example, the lending platform may show a “10% liquidation penalty” when a borrower fails to meet a margin call.  However, there may be no explanation of what a “10% liquidation penalty” means in the lending process.  Does it mean 10% of the borrowed assets or 10% of the collateral assets?  As of what time are the assets valued?  Which exchange platform’s price governs the assets’ value?  To figure out the answers, a borrower may need to read the technical whitepapers of the lending platform or even read the source code of the smart contracts, and the platform may put the borrower on notice of such need. If the borrower fails to reference those materials, there might be a gap between the borrowers’ understanding of the lending agreement and the actual lending agreement programmed in the smart contract code.

During contract interpretation, “[t]he whole of a contract is to be taken together, so as to give effect to every part, if reasonably practicable, each clause helping to interpret the other.”  Cal. Civil Code § 1641.  One could argue that the whitepapers and the source code are part of the lending contract or should be considered in contract interpretation.  Thus, parties may need to review the source code carefully to support their legal positions in a dispute.


What Lender Liabilities Are at Issue?

Common lender liability claims include breach of contract and fraud.  DeFi borrowers may rely on one or more of them in a dispute.  For example, when a borrower believes certain code in the smart contract is material but is not disclosed during the lending process, she might argue it is a fraud because the lender fraudulently induced her to enter a lending contract.  When liquidation is triggered, DeFi borrowers might argue that the lender inappropriately sold the collateral assets.  Courts have relied on the Uniform Commercial Code and held that the method, manner, time, place, and terms of the collateral sale must be “commercially reasonable.”  See, e.g., Caterpillar Fin. Servs. Corp. v. Wells, 278 N.J. Super. 481, 651 A.2d 507 (Law Div. 1994).  But whether the Uniform Commercial Code applies to Defi transactions and what is commercially reasonable in the context of DeFi transactions are currently uncharted waters.  The coming years will likely see a growth of high-stakes DeFi disputes involving unique and novel legal issues, especially when crypto markets swing in ways that lead to significant losses for DeFi lending participants.