[ENG] The Tokenisation of Real World Assets — a Decentralised Metamorphosis

DeFi is gradually extending its influence outside of cryptocurrencies to impact the real world — the financial sector is set to change as legacy capital markets move toward blockchain tokenisation…

Due to rising rates, declining DeFi demand, and a dismal global macroeconomic environment, the opportunity cost of transferring money on-chain is at its highest point in cryptocurrency history.?Real World Assets?(RWAs)?give yield-starved DeFi investors access to a range of off-chain debt markets while enabling TradFi institutions to tokenise and issue debt/assets regardless of the market’s location.

What Are RWAs?

RWAs are tradable, on-chain tokens that can be fungible or non-fungible. Real estate (homes and rental streams), loans, contracts, and guarantees are a few examples of RWAs. They also include any high-value item that will be used in a transaction.

RWAs lift many conventional restrictions.?For example, consider Colossus Digital, a?hypothetical?middle-sized FinTech business in Italy. Colossus wants to raise money to support its growth and marketing efforts. As opposed to using traditional banks or VCs, this company can raise over $100,000 in hours by issuing tokenised bonds. Then, this bond token could be bundled with other comparable Italian FinTech bonds and sold in various capital tranches.

Colossus’ finances are transparent and observable, similar to other on-chain assets. Therefore, changes in credit risk are automatically reflected in loans and in Colossus’ earnings and expenses, which also affect the token price.

When DeFi yields are low, RWAs provide investors access to competitive real-world lending rates; as a result, Colossus can borrow at a competitive 7% rather than the standard 14% for Italian FinTechs. Moreover,?RWAs enable economic expansion regardless of location, with a long-term steady state characterised by businesses raising capital through conventional and digital channels.

Why RWAs?

Take the 1990s’ success with securitisation as an illustration of how altered norms affect capital development. We dramatically enhanced liquidity and originations by establishing a baseline that assets must adhere to in terms of duration, risk, etc. Through the institutionalisation and deployment of mortgages, corporate loans, and consumer loans through securitisation, consumers, businesses, and homebuyers could obtain finance at lower costs.

Thirty years later, securitisation remains unchanged; the financial markets still need to change to embody the internet’s potential. Because of a web of intermediaries — including investment banks, trustees, rating agencies, servicers, and others — borrowing costs are higher than expected. Moreover, since most assets don’t neatly fit into a box during origination, they cannot be securitised.

Moreover, most business owners still lack access to international financial markets. Necessities like insurance are still hard to come by in Asia and Africa: this begs the question of what digital capital markets must accomplish to pass TradFi’s moat.

If it is to be effective, DeFi’s major objective must be to provide a bridge between crypto and the real world. The market for physical assets is huge (>$600T); meanwhile, the market for digital assets is still very modest ($1T). If cryptocurrency wants to impact how commerce is done, it must address this sea of value.

Asset Custody

We cannot stress enough?the importance of strong institutional custody in light of the development of digital assets and the entrance of new players. As a result, the number of authorised DeFi custody services has increased. Examples are?Anchorage Digital,?Fireblocks?and?Copper. On these institutional-focused permissioned networks, some credit systems, such as?Maple, guarantee their tokens.

Currently, a legal framework is established whenever a pool is created, and common KYC/AML procedures ensure custody. Consider?Centrifuge: When investors interact with a pool, they sign a contract with the pool issuer that designates the pool as a Special Purpose Vehicle. The issuer is responsible for any future repayments under this agreement.

On-chain financial exchanges and payments occur directly between borrowers, the SPV, and investors. Credit protocols intend to integrate further with decentralised identities (DIDs), such as?Kilt, to enable asset certification. The current oracle system would subsequently be replaced by a panel of underwriters who would serve as independent risk assessors.

Liquidity

Some tokenised assets, such as real estate deeds, may be extremely illiquid. Pool liquidity is influenced by investor inflow, outflow, and asset maturity. Another good source of liquidity is revenue-based incentive structures.

As an alternative, protocols can work together to generate liquidity with DEXs, AMMs, and other DeFi apps like?Balancer?and?Curve.

Using?FIDU, a token that stands in for a liquidity provider’s deposit to the senior pool, and USDC, members of Goldfinch developed a liquidity pool on Curve as a perfect illustration of this. This made it possible to stake FIDU-USDC Curve LP positions for?GFI liquidity mining?payouts.

