# Credit Risk

## Definition

Credit risk is the risk of financial loss to the protocol arising from a default, delayed payment, or deterioration in the credit quality of securities held as collateral. For **USD0**, credit risk would materialize if issuers of the underlying collateral assets fail to meet their obligations—such as paying interest on time or returning principal at maturity.

## Impact on Usual’s Collateral

USD0 is backed by tokenized **Real-World Assets (RWAs)**, primarily invested in short-term debt instruments such as **US Treasury Bills**, **reverse repurchase agreements**, and other highly liquid government instruments. While this is among the lowest-risk, yield-generating asset classes available, credit risk cannot be fully eliminated.

Some money market funds and tokenized RWA products may invest beyond sovereign debt, including **commercial paper**, **certificates of deposit**, and other short-term securities. If any collateral provider held instruments issued by entities with weak creditworthiness or under financial stress, the fund could suffer a decline in value and potentially incur direct losses—threatening the **1:1 backing** of USD0.

To mitigate this risk, Usual applies a strict credit policy that **prohibits corporate debt exposure** and restricts investments to **sovereign obligations only**.

## Collateral Eligibility Requirements

Before any RWA tokenizer is accepted as USD0 collateral, it must pass rigorous due diligence. From a credit risk perspective, the key requirements are:

| Criterion             | Requirement                                                                          |
| --------------------- | ------------------------------------------------------------------------------------ |
| **Asset type**        | US Treasury Bills, quasi-government debt, or cash only                               |
| **Corporate debt**    | Strictly prohibited                                                                  |
| **Collateralization** | Must be fully collateralized with **no leverage** or **fractional reserve** exposure |
| **Duration**          | Portfolio duration must remain below **0.33 years** (\~4 months)                     |
| **Liquidity**         | Redeemable or sellable with minimal slippage within a maximum of **5 days**          |
| **Transparency**      | On-chain verifiable reserves with frequent independent off-chain audits              |

These requirements ensure USD0 collateral is exposed only to **sovereign credit risk** (primarily the US government), which is generally considered the lowest available credit risk among yield-generating assets.

## Risk Monitoring and Management

Usual uses a **three-line-of-defense** framework to monitor and mitigate credit risk across all accepted collateral.

### 1) First Line of Defense: Zero-Tolerance Policy

* Usual maintains a **zero-tolerance** posture for credit risk by restricting investments exclusively to **US Treasuries, quasi-government debt, or cash**.
* **Corporate debt** is **strictly prohibited** across all accepted tokenized RWA providers.
* This policy is enforced at onboarding: any tokenizer with corporate debt exposure is **ineligible** as USD0 collateral.

### 2) Second Line of Defense: Asset Manager Controls

* Usual only invests in tokenized RWA funds where corporate debt is explicitly prohibited at the **fund level**.
* Each tokenizer’s asset manager controls serve as the primary operational safeguard.
* These controls are designed to ensure compliance with Usual’s criteria and prevent unauthorized credit exposure.
* Tokenizers must use **skilled, regulated asset managers** operating under strict diversification and asset selection guidelines.

### 3) Third Line of Defense: Active Monitoring by Usual

* Usual independently monitors holdings within each accepted RWA tokenizer’s portfolio.
* Monitoring includes **regular checks and audits** to identify deviations from the credit policy.
* Both **on-chain verification** and **off-chain review** of fund reports are performed to confirm ongoing compliance.
* Any discrepancies are promptly escalated to the tokenizer and its asset managers for resolution.

## Counterparty Risk Layers

In addition to the credit quality of underlying securities, Usual evaluates counterparty-related risks at three levels:

| Layer                   | Risk                                           | Mitigation                                                                                                                                                |
| ----------------------- | ---------------------------------------------- | --------------------------------------------------------------------------------------------------------------------------------------------------------- |
| **Tokenizer risk**      | Default or failure of the tokenization entity  | Bankruptcy remote vehicles (BRVs), independent audits, periodic performance reviews; assets must be ring-fenced in the event of tokenizer bankruptcy      |
| **Fund manager risk**   | Poor investment decisions or policy violations | Only regulated fund managers with proven track records; regular assessment of investment decisions and compliance                                         |
| **Bank/custodian risk** | Failure of a custodian or banking partner      | Only highly rated institutions (e.g., BNY Mellon with **AA-** or higher); diversified banking relationships; contingency plans for institutional failures |

The primary collateral provider, **Hashnote USYC**, illustrates these safeguards: its reverse repurchase agreements are conducted through the **Depository Trust & Clearing Corporation (DTCC)** (rated **AA-**), and custody is provided by **BNY Mellon**, one of the world’s largest and highest-rated custodians.

## Insurance Fund Protection

In the unlikely event of collateral loss, Usual maintains a dedicated **insurance fund** to protect USD0 holders:

* The insurance fund is funded from a portion of collateral yield (approximately **20%** accrual rate, set by the DAO).
* The fund is sized to absorb potential losses, with a maximum cap ranging from **0.33% to 5.33%** of all USD0 in circulation, calibrated using historical stress tests.
* In a loss event, the insurance fund **burns USD0** to increase the redeemable value per remaining token and restore the backing ratio.
* With an average bond duration of **0.33 years** and a **5%** coupon rate, the fund can be fully replenished in approximately **24 days**.

## Non-Compliance Management

If deviations from the credit risk policy are identified despite the mitigation framework, Usual applies the following escalation and remediation process:

* **Decisive action:** If a deviation persists after initial corrective steps, Usual escalates the issue in consultation with protocol governance to determine the appropriate response.
* **Potential remedies** include:
  * Immediately reducing exposure to the non-compliant collateral provider.
  * Removing the RWA tokenizer from the eligible collateral list.
  * Temporarily pausing minting via the non-compliant collateral type.
  * Activating the **Counter Bank Run Mechanism** if collateral value is impacted. This mechanism can pause the minting engine and route activity to the secondary market while remediation is underway.
* All remediation actions are subject to **DAO governance**, ensuring transparency and community oversight.

## Historical Context

Usual’s zero-tolerance policy is informed by real-world precedent. During the **March 2023 Silicon Valley Bank (SVB) crisis**, Circle had approximately **8%** of USDC reserves exposed to SVB, and USDC traded at an average of approximately **$0.95** (a \~5% deviation from parity). Usual’s policy is designed to eliminate comparable exposure by requiring collateral invested exclusively in **sovereign bonds** and prohibiting exposure to **commercial bank deposits**, reducing the likelihood that USD0 could be affected by a similar event.

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## Note on KB Updates (Action Required)

This draft references updating “risk parameters, collateral requirements, and safety mechanisms from the KB.” No KB content was provided in this request, so the values and mechanisms above have been preserved as-is. If you share the relevant KB excerpts, I can align the document precisely while maintaining technical accuracy.