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Analysis of the Dharma protocol

*I based the below analysis solely on the whitepaper alone which was published in November 2017. *

Introduction

After reading the whitepaper for Dharma Protocol (DP) I am inspired by the many uses cases that a decentralized system and ledger of everything can furnish to society. This protocol is the answer to the 2008 crash, if this was implemented back then, I am convinced the crash could have been avoided altogether. The Dharma Protocol has a number of use cases and what is apparent off the bat is that it should not be characterised as a cryptocurrency or cryptoasset. This is more akin to a digital asset that is non- fungible and can be stored in any ERC-20 wallet. This analysis will explain the protocol, the use cases, the debtor-creditor relationship, the Relayer and the Underwriter. These are all different chains in the link that is the Dharma Protocol are all necessary for the issuance of the debt token.

In 2008 the creation of Collateralized Debt Obligations (CDOs) tied to the housing market sparked a frenzied approach to the rating and sale of mortgages. Due to the ratings agencies falsifying the risk ratings of these CDOs they were then able to package and sell them all around the world to unsuspecting Financial Institutions. These FIs would then in turn repackage and resell them off again and again. This blatant disregard and ignorance eventually saw the collapse of the US housing market and sent seismic shockwaves across the entire world. Today, auditors still cannot find the trail of events that sparked the conflagration that happened in 2008, this is due to banks deleting records, initiating cover ups and blatant falsified information. The trillions of dollars that had to be used to bail out the banks were of course borne by the tax payers. Satoshi’s vision for BTC was the answer to this, a protocol that didn’t rely on ‘trusted’ parties and let nodes all around the world communicate with each other and facilitate the transfer of assets in a verified and trust-less manner. If this is Satoshi’s vision than the DP builds on this vision and then some, it effectively erases the chance of opaque financial debt instruments of mass destruction and replaces it with a fully audit-able trail from debtor to creditor. Cheaper, faster and more efficient. While it should be said on the outset that the DP is neither Trust-less nor Anonymous (anonymity when issuing debt would be catastrophic) so while it varies from the original BTC vision it fills a very unique and pivotal role for the structured finance industry.

Whereas equity-like tokens are tied in value to branded protocols, projects, or entities, debt-like tokens are tied in value to empirical financial obligations from counter-parties that are often anonymized.- Dharma Protocol whitepaper

While there is no shortage of ICOs with tokens tied to the utility of the underlying protocol, Dharma is a refreshing approach to the Token Economy. To put it another way, if there was a party and every person at the party represented a different cryptoasset, Dharma would be the quietly confident kid in the corner letting the overhyped jocks battle it out. Dharma does not compete in the already over-crowded token marketplace and simply states their intention of bringing accountability to an industry rife with fraud without pushing an overvalued token, in fact, Dharma has no token. Dharma is really just a set of instructions and framework for issuing credit in a decentralized way. We will go into how the DP works below:

Underwriting and Relaying- The pivotal roles in Dharma Protocol

What the Dharma Protocol does is define a set of procedures for issuing, funding, administering, and trading debt assets using a set of smart contracts, keeper marketplaces and standardized interfaces. Simply put, it keeps track of not only the principal sum agreed to be lent but the repayment terms, the risk rating as defined by the underwriter, the loan agreement and collateral in case of default. This protocol has use not only with new underwriting agencies that are built around this protocol but can also be integrated in the back-end of already established underwriting agencies. Throughout this analysis, I will use the term ‘underwriter’ to describe a person who assesses the risk of default for any given debtor who is seeking x sum from a creditor, this underwriter then uses their own proprietary method of underwriting to assign a % to the debtor on how likely it is that they will default on the loan if granted.

i.e if Gary applies for a loan and through the underwriting process the underwriter uncovers that Gary has defaulted on 2 loans in the past 10 years then the underwriter might assign a percentage of 60% to Gary’s application for credit. In the DP this % is expressed as a 9 decimal place number, in Gary’s instance the likelihood of defaulting would be 600000000 and this number would be coded into the smart contract.

