Hybrid Prudential Reserves and Tokenized Capital for DAO-Based Credit Issuance

Abstract

Lending protocols in decentralized finance have traditionally relied on over-collateralization mechanisms, where investor protection is primarily ensured through the automatic liquidation of collateral. While effective from an operational perspective, this approach limits the economic role of credit when compared with under-collateralized structures. In such settings, the prudential management of credit risk becomes a central element for protocol sustainability. This paper proposes a prudential framework for decentralized lending protocols by introducing an additional protection layer based on the distinction between tokenized loss-absorbing capital, an operational buffer, and a prudential reserve. The model defines three classes of subordinated instruments-First Loss Token, Contingent Capital Token, and Subordinated Backstop Token-arranged according to a progressive loss waterfall. The model is first applied to public data from Goldfinch and then extended to a TrueFi dataset, with the aim of assessing the ability of the policy to reduce losses borne by senior liquidity providers. The model shows a net reduction in losses. The sensitivity analysis confirms that the mechanism maintains a positive net benefit across variations in instrument costs, risk weights, and loss severity. The results suggest that an explicit prudential layer may contribute to strengthening the resilience of DAO-based credit protocols by making the prudential cost of risk-taking more transparent and by distinguishing between available liquidity, loss-absorbing capital, and protective reserves.