The Tie Research
Real World Assets: Finance’s Bridge to Crypto
If you missed our webinar with Maple Finance, Centrifuge, and Goldfinch last week, check it out here.
The financial industry is on the verge of transformation. DeFi is slowly expanding beyond cryptocurrencies to have an influence in the real world. As more assets are tokenized, conventional capital markets are also moving toward blockchain.
Simultaneously, the opportunity cost of transferring money on-chain is at its greatest level in cryptocurrency’s history as a result of rising rates, declining DeFi demand, and a negative global macroeconomic climate. Real World Assets (RWAs) offer a unique opportunity for yield-starved DeFi investors to access diverse off-chain debt markets, while also allowing TradFi institutions to tokenize and issue debt/assets, agnostic of market geography.
What Are RWAs?
RWAs are tokens (fungible or non-fungible) that can be traded on-chain, and represent actual assets. RWA examples include real estate (homes & rental streams), loans, contracts and guarantees, as well as any item of a high value that will be utilized in a transaction.
RWAs remove many conventional constraints. Imagine a hypothetical middle-sized FinTech company in Indonesia, called Bali. Bali wishes to fundraise to fuel their growth and marketing campaign. Within hours, this firm is able to raise over $100,000, not from traditional banks or VCs, but rather from issuing tokenized bonds. This bond token could then be packaged with many similar Indonesian FinTech bonds, and sold in different capital tranches.
Like another on-chain asset, Bali’s finances are all transparently visible. As Bail's earnings and costs change, so does the token price, and changes in credit risk are automatically reflected in loans.
As a result of RWAs, Bali is able to borrow money at a competitive 7% instead of the usual >14% for Indonesian FinTechs, and investors are able to access competitive real-world lending rates when DeFi yields are low. RWAs enable economic growth regardless of geographical location, with a long-term steady state featuring companies raising capital through either digital or traditional means.
Consider the success of securitization in the 1990s as an example of how improved norms alter capital formation. Securitization is only a system for creating, gathering, storing, and dispersing risk. By presenting a benchmark that assets must meet (in terms of length, risk, etc.), we increased liquidity and originations significantly. Mortgages, corporate loans, and consumer loans were institutionalized and deployed through securitization, resulting in more affordable financing for consumers, companies, and house buyers.
Securitization is virtually identical 30 years later; financial markets have not yet evolved to effectively accommodate the internet. Borrowing costs are greater than they should be because of a network of middlemen, including investment banks, trustees, rating services, servicers, and others. The majority of assets cannot be securitized since they don't fit neatly into a box during origination. International financing markets continue to be inaccessible to the majority of business owners. In Africa and Asia, basic resources like insurance are still difficult to come by. This raises the question: what do digitized capital markets need to do to cross TradFi's moat?
Building a link between crypto and the real world must be DeFi's main goal if it is to be successful. Despite the fact that the market for digital assets is still quite small ($1T), the market for actual assets is enormous (>$600T). Crypto must address this sea of value if it is to have an impact on how business is conducted.
In light of the proliferation of digital assets and the influx of new institutions, the significance of solid institutional custody for digital assets cannot be overstated. Permissioned DeFi custody services, like Anchorage Digital and Copper, have proliferated over the past years. Some credit protocols, like Maple, guarantee their tokens on these permissioned platforms catering to institutions.
As it stands today, custody is largely guaranteed by a legal structure that's created whenever a pool is created, as well as through standard KYC/AML procedures. Take Centrifuge for example- upon interacting with a pool, investors sign an agreement with the pool issuer, setting up the pool as a Special Purpose Vehicle. This agreement holds the issuer liable for any future repayment.
All financing transactions and payments are done directly between Borrowers, the SPV, and Investors and happen on-chain. In the future, credit protocols hope to have more integration with decentralized identifiers (DIDs) like Kilt, allowing validation of assets. A group of underwriters would then be integrated to act as third-party risk assessors, rather than the status quo oracle system in place.
Particular tokenized assets like real estate deeds can be highly illiquid. Liquidity on pools depends on asset maturity and on inflow and outflow of investors. Revenue-based incentive models are another lucrative source of liquidity.
Alternatively, protocols can collaborate with DEXs, AMMs and other DeFi apps like Balancer and Curve, to create liquidity. A prime example of this is with Goldfinch, where members created a liquidity pool on Curve with FIDU, a token that represents a Liquidity Provider’s deposit to the Senior Pool, and USDC. This allowed for FIDU-USDC Curve LP positions to be staked for GFI liquidity mining rewards.