The underwriter will assign this % to the debtor and then stake their reputation to that assignment. The application (for lack of a better word) then gets sent to a Relayer who then puts the application in an order book for various creditors to view and then fill. Think of the Relayer as the maintainer of the order book, they would only accept applications from respected and reputed underwriters who have a track record of properly evaluating risk.

The underwriter is also in charge of collecting on defaults or delinquencies whether by collecting the secured collateral in a smart contract or via legal off-chain mechanisms. This could also take the form of traditional debt collection, once the collateral has been procured they would then pass this onto the investors minus any fee.

Enter 3 contracts- The building blocks of the DP

1. Debt Kernel- The governance contract

The debt kernel is a simple smart contract that governs all business logic associated with minting non-fungible debt tokens, maintaining mappings between debt tokens and their associated term contracts, routing repayments from debtors to creditors, and routing fees to underwriters and relayers.

As the above alludes to, the Debt Kernel is a smart contract that governs how the entire process from debt application to repayment should play out. The really interesting thing is that the debt kernel will issue a Non- Fungible Token (NFT) which means that the token will not be divisible (Atomic) and will only ever be linked to the one debt agreement. Even if there are multiple applications for the same person with the same agreed upon loan with all identical parameters there will be a certain random value assigned to the contract (called Salt) that will set each of the loan agreements apart from each other. Even though almost identical, the tokens will all be different and represent a different agreement. This is integral as without the Salt value the agreements could be difficult to tell apart from one another which could lead to potential issuance of the same (now) fungible token.

2. Term Contract(s)- Loan repayment agreement

This is a smart contract coded in Ethereum that basically sets out the agreed upon terms between a debtor and creditor. This is the basic guidelines set out and determined by both parties to govern how the term will be played out.

Interesting to note, a single term contract can be reused again and again if it turns out to be sound and useful. This means that a simple compounded interest repayment scheme can be committed to by any number of debtors and creditors.

DP does not explicitly define loan repayment terms as this could limit its usefulness and practicality. In order to be attractive to a wide array of investors and options, DP has decided to remain agnostic about repayment schedules and will maintain a generic interface for the terms contracts which opens the door to an infinite amount of different debt term arrangements. The best-case scenario for all parties involved would be to agree to an on-chain settlement structure that can be fully audit-able and agreed upon by all parties involved. This also simplifies collection of collateral that the debtor would need to post in order to secure the funding. i.e posting 3ETH in a smart contract to be released if delinquent or in default is more advantageous than collateralising the debtor’s car off-chain.

3. Repayment Router- Trust-less re-routing of funds

A simple smart contract that routes payments from the debtor to the owner of the debt token. The repayment router also acts as an oracle to the Term Contract associated with any given debt agreement, this means that the router will notify the term contract when any debt has been repaid off-chain. It can also determine the default status of the debt.

The Process- High level view

The entire debt issuance process occurs synchronously in one on-chain transaction, when a signed debt order message is submitted to the Debt Kernel contract.

Here is the process in 3 steps:

1. Debtor’s adherence to the chosen terms outlined in the Term Contract and the underwriter’s prediction of default likelihood are committed to on-chain

2. Issuance of an NFT that cannot be divided and linked to the particular debt contract

3. Principal amount is issued to the debtor from the creditor minus any fees for the Underwriter and the Relayer.

There you have it, in three simple steps a debtor can agree to the terms, have a non-divisible and encrypted token issued to the contract and collect the principal sum. This is all done without the fear of an opaque financial instrument being traded and sold between different financial institutions in order to purely make profit. All of this is done in an auditable, fully transparent and verifiable method using the Dharma Protocol.

Where the rubber meets the road-

Up until now we have explored the basics of the DP and how by using the protocol we can efficiently set up and collect on debt contracts. Now that we have the basics down pat, let’s look into the really interesting part of how a blockchain company can use the DP:

Companies using ICOs-

I learned through the whitepaper that ICOs can be very costly to run. ICOs are turning more and more to pre-ICO investment in order finance the cost of the token issuance. Something called the SAFT has been created, this stands for Simple Agreement for Future Tokens (if you want to read more click here) and it aims to give pre-ICO investors a guarantee of future tokens and is based upon their level of investment. The SAFT is a legal agreement and is interesting because the Dharma Protocol can actually take the place of this SAFT with a specialised term agreement. The reason why someone would use the DP over a SAFT is that multiple investor compensation schemes can be thought up and coded for. The following example could apply:

The investor could front x with the intention of claiming a certain amount of y back in the tokens that the ICO has created. The debtor could not only pay back the initial amount in ETH but could code different y repayments depending on the interest. i.e if the creditor thinks there will be a large amount of interest he could take a smaller initial down payment and a larger portion of the y tokens. A SAFT is clunky and would need a legal team to edit if there was a large uptick in acceptance of the token, a DP is nimble and only needs to be accepted by the two parties without potentially involving expensive legal teams.

