Consultant with Bankless Consulting and Tokenomics DAO. Writer and Researcher for Web 3. Crypto Class of 2016
Consultant with Bankless Consulting and Tokenomics DAO. Writer and Researcher for Web 3. Crypto Class of 2016
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Key Takeaways
Traditional Financial Markets can help to bring the over 20 trillion dollars in debt denominated assets onto the blockchain and into the greater Decentralized Finance (DeFi) ecosystem.
Real World Assets on the block chain allow for greater transparency, easy accessibility to liquidity, and fast, cheap transaction fees we’ve come to expect from the blockchain
The stability of these assets give defi protocols like Maker and Aave a great way to back stable coins with stable assets creating a new world of defi and liquidity for both asset orginaiators, credit facilities, and defi lenders.
Traditional businesses can leverage this technology to gain an economic edge over their competition and fuel faster growth.
Introduction
In the early days of crypto (back before we started calling it all Web3) the idea of bringing real world asset (RWA) ownership rights to the block chain has been a dream of many developers and financiers. In 2017 the first apartment was sold via the blockchain in Ukraine and in the following years more sophisticated assets like “collateralized debt positions” , music and movie royalty payments, payroll advances, and commercial real estate have been “tokenized” and added to the block chain. In this article we will explore the basics of tokenizing a RWA, what it means for both traditional finance and decentralized finance, and demonstrate some use cases that your business can use today to access liquidity, reduce fees, and gain access to this growing sector.
Types of RWA Assets On Chain
Bringing a RWA on chain
Let us begin by going through the technical details to demonstrate how a RWA gets onto the blockchain in the first place. Many companies and protocols are building tools and methods to “tokenize” assets, but for our example we are going to demonstrate how “Centrifuge” get’s assets onto the block chain and how those assets are valued. We chose Centrifuge as they are currently leading the RWA + Blockchain industry and have integrations with two of the most battle tested DeFi protocols: Aave and Maker DAO.
Centrifuge runs its own blockchain on the “Substrate” network, this is the starting point where the asset originates on the blockchain.
A peer to peer (P2P) protocol allows the asset originators to create, verify, and exchange data with service providers who can in turn access this data to verify pricing, details, and complete an underwriting process of the asset. Once the details are agreed upon a cryptographic signature (hash) is made to show consensus of the details of the asset and are then “anchored” onto the Ethereum blockchain as an ERC725 NFT.
These NFTs are used in the “Tin Lake” Decentralized Application (Dapp) which is the market place run by Centrifuge for these assets and allows them to communicate with various decentralized finance applications.
In this example Big Car Inc. orders millions of tires from Tire LLC., Tire LLC needs financing to purchase the rubber, electricity to run the plant, and capital to pay the employees who produce the tires. Tire LLC. sends the invoice to Centrifuge who in turn verifies all the particulars (price, delivery date, amount payable, credit worthiness of both parties). Once Centrifuge, Tire LLC, and Big Car Inc. are in all agreement the document is signed through a cryptographic hash, anchored to the blockchain, and then Tire LLC mints the invoice on chain as an ERC-725 NFT that represents all the information verified.
Valuations of the Underlying Assets
One of the large criticisms of RWA on chain is about pricing data; with a standard crypto asset for example “Ether” the price is fed to a smart contract through a pricing “Oracle” to show the constant value of the asset and allows the smart contract to perform its function. Multiple projects are working on ways to bring this pricing data directly to the blockchain in a variety of ways. Centrifuge uses a set of off chain entities to determine the price of the underlying assets to confirm the invoices details:
Keeping with the previous example this is the invoice from Big Car Inc. sent to Tire LLC. for the order of 1 million tires. The process involves up to five separate entities to verify and value the asset to ensure the value of the NFT on-chain matches the real world value.
This process involves “trusted third parties” and has been criticized by many in the crypto community as it breaks the ethos of a “trustless system” as the findings of each actor are not transparent to the end buyer and involves human judgment which of course comes with human error. The counter argument is that by having so many separate parties involved the risk is minimal and the rate of default of these types of invoice financing is very low.
Why Do All This?
