Fixed Income: Blueprint for web3

Like several others in web3 today, I came into it from TradFi - I have built several complex and innovative fintech and financial services products for creating easier distribution, for portfolio risk assessment, or for achieving meaningful operational efficiencies. I have also structured several fixed-income and income-oriented private capital markets transactions as an investment banker. We have gone through a century of learning best practices and creating financially engineered products to get to where we are today. Of course, over time, many aspects of TradFi have become very complex and expensive, with several bottlenecks and rent-seeking intermediaries. If done right, web3 has the potential to preserve the best practices and innovative financial engineering, while drastically simplifying the process and complexity.

In the TradFi world, this is a fairly representative breakdown of how you can save and invest:

• Short-Term cash: Checking and Savings Accounts (generally no yield or very little yield)
• Bank CDs: Longer lock-in periods with reasonable yield (in many developing countries, this yield may be less than inflation though).
• Publicly traded "risk-free" products: This requires going beyond banking and working with a brokerage firm - money market, bond ETFs and so on (these are easily available to folks in developed countries like the US, but probably out of reach for many globally).
• Publicly traded "investment grade" products - Again, this bucket can include baskets of investment-grade bonds (agency MBS, corporate bonds etc). These could be longer duration assets, so investors do take on some duration risk - where price/yields can shift.
• Publicly traded "high yield" products - these are speculative bonds (companies with higher credit risk, lower tranches of senior-subordinated bonds etc).
• Project Finance & Private Credit: This is a broad bucket that ranges from small to big investments, from companies that are profitable to those that aren't, from deals that are secured and overcollateralized to those that aren't etc. Needless to say, there is a whole specialized industry covering the entire range of opportunities in this space. These deals typically command a 150-300 bps illiquidity premium (for secured uni-tranche issuances), with spreads increasing based on lack of adequate collateralization, duration and so on.

Let's take a look at Securitization:

Securitization was a phenomenal example of TradFi financial engineering - conceptually it is better for both lenders and borrowers (of course, like with any innovation, there are dangers when these powerful tools are not wielded correctly - eg., 2008 financial crisis).

One of the structural shortcomings of securitization is that an issuer needs scale, otherwise the costs (legal, asset diligence, trustee, rating agency, calculation agent, payment agent...) just don't make sense.

This was a use case that many web3 DeFi Private credit protocols wanted to capitalize on - simplify the "process complexity" by using smart contracts. However, in v1, many of these protocols focused on the technology without appropriate handling of of credit risk - initial underwriting, periodic bring-down diligence, performance monitoring etc., resulting in delinquencies and default.

So what is a good blueprint for web3:

The premise of web3 (why do all this) is that web3 is better for (a) 24x7 settlement, (b) repo ability - short-term borrowing against these assets (DeFi rails), (c) global access to a safe USD denominated asset (in many countries local currency devaluation is a huge problem - so much so that a non-interest bearing stablecoin gives people more purchasing power than interest-bearing instruments in local currencies), and (d) Paytech use cases are increasingly using stable coins for payments/settlements (they need access to investment products).

1. Tokenized Deposits: This should be a banking product (easily convertible to a stablecoin) but as tokenized equivalent of checking or savings accounts.
2. Tokenized US Treasuries ETF: Stablecoin market cap has grown to over $160B - arguably the "digital dollar" is the first proven "RWA" use case. Currently, short-term risk-free assets yield 5% in TradFi. Since it's not possible to issue "yield bearing stablecoins" in many jurisdictions, a good surrogate is some fund structure that offers tokenized short-term US Treasuries ETFs. These are highly liquid and while the yields are not in the teens, they are foundational infrastructure for fixed-income products.
3. Tokenized Agency and Corporate Bonds: As a next step, to align with the TradFi world, providing access to other tokenized fixed-income opportunities would be the next step.
4. Private Credit: There is definitely a long tail opportunity in private credit. In the US, private credit is $1T and globally it is estimated to be $1.7T (and this does not include the many good companies globally that don't have access to established public or private capital markets). The tricky aspect is how do you find, fund and manage issuances from creditworthy issuers. In my opinion, there are two viable models: (a) go deep - industry and geographic specialization, or (b) stay generic by becoming a distribution partner to other private credit funds.

Going Deep:

This involves building industry and geographic specialization (perhaps vertical integration to a good fintech in TradFi - through strategic partnership or acquisition). This creates Alpha and you can probably get a spread for providing this value.

Staying Broad:

This involves finding good managers with established track records - you are more like a fund of funds - investing in managers, rather in investing in deals specifically (or you grab an allocation on each deal you want to participate in). Smaller investors get in on the action that only large asset allocators had access to, but the returns will be lower (double fees - the manager and the DeFi protocol). Still people may be ok with getting 30-50 bps lower fees for access to otherwise institutional products.

Other opportunities

Beyond tokenized fixed-income, there could be great opportunities for providing global access to tokenized public equities - eg., global access to the S&P500, or actively managed ETFs comprising of sectoral companies - eg., Robotics and AI.

Challenges

1. We need to solve wallet and gas abstraction: We cannot have people remembering private keys and buying ETH for gas.
2. We also need cross-chain compatibility - all the complexity of native mints and burns need to be abstracted away - if someone wants to move money from Solana to EVM, it should be a simple one click experience.
3. We need seamless on and off-ramp: We cannot have expensive on and off-ramp interfaces (it has to be easy, fast and cheap).

Once these problems are solved, we will see exponential growth in the adoption of traditional investment products on web3 rails.