DeFi Financing and RW Credit: 0 to 1 Regulatory Movers | Jeff Riazi - Rodman Law

All right, good afternoon everyone. My name is Jeff Riazi and I'm an attorney at the Rodman Law Group. We have a booth down there, so feel free to stop by to chat with us and get any swag that we have left. Uh I think there's still a little bit left. Uh today I'm here to talk about uh DeFi financing and real world credit zero to one regulatory movers.

DeFi products that focus on lending or more broadly speaking advancing credit if targeted to US customers must still comply with US lending and credit laws. This talk will focus on the top five legal movers for founders so your project can get from zero to one. Interest rates you can charge. chartered banks versus everyone else. And when I mean everyone else, I mean traditional fintech.

And as fintech starts to become DeFi or is now DeFi. If I were to pull the audience and say, "Hey, what do you think the federal interest rate cap is on lending in the United States?" I'd probably get a variety of responses, but it's a trick question. There actually isn't a federal rate cap. It's state law driven.

And so the way banking and specifically chartered banks are set up is they pick a home state. Think Delaware, think New Jersey, think California. And as long as they comply with their home state and obey their home regulator, which if it's a state chartered bank would be the OC or excuse me, the FDIC and if it's a national bank, it be the OCC. They're free to export that rate throughout the United States. So take Delaware, which doesn't have a rate cap, moves to New York, which has a cap very much so at 16%.

They're free to charge the rate that they want, even though they're only based in Delaware. So what does that leave for everybody else? Traditional fintech, it's a 50-state patchwork of licenses and user recaps. And I'll walk through what each one means. So what's an what's a what's a lending license?

If you want to lend in, let's say, California, which is pretty much the most common state we'll get queries from. I'd say New York, second most, uh, California would require a license to lend in their state. However, once you get the license, there's no rate cap. But flip to New York. New York on the other hand only requires licensing for 50K and less, but would impose rate cap.

So if you're in the fintech space, you have to sort of run this Swiss cheese Patrick approach in terms of where do I get a license? Do I have to comply with the license? Uh and then what interest rate caps would fall following that? Uh that's on the license side. Now think on the interest rate side.

Okay, maybe I don't need the license, but maybe there's a usery cap. What usually means is interest rate top out meaning you cannot charge more than so some states it's super high take Colorado our home state right here at 45%. Some states is low say New York 16% which for alternative credit products is is is could actually be a challenge. So you're probably thinking okay well maybe I'll come up with a lending protocol and I'll just dodge it or I'll push the envelope on it. Well maybe you'll get a slap on the wrist, maybe you won't.

But if you dig deeper into the reggg, some states will make the debt uninforceable. So if you build a protocol and you're relying or resting on getting that money back, you may not be able to sue to get it back. Some states, and there's eight of them, including New York, uh actually make exceeding the interest rate cap penal, meaning you're looking at jail time. So it can get pretty serious, right? Three, state versus federal.

So I just mentioned earlier that there is no federal interest rate cap, right? So then what where does the federal law come into play? Well, federal law is largely a yes but system. So while the states say nope, you need to get a license or nope, you can't charge more than this, feds say sure, you can go ahead and do it if you dot dot dot. And that's where you get into the whole suite of federal regulations.

And so from a lending perspective, think equal, I'm sure you've heard of the Equal Credit Opportunity Act. Obviously, people, most people I would hope, don't make, you know, racially or religiously biased decisions, but you do have to actually send what's called a no action letter if you decline someone. And that gets a little more dicey in terms of the reasons you say no and it layers into your protocol. Um, Tila, lenders often dislike this regulation where they're otherwise forced to disclose APR. And for a lot of products that are short-term or short-term in orientation, an APR number can actually make their credit product look unattractive or a lot more expensive than let's say total cost of capital or cents on dollar, which historically traditional fintech has has tried to look to model after.

Um, another big difference in federal versus state law is purpose. So, federal law is heavily regulated or regulates heavily, I should say, on consumer lending. And consumer lending is defined as for personal, family, or household purposes. Commercial lending ends up being a lot less regulated. And so, depending on the protocol you want to throw out there, if there's a commercial purpose you can tie it to or limit it to, it's going to be a lot easier to get off the ground than consumer.