Invoice financing is a common practice in traditional finance, companies need capital to fulfill incoming orders, make payroll, pay rent and continue operations. Typical invoice payment times can vary from 30, 60, 90, and 120 days to obtain payment after the order is delivered (that is not counting the amount of time needed to produce the product and fill the order). To help businesses bridge the gap from order to payment, banks lend capital against the invoices they have in turn for interest, which can be quite high for a small or medium size enterprise (SME). SME financing can have rates higher than 15% to borrow capital while a top 2000 company like Google can access capital for less than 1%. The difference in these rates is not commensurate with default rates as the SME industry has a less than 2% default rate on loans of this kind. Because of these high rates and low risk the opportunity to bring these assets into the liquid world of decentralized finance is an attractive opportunity for lenders and borrowers alike. Fees for lenders in the RWA space on Maker DAO and Aave can earn between 4%-10% by lending funds into these vaults and borrowers can get interest rates as low as 5% and upwards of 12% to access capital. Here is a snapshot from 9/9/202 showing rates for lenders to specific pools:
Getting DeFi Liquidity with Maker DAO
Maker DAO is the oldest and most battle tested Decentralized Finance protocol in existence today; they continue to innovate and build new ways to democratize finance. Maker Vaults are an over collateralized lending protocol, essentially you lock up an asset (typically crypto currency) and you can borrow DAI (a dollar backed stable coin) in the amount the vault will allow depending on the asset deposited (typically 50%-80% of the underlying value). Due to the overcollateralized nature of these loans they are typically very stable and if the underlying collateral ever reaches the amount borrowed, MAKER automatically liquidates the assets to repay the loan plus the liquidation fee. This works the same with RWA as it does with crypto assets:
Maker Vault Smart Contracts need to have the pricing fed to it to maintain the ratio of debt to collateral, ERC-721 tokens (NFTs) cannot currently reflect prices directly to smart contracts so Centrifuge found a work around using Collateral Value Tokens (CVT). The process goes like this:
The CVT token represents a 1–1 unit of value (in this case the dollar) to the smart contract that then allows the owner to withdraw DAI from the Maker Vault according to the collateral ratio.
Legal Framework
Disclaimer: I am not an attorney and nothing in this article should be construed as legal advice, this is for entertainment purposes only
Let’s take a step back and look at the the interaction of the legal, financial, and technical processes that are taking place:
The originator of the debt places the debt instrument in a special purpose vehicle (SPV) LLC. This LLC is controlled by a third party “RWA LLC” in the case of Centrifuge. This company will put multiple invoices into this SPV and then the SPV will originate a Debt instrument with specific legal language that corresponds with the type of assets it is holding and explains the on chain and off chain procedures in the case of a liquidation. It’s important to understand that in the case of the MAKER Vault the asset being borrowed against is not a single invoice, but a basket of invoices from the same company.
This gives the collateral placed in the Maker Vault more protection as if one invoice is not paid, but the other 99 out of 100 are then the underlying asset can be “marked down” to the real price and no liquidation happens on chain. Let’s take a look at the amount of buffers present in the system:
By providing a buffer between the underlying collateral and the value of the debt the position can withstand some defaults and markdowns at every stage of the valuation. This ensures the position’s health and allows the companies to mark down their own collateral, repay a portion of the borrowed funds, or deposit more collateral to ensure a liquidation doesn’t happen. In the event a liquidation does happen the legal system comes into play, this process varies based on the asset inside the SPV. In the case of a real estate loan for a fix and flip property the SPV sells the asset (the house) to another firm or person to raise the funds needed to repay the DAI, liquidation fees, and lawyer fees that were incurred to sell the asset and the original owner would get the remainder of the amount left over (if any).
Conclusion
The cross section of traditional finance and decentralized finance continues to evolve with what seems like almost daily news of a new use case of technological convergence. With new ideas ranging from carbon credits on chain, to financing green energy facilities, to fractionalized token ownership of commercial real estate. Centrifuge and Maker DAO are continuing to work together to maintain and grow a robust market place for lenders and borrowers alike to gain exposure to the fast, secure, and transparent system Defi offers users. How do you envision block chain technology will transform your business or financing needs? Bankless Consulting can assist your company with an exploration of how these technologies can unlock new liquidity, earn increased yields, and turbo charge your growth with Web 3 integrations. <insert contact information here>
Key Takeaways
Traditional Financial Markets can help to bring the over 20 trillion dollars in debt denominated assets onto the blockchain and into the greater Decentralized Finance (DeFi) ecosystem.