As an insurance underwriter I have little knowledge in valuing a person or entity’s debt, but I do have knowledge in evaluating a company for insurance purposes. I could see the DP be applied to any sort of situation that needs underwriting of risk, which would be potentially very disruptive to the insurance industry.

I posit the below:

An applicant for insurance makes an application to a known underwriter. The underwriter then has a set agreed upon parameters that would dictate the risk of the business, they would then assign a risk category with all pertinent underwriting criteria for that particular applicant. That rating would then form part of the Term Contract (or in this case a policy) and an already agreed upon wording would be generated by the underwriter. The underwriter would then send to the Relayer who takes care of the order book for insurance companies to then agree to put up the amount of insurance for the premium agreed upon by the underwriter. The company would accept the underwriter’s recommendation, the policy would be issued identifying the company and the applicant would pay the premium less the fees for the underwriter and the relayer. A NFT would be created specifically for that policy and that Named Insured with no chance of copying or dividing. This would have to integrate with Parametric Insurance and would only be able to be triggered for an easily quantifiable and identifiable loss (i.e property loss from an insured peril like fire, lightning, EQ etc..)

If a loss does occur, an oracle would send the instructions on-chain which would then trigger an independent Third Party to review. This would most likely happen off-chain and would be the traditional role of a Loss Adjuster. Once the claim is independently verified the settlement would be paid out from the Escrow account held by the insurance company to the token holder in whatever cryptocurrency is set out in the policy.

While the above view does have its draw-backs and would need a large amount of further exploration it only lends credence to the Dharma Protocol and the architecture it could achieve in other areas of finance.

The double-edged sword

Ironically, the DP could be a double-edged sword as the biggest hurdle itself could potentially be the traditional debt issuers of today’s society. As the Dharma Protocol’s main advantage is that it leaves a clear and audit-able trail for anyone to review, this might go against some of the more dubious debt security issuers of today. Why would a company who has complete control of their ledger give it over to a company who promises full transparency? It might be a tough sell to these firms who have plausible deniability in the face of financial catastrophe. What the Dharma Protocol does is potentially take out the human error element that could have been relied upon in depositions when the 2008 financial crash started being investigated.

There seems to be a dichotomy that could arise between new underwriting firms solely using the DP that have a harder time gaining confidence from the Relayer and the Creditor to older more established firms that would have a laudable reputation but be hesitant in operating in full disclosure. As this is a new project, only time will tell which wins out or if it is a healthy balance of the two.

Conclusion

The Dharma Protocol is a new way of issuing debt securities and has numerous real-world applications that can be of great benefit to society. The DP is set to disrupt one of the most opaque financial instruments of today, namely the CDO which has different layers (tranches) of risk, in an attempt to become a fully transparent and auditable financial instrument. What the Dharma Protocol is not is an anonymous and fully trust-less decentralized offering, as already pointed out this is to the benefit of all parties involved and can contribute to each party’s reputation as a trusted service provider or debtor. The Dharma Protocol does not have its own token and does not function like a cryptoasset which pegs its value on the usefulness of the native ecosystem, DP is a forward forward-thinking project that does not muddy up the already overcrowded token ecosystem with another ‘Me Too’ coin. Although the protocol has yet to be battled tested in a public setting there are a number of benefits that we could see come out of this protocol as well as different iterations in different industries (i.e as seen in the insurance example).

It has been a pleasure learning about the issuance of debt securities through the Dharma Protocol and excited to see what the team has in store for us in the future.

Are You Better Off Today Than You Were Four Years Ago?

Analysis of the Dharma protocol

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