One of the biggest reasons for institutional trepidation around DeFi is the lack of a standardized reputation system, like a credit score. DeFi protocols are forced to request liquid tokens as collateral due to an inability to enforce the future repayment of the loan in the event of default. This takes credit risk out of the equation, but also limits the number of possible financial products available. Credit protocols are using complementary strategies to give loans a reputational component. While some endeavor to bring off-chain reputation into the on-chain world, other initiatives truly aim to create an on-chain reputation system.
While exact instantiation varies, this is what major credit protocols like Maple, TrueFi, Goldfinch, Centrifuge, and Clearpool aim to do.
Goldfinch is developing a decentralized loan underwriting protocol that would enable anybody across the globe to issue loans on-chain as an underwriter, using data like Unique Identity (UID) NFT, representing KYC/KYB. Their thesis is built on two foundational principles:
- Over the next ten years, investors will demand new investment opportunities due to the overall transparency and efficiency of DeFi, as well as a general environment of suppressed rates (which is now changing). Investors will also demand higher-yield opportunities than what their traditional banks and institutions can provide.
- Global economic activity will shift to an on-chain model, making every transaction transparent and resulting in the creation of a new public good: an immutable, publicly available credit history, as well as a reduction in the significant transaction costs associated with banking.
The objective is to gather information created in both real life and online and use it to build a user's reputation that can be applied on-chain.
As with any credit lender, this system is not without risk. Protecting lenders involves preventing defaults, or in the event of default – reimbursing lenders as much as possible.
Goldfinch relies on its Backers (investors who supply USDC to Borrower Pools) to monitor the health of the pool and provide liquidity. They are motivated to do this job because in the case of default, it’s their liquidity that is lost first. Similar to TrueFi, Goldfinch offers smart contract insurance through Nexus Mutual.
Centrifuge is a network that provides access to fast, cheap capital for small businesses and stable yield for investors. Centrifuge bridges real-world assets into DeFi to bring down the cost of capital for small-medium size enterprises, and provide DeFi investors with a stable source of yield uncorrelated from volatile crypto assets. Centrifuge depends on Asset Originators and Issuers for solid loans with low default rates. Investors in Centrifuge's junior tranche, bear any losses first in the event of a default.
Tinlake, their first user-facing product, provides any firm with a simple method to access DeFi liquidity. For investors, these assets will produce a secure, consistent return on their investment that is unrelated to the erratic results in the cryptocurrency markets. Their native coin, the Centrifuge token (CFG), uses a Proof-of-Stake consensus method to stake validators and offer adoption incentives. Through on-chain governance, CFG holders may actively influence Centrifuge's evolution.
Tinlake’s valuation methodology is based on a fair value discounted cash flow model, and their approach can be summarized as follows:
- Derive expected cash flows: For every outstanding financing of an asset, the expected cash flow is calculated. This is based on the expected repayment dates and the expected repayment amounts.
- Risk-adjust expected cash flows: Cash Flow is risk-adjusted for credit risk by the expected loss. The Expected Loss is calculated as Expected loss = Expected Cash Flow * PD * LGD and subtracted from the expected repayment amount to adjust for credit risk.
- Discount risk-adjusted expected cash flows: The risk-adjusted expected cash-flows are discounted with an appropriate discount rate (this depends on asset class and pool) to derive the present value of a financing.
- Calculating NAV: Adding up the present values of the risk-adjusted expected cash flows for all financings in the pool leads to the NAV.
TrueFi is a leading credit protocol, offering on-chain capital markets with a broad selection of real-world and crypto-native financial opportunities. As of November 2022, TrueFi has originated over $1.7 billion in uncollateralized loans and paid out over $35 million to lenders, with every dollar allocated and reported on-chain. Through a path of progressive decentralization, TrueFi is now owned and governed by holders of the TRU token, with underwriting owned by TrueFi DAO or independent portfolio managers.
TrueFi serves – and is made possible by – four major actors, acting in coordination:
- Lenders use TrueFi to access opportunities across a range of portfolios.
- Borrowers, after vetting, depend on TrueFi to quickly access competitively priced capital with no collateral lockup, allowing them to maximize capital efficiency.
- Portfolio managers use TrueFi to set up on-chain portfolios, bringing the benefits of blockchain to their investing activity - such as 24/7 access to global lenders, greater transparency, and lower operating costs.
