Lending is a fundamental pillar of finance that supports the growth and expansion of businesses. Loans can, however, come in different forms with varying characteristics. In this post, we’ll delve into some of the intricacies of secured and unsecured lending, and how Credora, a leading Private Credit Platform, facilitates these transactions.
Collateral and Possession
First, the primary difference between secured and unsecured loans is the inclusion (or absence) of collateral. Broadly, collateral refers to any valuable asset or property that is pledged by a borrower as security for a loan. Including collateral for a loan acts as a backstop for the lender in case the borrower defaults on a loan. Collateral can take various forms. For crypto-native firms, a loan in one digital asset (such as USDC) can be secured by providing another asset (such as BTC). For more traditional companies, loans may be secured by real estate, financial accounts, or other assets. Collateral plays a crucial role in secured loans, allowing lenders to mitigate risk and offer borrowers more favorable terms, such as lower interest rates or higher loan amounts.
For crypto collateral, the lender has direct control over the digital assets until the loan is repaid. Legally, this gives the lender a high degree of security, as they can liquidate the digital assets to recover their funds in case of a default. An additional risk factor for borrowers may be introduced if lenders are able to utilize the collateral for operations or trading purposes. However, the tradeoff in this setup is that borrowers end up with lower interest rates.
In cases where assets are not digitally or physically possessed, they can be legally segregated or pledged. This means that while the lender may not have direct control over the assets, they have a legal claim to them. This can also ensure that assets are not lost or commingled, and can be “collected” for the benefit of the lender. Lenders, in these cases, would require an independent third party firm with predictable operational flows to ensure access to collateral if and when it is required.
Unsecured Lending
Simply put, unsecured loans rely on a borrower’s creditworthiness for repayment and are not backed by any collateral. As discussed in more detail below, Lenders must evaluate and consider the borrower’s current creditworthiness, including an assessment of their business operations, financial performance, and credit history. With no collateral involved, unsecured loans typically pose a higher risk to lenders who are compensated for the risk by demanding higher interest rates or imposing restrictions (aka covenants) on the Borrower. Credora’s platform helps minimize risk in unsecured lending by facilitating the validation of financial reports and KYC. Credora’s real-time data monitoring and privacy-preserving computation can unlock unique insights on a borrower, providing an up-to-date proxy of the borrower’s current creditworthiness.
For an unsecured lender who has made a loan to a company, the process of recovery in the event of default can be more challenging compared to secured loans. Upon a default, a lender will usually proceed to court to obtain a judgment on the debt. However, obtaining a judgment is the easy part — actually collecting on the judgment is much harder. Without collateral, collection can be time consuming, expensive, and financially uncertain. This is especially true for lenders who make loans to borrowers from across the world. The recent FTX/Alameda bankruptcy has proven this point — the companies filed for bankruptcy in November 2022 and unsecured creditors are still a long way from that process to concluding.
Where a borrower’s default may occur with respect to a specific loan or agreement, the borrower (or creditors on the borrower’s behalf) may also file for bankruptcy protection. While secured creditors may be entitled to quickly collect on the borrower’s pledged collateral up to the amount owed, unsecured creditors’ claims are pooled together with limited recourse. As the bankruptcy process unwinds, secured creditors collect their claims first, and unsecured creditors may receive their pro-rata share of any remaining assets.
Underwriting Considerations
For unsecured loans, lenders will typically analyze the “Five Cs” of credit: character, capacity, capital, collateral and conditions.
- Character: This may include a borrower’s repayment history, in terms of both amounts and cadence, and general reputation in the industry. Character may be reflected in tangible items such as the quality of financial reporting, depth of responses to diligence questions, and asset transparency.
- Capacity: Without a security interest backing a loan, it is imperative that the lender receive complete and up-to-date financial information to determine a borrower’s capacity for repayment. Specifically, lenders must be sure the borrower’s income and assets are sufficient to repay the principal and interest, and that the business is financially stable. This is particularly true where the borrower may have sudden or seasonal changes in income.
- Capital: Equity capital that a borrower invests helps further reduce the probability of default. In the context of a trading company, capital may refer to the ratio of borrower’s equity to trading margin extended at a particular exchange.
- Collateral: If any assets have been offered as collateral to secured lenders, it should be factored into a lender’s analysis on what assets would remain after senior lenders have been repaid.
- Conditions: This may include the proposed terms of the agreement, as well as covenants such as those related to financial performance. Market conditions should generally be analyzed to ensure the borrower’s market will allow them to properly operate to generate sufficient income to meet debt obligations.
Secured Lending
Secured loans, on the other hand, are loans that require collateral as a form of security for the lender. Collateral can be any valuable asset such as investments, intellectual property, digital assets, or other financial instruments. The collateral serves as protection that, in the event of default, the lender can seize and sell the asset to recover the loan amount. In short, having a security interest in collateral means that the lender has a legal claim or right to the collateral pledged by the borrower.
