Can DeFi Fix Private Credit?

Author: Prathik Desai

Article Translation: Block Unicorn

Preface

In 1719, Scottish gambler and monetary theorist John Law convinced the Regent of France to allow him to establish a system that packaged illiquid colonial assets into highly liquid paper financial instruments. He created the Mississippi Company, which monopolized trade with French Louisiana—a vast territory mostly marshland.

John Law packaged these illiquid colonial assets into company shares exchangeable for gold. Ordinary Parisians flocked to invest. A year later, this scheme made him the richest man in Europe and France’s finance minister. Though only temporarily.

What happens when you hold stocks redeemable for gold? You wait for the stock price to rise, then request to exchange for gold. Investors were doing just that. A redemption wave began, and they wanted their gold back. But gold supplies were insufficient. John Law’s response was to change the rules. He limited the amount of gold anyone could hold. He devalued the paper currency through decrees and mandated that shares could only be sold at prices set by his bank. Each intervention bought him a few more weeks but destroyed trust. By 1720, redemption certificates became worthless. John Law fled France after leading it into the Mississippi bubble.

Three centuries later, the world’s largest private credit funds are responding to surging redemption requests in a similar way. They are modifying redemption rules to control losses. But is this a solution or just a stopgap? Can on-chain private credit help? In today’s deep dive, I’ll explore this question. Let’s get started.

From Origins to Redemption

Private credit refers to lending activities outside banks and public markets. Companies borrow directly from specialized funds like Blackstone, Apollo Global Management, or Blue Owl, instead of from banks or issuing bonds. Borrowers are typically mid-sized firms not yet capable of going public.

Twenty years ago, this market barely existed. Today, it exceeds $3 trillion and is projected to reach $5 trillion by 2029. The industry filled the void left by the 2008 financial crisis, when regulatory and capital requirements made high-risk bank loans prohibitively expensive.

Private credit offers returns above public markets (8-10%) but at the cost of poor liquidity. Funds’ capital is locked up for years. That’s the essence of private credit. Compared to traditional bank syndicate loans, private credit provides greater flexibility and convenience for businesses to manage operations. Investors, in turn, earn a liquidity premium for their long-term capital.

Subsequently, the industry decided to change the rules. They aimed to attract retail investors—either to offer more attractive returns or to develop the private credit market. In 1980, the U.S. Congress established Business Development Companies (BDCs) under the Investment Company Act. For decades, BDCs remained niche products, but with firms like Ares, Blackstone, and Blue Owl launching non-listed BDC products targeting retail and high-net-worth individuals, they gained popularity. These products package less liquid corporate loans and set quarterly redemption windows to appease retail investors.

Retail investors participated but overlooked a major structural flaw: the private credit industry promised liquidity, yet the underlying loans were highly illiquid. If a credit cycle bubble burst and retail investors rushed to redeem, the private credit funds issuing these retail products would face trouble. Therefore, they limited redemptions to 5%. This seemed to solve fund managers’ problems. But what if the market crashes, and redemption demands exceed that 5% cap? Ultimately, the inevitable happened.

In September 2025, two major collapses shattered retail confidence in private credit.

First, auto parts supplier Brands Group filed for bankruptcy after undisclosed off-balance-sheet liabilities were uncovered in its loan agreement. The underwriters believed it was a 5x leveraged buyout, but the actual leverage was close to 20x. Additionally, subprime auto lender Tricolor Holdings allegedly used the same collateral for multiple loans. Once the truth surfaced, redemption demands surged.

This forced top private credit fund managers to consider discretionary rule modifications or redemption restrictions.

These responses carry echoes of John Law’s style. Some directly limit redemptions; others change rules during crises.

I worry that such gatekeeping and arbitrary rule changes are a double-edged sword. For investors, it signals that the terms they previously agreed upon are negotiable and can be unilaterally altered. Investors are at the mercy of fund managers, who can tighten redemption limits or even halt redemptions altogether and reallocate returns. Even more unfairly, these changes are often made after capital has been invested, violating the spirit of any contractual agreement.

On the fund manager side, they are becoming more cautious. Funds under ongoing redemption pressure are less confident deploying capital. Instead, they tend to hold cash rather than lend it out.

Is on-chain private credit a solution?