Real World Assets on the block chain allow for greater transparency, easy accessibility to liquidity, and fast, cheap transaction fees we’ve come to expect from the blockchain
The stability of these assets give defi protocols like Maker and Aave a great way to back stable coins with stable assets creating a new world of defi and liquidity for both asset orginaiators, credit facilities, and defi lenders.
Traditional businesses can leverage this technology to gain an economic edge over their competition and fuel faster growth.
Introduction
In the early days of crypto (back before we started calling it all Web3) the idea of bringing real world asset (RWA) ownership rights to the block chain has been a dream of many developers and financiers. In 2017 the first apartment was sold via the blockchain in Ukraine and in the following years more sophisticated assets like “collateralized debt positions” , music and movie royalty payments, payroll advances, and commercial real estate have been “tokenized” and added to the block chain. In this article we will explore the basics of tokenizing a RWA, what it means for both traditional finance and decentralized finance, and demonstrate some use cases that your business can use today to access liquidity, reduce fees, and gain access to this growing sector.
Types of RWA Assets On Chain
Bringing a RWA on chain
Let us begin by going through the technical details to demonstrate how a RWA gets onto the blockchain in the first place. Many companies and protocols are building tools and methods to “tokenize” assets, but for our example we are going to demonstrate how “Centrifuge” get’s assets onto the block chain and how those assets are valued. We chose Centrifuge as they are currently leading the RWA + Blockchain industry and have integrations with two of the most battle tested DeFi protocols: Aave and Maker DAO.
Centrifuge runs its own blockchain on the “Substrate” network, this is the starting point where the asset originates on the blockchain.
A peer to peer (P2P) protocol allows the asset originators to create, verify, and exchange data with service providers who can in turn access this data to verify pricing, details, and complete an underwriting process of the asset. Once the details are agreed upon a cryptographic signature (hash) is made to show consensus of the details of the asset and are then “anchored” onto the Ethereum blockchain as an ERC725 NFT.
These NFTs are used in the “Tin Lake” Decentralized Application (Dapp) which is the market place run by Centrifuge for these assets and allows them to communicate with various decentralized finance applications.
In this example Big Car Inc. orders millions of tires from Tire LLC., Tire LLC needs financing to purchase the rubber, electricity to run the plant, and capital to pay the employees who produce the tires. Tire LLC. sends the invoice to Centrifuge who in turn verifies all the particulars (price, delivery date, amount payable, credit worthiness of both parties). Once Centrifuge, Tire LLC, and Big Car Inc. are in all agreement the document is signed through a cryptographic hash, anchored to the blockchain, and then Tire LLC mints the invoice on chain as an ERC-725 NFT that represents all the information verified.
Valuations of the Underlying Assets
One of the large criticisms of RWA on chain is about pricing data; with a standard crypto asset for example “Ether” the price is fed to a smart contract through a pricing “Oracle” to show the constant value of the asset and allows the smart contract to perform its function. Multiple projects are working on ways to bring this pricing data directly to the blockchain in a variety of ways. Centrifuge uses a set of off chain entities to determine the price of the underlying assets to confirm the invoices details:
Keeping with the previous example this is the invoice from Big Car Inc. sent to Tire LLC. for the order of 1 million tires. The process involves up to five separate entities to verify and value the asset to ensure the value of the NFT on-chain matches the real world value.
This process involves “trusted third parties” and has been criticized by many in the crypto community as it breaks the ethos of a “trustless system” as the findings of each actor are not transparent to the end buyer and involves human judgment which of course comes with human error. The counter argument is that by having so many separate parties involved the risk is minimal and the rate of default of these types of invoice financing is very low.
Why Do All This?