As secured loans give the lender comfort that they may recover the loan principal in the event of default, secured loans carry less risk for lenders and typically offer lower interest rates and more flexible terms.
Seniority
Seniority is a critical aspect of secured lending that determines the order in which creditors are paid in the event of a default. In the default and bankruptcy context, it pays to be a secured lender as they are typically senior to unsecured creditors. While the value of specific collateral assets may fall (for example, during an industry-wide credit event), secured lenders may exercise their rights to claim the collateral in an efficient manner, maximizing their chances of recovery. Unsecured creditors, meanwhile, must wait their turn and take what remainder they are given.
However, rules governing security can be complicated and may vary between jurisdictions. Even within the secured lenders' capital stack, there can be different levels of seniority. Before making any loan, it’s crucial to understand your position in the stack as it can affect your ability to recover funds.
Perfection
We’ve seen how seniority plays a critical role in secured lending, but how do you become a secured creditor? “Perfection” is the process by which a secured lender establishes their legal claim and priority interest in collateral, typically by filing a financing statement in a registry operated by a governmental body where the collateral or borrower is located. Perfection is a public process and set of procedures that is designed to put other potential creditors on notice of existing claims in the collateral. Once a security interest has been “perfected,” that lender is deemed to have given notice to subsequent creditors of its claim, and takes priority and seniority over who may claim the collateral. This concept is often referred to as “first in time, first in right.”
It is self-evident that perfection plays a key role in the secured lending process. Without it, or because of a mistake in the process (failure to renew a filing or incorrect information on the filing, for example), a secured creditor — or someone who thought they were a secured creditor — may encounter a situation where other creditors have superior rights to the collateral. Additionally, in the event of a bankruptcy, non-perfected security interests can be set aside, leaving the lender as an unsecured creditor as noted above.
While filing a financing statement is a common way to put other potential creditors on notice of the perfected claim, it is not the only way. Perfection can also be achieved by possession, i.e., taking physical possession of collateral. Similarly, perfection can be established by control; this is often the case for bank accounts or investment accounts that serve as collateral. In that instance, the parties may elect to use an Account Control Agreement or Asset Control Agreement to establish control over collateral accounts. An ACA is a tri-party agreement between the borrower, lender, and custodian that allows the lender to access the borrower’s accounts in the event of default. Given that perfection is intended to give others notice of prior claims, it makes sense that perfection can occur where a lender has already established possession and control of the collateral.
Secured lending deals often simplify the security guarantees by using bankruptcy remote Special Purpose Vehicles (SPVs) that warehouse the pledged collateral and are the ultimate borrowers of the loan. This can ensure that in the event of a default within a larger corporate structure, creditors to the SPV are not affected, and still have claim to the collateral in the SPV. Credora provides a segregated legal infrastructure for secured lending deals, helping borrowers easily set up SPVs where assets can be placed as collateral, and these assets can be thoroughly vetted and monitored.
Underwriting Considerations
- Quality of Assets: The amount of collateral, and hence the overcollateralization ratio, alongside the depth of liquidity for the collateral is crucial. Assets that can be quickly and easily sold into deep, liquid markets are more likely to return the expected amount, whereas illiquid assets may be more volatile and difficult to unwind. For example, while Bitcoin can be immediately sold at any time, the shares of a non-public company may take time to sell with uncertain outcomes.
- Financial Covenants: These are terms and conditions that the borrower must adhere to, which can affect the value and security of the collateral. Covenants may permit or prevent a borrower from moving assets, impose certain financial metric requirements, or require the borrower to share financial information.
- Deal Structure: This can include special purpose vehicles (SPVs), security agents, custodians, and transfer agents. Each of these can affect the security and management of the loan.
- Insurance: Credit insurance can provide additional security for the lender, covering potential losses. Depending on specific policy terms and the credit quality of the insurer, credit insurance may also protect a lender in a protracted default situation where a debtor has not declared insolvency but has failed to pay or from a political event such as war or a regulatory situation where a government agency has, for example, revoked a borrower’s license or otherwise substantially impacted the borrower’s business.
Ultimately, lending is a risk and reward proposition. Whether you’re a borrower or a lender, understanding the nuances of secured and unsecured lending is crucial to making correct decisions.
Credora is actively involved in both secured and unsecured lending of digital assets. This includes the development and maintenance of various credit methodologies for the assessment of private credit opportunities and the required, regulated infrastructure to minimize risk in any deal.
Additionally, the Lending Marketplace on the Credora platform supports direct lending through customizable RFQs and dashboards for lenders. Borrowers can also market their loans to multiple channels, including partner on-chain applications.
For additional information, please contact us on LinkedIn or Twitter, or email us at info@credora.io.
