Anytime that a loan occurs that has a fee, some amount of debt is incurred by the borrower that is greater than the amount of the loan provided by the lender. This debt can be broken up into two parts, the principal and the interest. Alternatively, these two will be referred to as real debt and virtual debt, respectively. Interest is a virtual debt in the sense that, if some party were to account for all assets in the ecosystem this debt would not be able to be included as it is not tied to a real asset that is in existence.
As an example, consider that there are 100 units of some asset in existence. You loan 10 to someone, but expect 11 back. The principle (those 10 that you lent) are real assets that now are in the custody of the borrower, but the interest (the 1 extra you expect to receive back) only exists ephemerally within your contract. If there are no other lenders or borrowers in this ecosystem, then from 100 assets there are 101 assets that can be “accounted” for: the 100 real assets and the 1 virtual asset.
Now, one might wonder, “is this virtual debt a good thing or a bad thing?” The answer is nuanced and that it can be both. If lenders fully expect borrowers to repay this virtual debt then it effectively raises the value of the asset because now the “total value” in the ecosystem is the combination of all assets, both real and virtual. Debt is an effect way to increase the trading volume, i.e. the flow of assets through the ecosystem. On the other hand, it can also be susceptible to abuse, especially in low liquidity environments.
Take the example of the dynamics of DJED on Liqwid Finance. Currently, there is 7,386,171.41 DJED supplied on Liqwid and 5,730,441.04 DJED borrowed, however the total circulating supply of DJED is 4,234,416.93. How is this possible? Well, this is because much, if not most, of the supply on Liqwid is in fact virtual debt. Someone supplied 1 DJED on Liqwid, lent it to a borrower, and then that borrower supplied that same 1 DJED back into Liqwid. So, from the protocol’s standpoint it has 2 DJED supplied even though it used the same 1 “real” DJED supplied twice. This is equivalent to saying that 1 real DJED was supplied and 1 virtual DJED was supplied.
Okay, so how can this be a bad thing?
Well, these assets supplied are virtual debt which has to be paid back and accumulate further interest the longer they are loaned out. A bad actor with enough capital could decide to lend a significant portion of the real DJED supply and subsequently repurchase this supply off of the market. The effect of the repurchase would be to greatly increase prices as well as increase the interest rate on the debt that they are now owed. Borrowers would then be forced to either pay the increased interest rates on their borrowed assets, buy them back at the newly inflated price, or risk having their collateral liquidated at a premium to the liquidators (of which the bad actor is eligible to partake in). Since there is nearly twice as much DJED supplied as is in circulation, this implies that if a “bank run” occurred on DJED of people trying to close their positions there would not be enough real DJED available in the entire ecosystem for everyone to do so at once.
Is this avoidable by charging interest in ADA instead?
The short answer is, yes. The potential for a bank run type event is far less likely with ADA for a couple of reasons, both stemming from it having higher liquidity. First, the amount of virtual debt relative to real assets is much lower. Second, the amount of capital a bad actor would need to corner a substantial fraction of the marketplace to initiate and benefit from such an event is much higher.
What does this all have to do with Indigo?
Interest is an important tool for the DAO and it’s important to understand the pros and cons of choosing to have interest be charged in iAssets or in ADA. For instance, it would be much simpler for the DAO to get a more complete picture of an iAsset’s ecosystem if it’s individuals did not have to track down or estimate how much virtual debt exists and what economic effects that debt can have on the ecosystem. Unfortunately, even if the Indigo DAO chooses not to create iAsset virtual debt, they cannot prevent it from being created on other protocols. It would be advantageous, however, if this virtual debt was more of a perturbation to the real ecosystem rather than a significant part of it.