Invoice financing is a common practice in traditional finance, companies need capital to fulfill incoming orders, make payroll, pay rent and continue operations. Typical invoice payment times can vary from 30, 60, 90, and 120 days to obtain payment after the order is delivered (that is not counting the amount of time needed to produce the product and fill the order). To help businesses bridge the gap from order to payment, banks lend capital against the invoices they have in turn for interest, which can be quite high for a small or medium size enterprise (SME). SME financing can have rates higher than 15% to borrow capital while a top 2000 company like Google can access capital for less than 1%. The difference in these rates is not commensurate with default rates as the SME industry has a less than 2% default rate on loans of this kind. Because of these high rates and low risk the opportunity to bring these assets into the liquid world of decentralized finance is an attractive opportunity for lenders and borrowers alike. Fees for lenders in the RWA space on Maker DAO and Aave can earn between 4%-10% by lending funds into these vaults and borrowers can get interest rates as low as 5% and upwards of 12% to access capital. Here is a snapshot from 9/9/202 showing rates for lenders to specific pools:
Getting DeFi Liquidity with Maker DAO
Maker DAO is the oldest and most battle tested Decentralized Finance protocol in existence today; they continue to innovate and build new ways to democratize finance. Maker Vaults are an over collateralized lending protocol, essentially you lock up an asset (typically crypto currency) and you can borrow DAI (a dollar backed stable coin) in the amount the vault will allow depending on the asset deposited (typically 50%-80% of the underlying value). Due to the overcollateralized nature of these loans they are typically very stable and if the underlying collateral ever reaches the amount borrowed, MAKER automatically liquidates the assets to repay the loan plus the liquidation fee. This works the same with RWA as it does with crypto assets:
Maker Vault Smart Contracts need to have the pricing fed to it to maintain the ratio of debt to collateral, ERC-721 tokens (NFTs) cannot currently reflect prices directly to smart contracts so Centrifuge found a work around using Collateral Value Tokens (CVT). The process goes like this:
The CVT token represents a 1–1 unit of value (in this case the dollar) to the smart contract that then allows the owner to withdraw DAI from the Maker Vault according to the collateral ratio.
Legal Framework
Disclaimer: I am not an attorney and nothing in this article should be construed as legal advice, this is for entertainment purposes only
Let’s take a step back and look at the the interaction of the legal, financial, and technical processes that are taking place:
The originator of the debt places the debt instrument in a special purpose vehicle (SPV) LLC. This LLC is controlled by a third party “RWA LLC” in the case of Centrifuge. This company will put multiple invoices into this SPV and then the SPV will originate a Debt instrument with specific legal language that corresponds with the type of assets it is holding and explains the on chain and off chain procedures in the case of a liquidation. It’s important to understand that in the case of the MAKER Vault the asset being borrowed against is not a single invoice, but a basket of invoices from the same company.
This gives the collateral placed in the Maker Vault more protection as if one invoice is not paid, but the other 99 out of 100 are then the underlying asset can be “marked down” to the real price and no liquidation happens on chain. Let’s take a look at the amount of buffers present in the system:
By providing a buffer between the underlying collateral and the value of the debt the position can withstand some defaults and markdowns at every stage of the valuation. This ensures the position’s health and allows the companies to mark down their own collateral, repay a portion of the borrowed funds, or deposit more collateral to ensure a liquidation doesn’t happen. In the event a liquidation does happen the legal system comes into play, this process varies based on the asset inside the SPV. In the case of a real estate loan for a fix and flip property the SPV sells the asset (the house) to another firm or person to raise the funds needed to repay the DAI, liquidation fees, and lawyer fees that were incurred to sell the asset and the original owner would get the remainder of the amount left over (if any).
Conclusion
The cross section of traditional finance and decentralized finance continues to evolve with what seems like almost daily news of a new use case of technological convergence. With new ideas ranging from carbon credits on chain, to financing green energy facilities, to fractionalized token ownership of commercial real estate. Centrifuge and Maker DAO are continuing to work together to maintain and grow a robust market place for lenders and borrowers alike to gain exposure to the fast, secure, and transparent system Defi offers users. How do you envision block chain technology will transform your business or financing needs? Bankless Consulting can assist your company with an exploration of how these technologies can unlock new liquidity, earn increased yields, and turbo charge your growth with Web 3 integrations. <insert contact information here>
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