DeFi magic and credit default swaps converge in opaque lending market

Credit default swaps are hard enough to figure out. Shadow lenders and their repackaging of cash flows from loans into securities come with their own complexities. And cryptocurrencies, well, they can be as mind-bending as anything financial alchemists have ever dreamed up.

A new product combines all three into one.

It’s from fintech company Percent Technologies and Anzen, a new player in the corner of crypto known as decentralized finance, or DeFi. The idea is to use capital that crypto enthusiasts have stashed into stablecoins to offer investors in Percent’s high-yield securitizations protection from a default.

It’s not an obvious time to launch an insurance-like product backed by cryptocurrencies, amid a rout that’s in a few months wiped out a couple trillion dollars in value. Worries about stablecoins — which are akin to money-market funds in conventional finance, a place to park cash — and the failure of a prominent one have fueled the slump.

Adding to the uncertainty, Anzen has only been around since January, its plans to attract outside capital and generate returns are vague, and its founders are anonymous.

That hasn’t deterred Percent founder and Chief Executive Nelson Chu from forging ahead with the partnership, which will allow buyers of Percent’s structured notes to receive a payout if defaults in the underlying loans rise above a pre-defined threshold, similarly to what happens in the more than $10 trillion dollar market for credit default swaps.

“It is very timely to launch a CDS product given the volatility that we are seeing,” Chu said in an interview. “We are trying to take advantage of a dislocation and offering a product that is very valuable in the economy we are looking at.”

In a crucial difference with the traditional CDS market, capital to cover potential losses in the Percent investments will not come from an institution taking the opposite side of the trade.

Instead — and this is where the DeFi magic comes in — it will come from a reserve fund consisting of stablecoins staked on the Anzen protocol as well as interest and principal amortization payments contributed by Percent. The risk for investors will ultimately depend on the quality of those assets and their availability to cover losses.

CDS are not widely understood except among hard-core Wall Street professionals, and this product takes things a step further, a concern for Julia Lu, a partner at law firm Ashurst who specializes in derivatives and structured credit markets.

“It is a clever way of solving an issue, which is that in the true private credit market, CDS is difficult to obtain,” she said. “But I am concerned as to whether people understand the risks.”

Anzen has so far contributed $250,000 of its own USD Coin (USDC), one of the best-known stablecoins pegged to the US dollar, to capitalize the reserve pool, which investors can monitor in real time. For now, the pool only backs a $614,092 blended note Percent sold last month.

Junk or Stable

“In CDS, you try to protect yourself from the credit risk of the underlying asset, but at the same time you take credit risk of the counterparty,” said Athanassios Diplas, a veteran derivatives trader. And so any buyer of such a thing is forced to deal with the fact that the pool of assets backing it “could be full of stable stuff or could be full of junk,” he said.

Anzen plans to attract outside investors with yet-to-be-determined yield-farming opportunities to grow reserves. In a Medium post earlier this year, the company said its goal is “to create a perpetually scaling reserve pool” that can generate sustainable yields “indefinitely.” While Anzen’s founders remain anonymous, Chu said they are people he has known for some time and have backing from well-known institutions in the crypto space.

Initially, the default protection offered by Anzen will only kick in after Percent investors have already absorbed losses worth 10% of the notes’ face value. It would cover as much as an additional 10% of losses with a limitation of 2.5% for each underlying asset in default, according to documents seen by Bloomberg. Investors may be able to customize the level of coverage in future offerings, Chu said.

Percent is not new to esoteric offerings. Its platform was built to connect accredited investors looking for double-digit returns in private credit with non-traditional lenders in need of financing.

Taking a page off a playbook that big banks have been using for decades to repackage mortgages and auto loans into securities, Percent helps originators bundle hundreds of loans into short-term notes that can generate returns as high as 18%.

Opportunities offered on the Percent platform run the gamut from loans backed by motorcycles that are used as taxis in Sub-Saharan Africa to point-of-sale financing for Botox injections and other aesthetic treatments. The company has underwritten more than $850 million of transactions since 2018, according to its website.

The note it sold with the default protection provided by Anzen will acquire exposure to a rotating set of individual deals offered on Percent’s platform, potentially including small business loans, crypto loans as well as receivables from app and game developers, the documents show. The arrangement will be reported to Depository Trust & Clearing Corp., according to the documents.

Percent, which was previously known as Cadence, isn’t entirely unknown on Wall Street. Last year it served as a co-bookrunner on a whole-business securitization led by Jefferies Financial Group Inc.

–By Davide Scigliuzzo and Michael Tobin (Bloomberg)