Some tout the advantages of on-chain private credit—showing data dashboards, total value locked in protocols, etc. But in reality, most of these are just repackaging of existing traditional private credit. Why do I say that? Because the facts are as follows:

The core unique selling point (USP) of on-chain private credit is its ability to operate under any financial underlying via smart contracts. These contracts can set withdrawal limits, collateral ratios, and distribution rules in code. While on-chain private credit funds may not guarantee higher liquidity than traditional funds, they ensure that once capital is committed, no fund manager can unilaterally change the contract terms. No board votes can expand takeover bids or convert quarterly redemptions into capital returns like Blue Owl.

Regardless of managers’ intentions or market conditions, the code runs as programmed.

Smart contract-based private credit funds can also address issues like repeated collateralization. Tricolor’s collapse involved using the same collateral for multiple loans. Tokenized collateral creates a single, auditable record, with each debt represented by a set of tokens. This structural approach makes repeated collateralization more difficult.

Months before First Brands’ bankruptcy, its valuation was still maintained at par by private credit funds. On-chain, every transaction and repayment is visible in real-time. Self-reported valuations cannot mislead investors. If the on-chain market values the asset at 60 cents, it cannot be priced at 100 cents.

If on-chain credit tokens can be traded on secondary markets, better price discovery is possible. This addresses the valuation mismatch between non-traded Business Development Companies (BDCs) and their underlying loans. We saw this in cases where hedge funds like Saba Capital and Cox Capital bought Blue Owl shares at 20-35% below net asset value.

Various protocols are building this infrastructure. Maple Finance manages a $3 billion institutional credit pool. Apollo and Securitize launched tokenized sub-funds. WisdomTree integrates on-chain NAV data via Chainlink oracles. The infrastructure is in place.

However, all these efforts cannot solve a fundamental problem: they cannot assess whether borrowers will repay or whether a mid-sized software company can survive the disruptive wave of AI.

As seen in the cases of First Brands and Tricolor, underwriting issues caused by human judgment errors can be minimized through on-chain records but not eliminated entirely. Another bigger issue is that most operational processes—such as maintaining financial statements, vendor contracts, balance sheets—are entirely off-chain. Smart contracts cannot review borrowers’ books or verify their financial reports. Even if some protocol attempts to upload and verify such data on-chain, companies would not agree to publicly disclose sensitive financial and business details on a public blockchain. Therefore, fully on-chain underwriting remains unfeasible under current infrastructure.

Blockchain currently offers a range of trade-offs. But failures in DeFi private credit could be more severe than those in traditional private credit.

Imagine a fund’s assets continuously depreciate while redemption volume surges. For this fund, the DeFi ecosystem seeking high yields from real-world assets is an ideal target. Both investors seeking to redeem and fund managers seeking new capital are motivated to tokenize these loans and sell them into on-chain pools. DeFi easily becomes a dumping ground for illiquid, problematic products.

We saw this in the case of Goldfinch, a pioneer in on-chain lending: a borrower unauthorizedly transferred a large sum between companies, threatening the entire operation. Tokenization only reveals the aftermath but cannot prevent fraud.

There are counterarguments. On-chain secondary markets can bring liquidity to bad assets and help with more rational pricing. But the boundary between market functions and exit liquidity pools is blurry and prone to collapse.

As long as key information—borrower creditworthiness, contractual enforceability, financial reports—remains off-chain, on-chain credit cannot solve traditional industry problems and may introduce new ones.

If mainstream on-chain protocols direct hundreds of millions of dollars of DeFi deposits into defaults or weak assets, the damage could ripple across multiple protocols. On-chain private lending is still in its infancy. Currently, active blockchain-native loans total only $3 billion, compared to the $30 trillion size of traditional private credit. A major default event could set back the entire RWA-based lending concept by years.

To surpass the veneer of traditional private credit, on-chain private credit must first solve trust issues—such as third-party verification of collateral rather than relying on originators’ self-reports. It should adopt standardized risk disclosures, turning duration and credit risk into terms that DeFi participants can understand and value.

It should even include traditional institutions’ credit ratings of on-chain tools—Maple Finance CEO Sidney Powell expects this by the end of 2026. It should also incorporate frameworks to detect and prevent originators from dumping bad assets into pools. Without these measures, the fusion of traditional finance and DeFi risks will become exploitation rather than synergy.

That’s all for today. See you in the next article.

If you find this article interesting, you can star and add Block Unicorn to your desktop.

The information provided is for general guidance and informational purposes only. It should not be considered investment, business, legal, or tax advice under any circumstances. We do not take responsibility for personal decisions made based on this content, and we strongly recommend conducting your own research before taking any action. While every effort has been made to ensure the accuracy and currency of the information provided, omissions or errors may occur.