Credit Protocols

The absence of a standardised reputation system like a credit score is one of the main causes of institutional anxiety regarding DeFi. Because it is impossible to ensure the loan is repaid in the event of default, DeFi protocols are compelled to demand liquid tokens as collateral. This eliminates credit risk but reduces the variety of financial products that may be offered. Loans are given a reputational component by credit protocols using complementary tactics. Other initiatives aim to create an on-chain reputation system, while some attempt to bring off-chain reputation into the on-chain world.

Major credit protocols like Maple, TrueFi, Goldfinch, Centrifuge, and Clearpool aim to achieve this, though the precise instantiation varies.

Goldfinch

A decentralised loan underwriting protocol developed by Goldfinch will allow anyone worldwide to issue loans on-chain as an underwriter using information such as Unique Identity (UID) NFT, which stands for KYC/KYB. Their argument is based on the following two tenets:

• Due to the overall transparency and effectiveness of DeFi and the general environment of suppressed rates over the next ten years, investors will demand new investment opportunities (which are now changing). Additionally, investors will look for higher yield opportunities than their traditional banks and institutions can offer.
• An immutable, publicly accessible credit history will be created as a new public good. In addition, the significant transaction costs related to banking will decrease as the world’s economic activity shifts to an on-chain model, making every transaction transparent.

The goal is to compile offline and online data and use it to develop a user’s reputation that can be used on-chain.

This system carries some risk, just like any other credit lender. However, protecting lenders entails preventing defaults or, in the event of a default, fully compensating lenders.

Goldfinch depends on its Backers (investors who contribute USDC to borrower pools) to keep track of the pool’s condition and provide liquidity. They are driven to perform because if there is a default, their liquidity would be the first to be lost. In addition, Goldfinch provides smart contract insurance via Nexus Mutual, much like TrueFi does.

Centrifuge

With the help of the Centrifuge network, small businesses can get quick, affordable capital while investors can expect a steady return. Centrifuge connects real-world assets to DeFi to lower the cost of capital for small- to medium-sized businesses and offer DeFi investors a reliable source of yield unrelated to volatile crypto assets. Asset Originators and Issuers are a source of reliable loans with low default rates for Centrifuge. Investors first pay any losses incurred if Centrifuge’s junior tranche defaults.

Their first user-facing product, Tinlake, gives any company an easy way to access DeFi liquidity. As a result, investors will receive a safe, reliable investment return from these assets unrelated to the volatile outcomes in the cryptocurrency markets. The Centrifuge token (CFG), their native currency, uses a Proof-of-Stake consensus technique to stake validators and provide adoption incentives. In addition, holders of CFG have the opportunity to shape Centrifuge’s development through on-chain governance.

A fair value discounted cash flow model serves as the foundation for Tinlake’s valuation methodology, which can be summed up as follows:

• Calculate expected cash flows:?The cash flow is determined for each outstanding asset loan. Then, based on anticipated repayment dates and sums, this is calculated.
• Expected cash flows that account for risk:?The expected loss adjusts Cash Flow for credit risk. To account for credit risk, the expected loss is calculated as expected loss = expected cash flow * PD * LGD and deducted from the due repayment amount.
• Risk-adjusted expected cash flows discounted:?To calculate the present value of financing, the expected cash flows are discounted using an appropriate discount rate (the appropriate rate depends on the asset class and pool).
• NAV calculation:?The NAV is calculated by summing the present values of the risk-adjusted expected cash flows for all financings in the pool.

TrueFi

TrueFi is a top credit protocol that provides on-chain capital markets with a wide range of conventional and cryptocurrency-specific financial opportunities. With every dollar allocated and reported on-chain as of November 2022, TrueFi had originated over $1.7 billion in uncollateralised loans and paid out over $35 million to lenders. TrueFi is now owned and managed by TRU token holders, with underwriting owned by the TrueFi DAO or independent portfolio managers, thanks to a path of progressive decentralisation.

Four key actors work cooperatively to support TrueFi, making it possible:

1. Lenders?can access opportunities across a variety of portfolios by using TrueFi.
2. After being vetted,?Borrowers?rely on TrueFi to give them quick access to capital at a competitive price with no collateral lockup, allowing them to maximise capital efficiency.
3. With the help of TrueFi,?Portfolio Managers?can create on-chain portfolios and take advantage of the advantages of blockchain technology, such as constant access to international lenders, increased transparency, and lower operating costs.
4. By using open dialogue and on-chain voting,?TRU Holders?effectively own and run the TrueFi protocol, making the crucial choices and contributions required for its expansion.
5. With the introduction of the well-known TUSD stablecoin in 2018, TrueFi’s main contributor Archblock (previously TrustToken), began working with real-world assets. With the introduction of capital markets in early 2022, TrueFi moved further into RWA by enabling traditional funds to move their lending portfolios on-chain. TrueFi now houses portfolios facilitating loans to LatAm fintechs, emerging markets, and cryptocurrency mortgages.

