In an on-chain, permissionless and decentralized system, there is no court-based recovery process to squeeze assets out of a delinquent borrower. Borrowers can be anonymous blockchain addresses, or even smart contracts with no owner or physical entity.
These preconditions are enforced in the code of the Compound protocol, which runs autonomously and is open source. The code cannot be negotiated with. How it operates and makes decisions is completely transparent. This allows borrowers and lenders to know the rules and decide if they want to participate.
One way human decision makers may evaluate borrowers is by looking at their reputation for trustworthiness and financial success. Filing for bankruptcy instantly ruins this reputation. When a debtor actually becomes insolvent, their reputation lags behind. If the reputation is based on having assets, it is better to simply treat the assets as collateral directly, rather than believing in the reputation and the assets both at once.
Lenders have also fallen into the trap of letting their fates become tied to those borrowing from them. It is tempting to let the size of a single borrower or a borrow against a single type of collateral grow large in order to reap larger interest payments. In the case of Alameda / FTX, the companies were so intertwined that the motivation to liquidate Alameda’s loans on FTX was apparently absent.
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