- TRU Holders effectively own and govern the TrueFi protocol, making both the key decisions and contributions necessary for TrueFi to grow, using open discussion and on-chain voting.
TrueFi’s core contributor Archblock (formerly TrustToken) originally started with real world assets in 2018, with the launch of the popular TUSD stablecoin. Starting early 2022, TrueFi moved even deeper into RWA with the launch of capital markets, allowing traditional funds to move their lending portfolios on-chain. Today, TrueFi is home to portfolios facilitating loans to LatAm fintechs, emerging markets, and even crypto mortgages.
Becoming a borrower or portfolio manager on TrueFi follows a similar process to most other credit protocols: each incoming applicant has to submit a public proposal describing their business and intended use of funds, subject to community approval, while also needing to satisfy underwriting requirements (such as capital under management, maximum leverage and asset exposure) imposed by the TrueFi Credit Committee. Successful applicants are whitelisted to borrow from TrueFi’s permissionless DAO pools, or to design and launch their portfolio.
TrueFi takes a few unique measures to protect lenders. Besides managing an underwriting process, spearheaded by the DAO’s Credit Committee, and committing to regular code audits during major protocol upgrades, TrueFi has three layers of recourse in response to a default. Firstly, up to 10% of staked TRU is slashed to cover lender losses; after which TrueFi’s Secure Asset Fund for Users (or “SAFU”) may deploy its reserves to make up any further losses; and finally, any successful collection action against a defaulted borrower are routed through the DAO for appropriate disbursement. Additionally, TrueFi offers a Smart Contract Cover plan that can be purchased through Nexus Mutual, providing insurance in the event of a smart contract exploit.
Following a process of gradual decentralization, TrueFi is now owned and governed by holders of the TRU token. The TrueFi DAO now owns and manages TrueFi’s permissionless pools, treasury, and roadmap. The DAO has set its sights on both deeper institutional adoption and DeFi integration, with the launch of features like tranching as well as improved portfolio composability.
In 2021, Maple launched its under-collateralized lending program for permissioned KYC loans.
Instead of using the standard DeFi model, which depends on collateral that can be reduced in the case of underpayment, Maple enables users to offer undercollateralized loans to well-known companies based on reputation. Alameda Research, Framework Labs, and Wintermute Trading are some current borrowers from other pools.
The protocol is governed by the two Tokens (MPL and xMPL), which enables token holders to participate in governance, share in fee revenues, and provide pool cover to Lending Pools.
Holders of the Maple Token (MPL) participate in the following ways:
- Passive MPL Holders earn a portion of establishment fees.
- Savvy MPL Holders can earn additional yield by selecting Liquidity Pools to stake
- Staking MPL-USDC 50-50 BPTs provides a reserve covering loan defaults in return for a share of the ongoing fees.
As Maple moves towards full decentralization, MPL Holders will be able to submit proposals and vote on changes such as adding Pool Delegates and adjusting fees and staking parameters. For Pool Delegates, Maple is a vehicle to attract funding and earn performance fees.
Pool delegates are crucial to this process in Maple. Pool delegates go through a stringent approval process, as they are in charge of maintaining the stability of Maple’s lending pools. This is accomplished by authorizing loan requests, screening borrowers, and the initial establishment of lending pools. Finally, Maple requires each pool delegate to have a stake and post MPL tokens to be used as first loss capital. As a result, if the borrower defaults, the Pool Delegate suffers as well. Though, in the event of a default, Maple employs a Pool Cover, which is essentially the pool of first loss. This is funded by Pool Delegates and MPL holders.
The efficiency of capital movement will increase by an order of magnitude as the industry develops. In a perfectly efficient market, a pre-approved borrower might obtain a $5 million loan, pay it back in 30 minutes, and watch as another borrower promptly took out a loan for the same amount. This flow would be driven by a credit model that constantly evaluated each borrower's risk of default and priced in any new information that became available. Every capital dollar is immediately allocated in this future to the location that offers the highest risk-adjusted return. Credit protocols like TrueFi, Centrifuge, and Goldfinch, amongst others, will have a significant part in steering finance in this direction.
This report is for informational purposes only and is not investment or trading advice. The views and opinions expressed in this report are exclusively those of the author, and do not necessarily reflect the views or positions of The TIE Inc. The Author may be holding the cryptocurrencies or using the strategies mentioned in this report. You are fully responsible for any decisions you make; the TIE Inc. is not liable for any loss or damage caused by reliance on information provided. For investment advice, please consult a registered investment advisor
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