Of course, the consumer market is significantly larger. So these would be things that you want to be thinking through. Um ECOA is a common statute you'd have to comply with. Tila, which I just mentioned on on just APR disclosures, but it sort of runs down the gamut. Cradle to grave.

Uh FC, which is the Fair Credit Reporting Act. So if you're going to pull credit, you need to comply. Uh furnishing actually is a big piece for lenders. So if you're going to furnish data at the bureaus, you'd have to make sure that you're doing so in compliance. uh TCPA, the Telephone Consumer Protection Act, all these which would would not only dictates when and how you can call, but the underlying technology you can use.

Uh most lenders rely on, especially in this space, heavy tech softones. And a lot of those softphone technologies are actually pretty heavily regulated at the federal level. So these are things you'd want to be thinking through if you put that protocol together. four alternative products. So, you're probably thinking, okay, well, is there a way to get around the user and the lending laws?

Yeah, there are. And in fact, they're they're pretty popular in fintech. Uh I would want to step back and say, well, what makes a loan a loan? A loan is an absolute obligation to repay. Well, what contingent products are out there?

You probably heard of factoring. You may have heard of merchant cash advances. You may have heard of income share agreements. You may have heard of litigation finance which is a little bit more bespoke but here the feature of the product is conditional on success or conditional on revenue and I'll talk I'll take you through like merchant cash advance and income share real fast. On a merchant cash advance you're let's call it lender is funding a business but instead of lending it money it's betting a percentage of its future uh bank revenues.

Right? So very e very popular in the e-commerce space and this does translate over to DeFi fairly well where you're buying a percent and you're gambling on that business's success. So the underwriting here ends up becoming super key but the timing of the repayments can fluctuate a lot. So you may get back, you know, if you're going to buy, let's say, 10 or 20% or 30% of the revenues as they come in, uh, you may have ups and downs, but because it's contingent on the business success and contingent on cash flows, you're not necessarily subject, you aren't subject to the lending laws, let alone the user caps. So for a lot of I would say getting out there lending organizations or I say financing organizations, it's a great place to test out a proof of concept business.

It's a great way to get the business off the run, you know, off the ground and then to the extent you're looking to scale, maybe you then look to launch or mature into a more formal lending product. Another one in the consumer space is the income share agreement. This is super popular in student lending, but it actually applies into basically any form of consumer lending where you're funding someone, but you're taking a percentage of their income, provided that they actually have a job, and they're allowed to call in and say, "Hey, I don't have a job. I can't pay. But generally, most people want to pay and do the right thing.

So you're contingent again on their income production, which in this case is going to be their wages versus cash flows. Five, what's best for your project? Unit in portfolio economics drive legal strategy. So whenever clients come to us and they say, "Hey, I want to set up a lending organization or hey, I want to set up a factoring business structure. What do we need to do?

I ask, well, why don't you tell me a little bit more about what you're looking to do from a price point perspective? Is this going to have an like a 12% APR, 50% APR, 100% APR? Are you going to be funding $2,000? Are you going to be funding $50,000? Is it going to be $500,000?

Those economics actually drive quite a bit how intensive the regulations are going to be. Definitely at the state level in terms of whether it's going to be like a high reggg or a low reggg. So take for example low APR, high funding amount. You should be a lender. Like your regulatory lift is going to be low.

It's going to be easier to set the repayment structures and you're going to be able to get the product off the ground pretty easy. Take the other example where it's let's say under 5k average 40 to 50% APR. Now, you're going to have probably a much higher regulatory lift, but is that a problem? Maybe it's not. Maybe you have the team ready to go get licenses and comply.

Or maybe you look into an alternative product where if it's commercial, you can funnel it into the MCA structure. Or if it's consumer, you can funnel it more into like an income share structure. So, you want to really think through the business points, meaning the business drive strategy. As a correlated to that, the next step is loss rate. You may be thinking, what does that mean?

It means what do you expect to lose, right? I mean, every lender loses something and still makes money. So, if your loss rate is zero, it's probably too restrictive. Some lenders do just fine off a 10 or 20% loss rate, some even as high as 50. So, you want to think, does your loss rate matter and does your net loss rate matter?

Meaning, do you actually need to collect to get back your money? That has a lot to do with the product you set and the states you can target. Thank you very much. That's all I have for today.