The process for becoming a borrower or portfolio manager on TrueFi is comparable to that of most other credit protocols: each new applicant must submit a public proposal outlining their company and intended use of funds, subject to community approval, as well as meet underwriting criteria set by the TrueFi Credit Committee (such as capital under management, maximum leverage, and asset exposure). Successful candidates are added to a whitelist and allowed to design and launch their portfolios or borrow from TrueFi’s permissionless DAO pools.

To safeguard lenders, TrueFi employs several novel strategies. TrueFi has three layers of recourse in the event of a default, overseeing an underwriting procedure led by the DAO’s Credit Committee and committing to routine code audits during significant protocol upgrades. First, TrueFi’s Secure Asset Fund for Users (or “SAFU”) may use its reserves to cover any additional losses; next, any successful collection actions against a defaulted borrower are routed through the DAO for proper disbursement; and finally, up to 10% of staked TRU is reduced to cover lender losses. In addition, TrueFi provides a Smart Contract Cover plan, available through Nexus Mutual, that offers insurance in case of a smart contract exploit.

Due to a gradual decentralisation process, holders of the TRU token now own and control TrueFi. The permissionless pools, treasury, and roadmap of TrueFi are currently owned and operated by the TrueFi DAO. In addition, the DAO has launched features like tranching and improved portfolio composability to achieve deeper institutional adoption and DeFi integration.

Maple

The under-collateralised lending program for permissioned KYC loans was introduced by Maple in 2021.

With Maple, users can offer undercollateralised loans to well-known businesses based on reputation rather than the traditional DeFi model, which depends on collateral that can be reduced in the case of underpayment. Some current borrowers from other pools include Wintermute Trading, Framework Labs, and Alameda Research.

The two tokens (MPL and xMPL) that control the protocol allow holders to participate in governance, receive a portion of fee income, and give lending pools a pool cover.

Participants who own Maple Tokens (MPL) engage in the following activities:

• Passive holders receive a portion of establishment fees.
• In addition, smart MPL holders can choose to stake in liquidity pools to increase their yield.
• Finally, a reserve for loan defaults is created by staking MPL-USDC 50–50 BPTs in exchange for a portion of the ongoing costs.
• MPL Holders can submit suggestions and vote on changes, such as adding Pool Delegates and modifying fees and staking requirements, as Maple moves toward complete decentralisation. In addition, Maple serves as a means for Pool Delegates to obtain funding and collect performance fees.

Delegates from the pool are essential to this process in Maple. Since they are in charge of preserving the stability of Maple’s lending pools, pool delegates must pass a rigorous approval procedure. Authorising loan requests, vetting potential borrowers, and the initial creation of lending pools are used to achieve this. Finally, Maple mandates that each pool delegate post MPL tokens be used as first-loss capital in addition to having a stake in the pool. Therefore, if the borrower defaults, so does the Pool Delegate. However, Maple uses a Pool Cover, essentially the pool of first loss, in the event of a default. Pool Delegates and MPL owners pay for this.

Conclusion

As the industry matures, the efficiency of capital movement will rise by orders of magnitude. For example, in a completely efficient market, a pre-approved borrower might get a $5 million loan, repay it in 30 minutes, and then observe as another borrower quickly obtains a loan for the same sum. This flow would be controlled by a credit model that continuously assesses the default risk of each borrower, pricing in any new information that comes to light. In this future, every capital dollar will be allocated right away to the investment opportunity with the best risk-adjusted return. To move finance in this direction, credit protocols like?TrueFi?(truefi.io),?Centrifuge?(centrifuge.io),?Goldfinch Finance?(goldfinch.finance), and others will be crucial.

This report is for informational purposes; it does not constitute trading or investment advice. This report solely expresses the author’s opinions, which do not necessarily reflect those of Colossus SRL or its positions. The report’s author may use the suggested strategies or own the cryptocurrency. You are solely responsible for any decisions you make; Colossus SRL is not liable for any loss or damage brought on by reliance on the information provided. If you require investment advice, please get in touch with a certified investment advisor.