How is DeFi reshaping trillions of dollars of real-world assets(RWA)

DeFi is growing fast.

We imagined DeFi expansion “horizontally” in the balance sheet and “vertically” in interest rate market about three months ago. In less than a quarter, many ideas and predictions that were once daring are being tested quickly.

As interest-bearing underlying or synthetic asset classes become richer, more and more lending protocols begin to support all kinds of LP Token collaterals, a diversified DeFi financial system is becoming systematic and multi-dimensional.

Still, DeFi can never grow without assets, and we see three main ways to generate excess returns: leveraging, expand durations, and bring in new types of credit.

DeFi users are generally proficient and familiar with leveraging. Longer duration requires sophisticated interest-rate market instruments. The fastest growing trend is to bring more types of credit into the blockchain as on-chain assets, adding these assets to eligible collaterals, and expanding the DeFi balance sheet by introducing more collateral to free up liquidity.

In addition to the aforementioned innovations in the native crypto assets as eligible collaterals, along this line, we are pleasantly surprised to see that DeFi started to be adopted by new users by connecting real world assets. MakerDAO’s acceptance of Real World Assets as collateral signals the rise of a new race track.

DeFi startups like Centrifuge, NAOS Finance, ShuttleOne, and Persistence are working to bridge the gap between DeFi and CeFi, bringing all sorts of yield-generating real-world assets on-chain, such as consumer loans, supply-chain finance, corporate credit, and real-estate rents, significantly extending the boundaries of the DeFi world. Bringing real-world assets into the DeFi world would make the current market size of DeFi assets seem unbelievably insignificant.

The business model for these DeFi startups is not complicated. In the real world, many CeFi FinTech companies are providing financial services based on underlying assets with specific yield stream, which mirrors the logic of “structured finance” in traditional financial markets.

In the traditional structured finance business, we need financiers to package the underlying assets with future yield streams into SPVs (some kind of trust or asset management product), and issue senior tranches and junior tranches, whereby the junior tranches provide a safety cushion for repayment of the principal of the senior tranches.

If the senior or junior tranches are listed on any public trading exchanges, these tranches will become relatively familiar to asset-backed securities. During this process, the FinTech firms will be responsible for due diligence, asset management, operation, information disclosure, risk control, settlement etc.

DeFi protocols such as Centrifuge and NAOS Finance map the positioning of FinTech firms in CeFi structured finance on blockchain, replace the off-chain business process with “NFT + DeFi” : tokenize the asset with NFT and mapping them into the Defi protocols.

The NFT will be generated by tokenization of the underlying assets with yield streams (such as receivables, etc.), and the excessive collateralization of NFT (such a TVL of 70%, where loan value is at 70% discount on asset par value) is given to lending protocols such as Compound or MakerDAO. Then the dealers convert the stable coins or other cryptocurrencies into US dollars and lend it to real world borrowers. Investors can then obtain interest by investing the corresponding assets through DeFi protocols.

In this process, Centrifuge and NAOS Finance is to conduct the whole cumbersome business chain of packaging SPVs, structured financing through DeFi. They play the structured finance in a decentralized way, and makes full use of the capital pooling feature of DeFi to convert P2P(peer-to-peer) transactions into peer-to-pool, which changes the structure of risk management and improves the efficiency of capital matching.

We see DeFi’s efforts to connecting to real-world assets should be the closest to the original vision of Internet Finance. We are looking forward to see that the following short-term development of DeFi were expected to quickly replicate the early barbaric phase of P2P’s growth just like few years ago, and bring significant business opportunities and unfamiliar risks for DeFi users.

The breakout opportunities are obvious.

For the native DeFi market, on-chain real world assets essentially introduce a new credit class that is completely different from the current native crypto assets, and creates a total new asset class that provides DeFi users with a richer choice of asset management, thereby driving the expansion of DeFi balance sheet.

In CeFi financial markets, similar structured finance products require qualified investors. With NFT + DeFi, investors can get a non-threshold return from structured finance markets. This significant investment opportunity will further increase DeFi market penetration and user adoption.

Second, similar underlying assets have fixed maturities and interest rates. With the introduction of real-world assets, the DeFi interest rate market we’ve been expecting will have the foundation to develop. Users will need to invest in new asset classes through various types of interest rate protocols, catalyzing simultaneous increases in penetration and TVL. It is only a matter of time before the DeFi fixed-income market erupts.

The most innovative idea is the combination of protocols like Centrifuge and NAOS Finance with other stable coin protocols like MakerDAO, whereby MakerDAO mints more stable coins DAI to DeFi economy with real world asset NFT as collaterals and the stable coins will actually flow into the real economy, embracing real payment, lending and commercial scenarios. This is a surprising monetary policy instrument for all stable coin protocols. Stable coins naturally circulate across borders, with physical assets tokenized into NFTs. We expect to see global financial assets swapping values in a single borderless blockchain network.

The risks of introducing real-world assets to DeFi will also present a huge challenge to current DeFi world.

Given the complication of structured finance business and the large gap between the risk-return characteristics of underlying assets and those of the native crypto assets, many investors are still wary of the past turmoil in the P2P crush, including self-financing, debt capital pooling, duration mismatches, and frequent default events. Investing in real-world assets in the DeFi market will inevitably face similar risks.

In the early stages of P2P, P2P firms often pool short-term funds and invest in long-term financial assets with high credit risk in the form of a black box. This kind of debt capital pool makes each investment made by a user unable to correspond to a specific single underlying asset, and the risks borne by the user change from the default risks of a single underlying asset to that borne by the P2P firm itself as a whole. In addition, the duration mismatch leads to risks of accumulating liquidity vulnerability of P2P firms. Once a single underlying assets default, there may be a series of thunderous liquidity crisis.

Unlike P2P in traditional Fintech, however, DeFi runs on public ledgers.

In the design of protocols such as Centrifuge and NAOS Finance, a single user investment can be matched to a single underlying asset NFT, which can reduce the occurrence of debt pooling risks and duration mismatch, and greatly reduce the possibility of the overall liquidity crisis of the protocol.

In addition, because the business involves real-world assets, it is inevitable to face the credit risk of the underlying asset itself and the moral hazard of asset managers, which is also the biggest risk of the P2P industry.

For example, supply chain assets have very complicated risk of right confirmation and verification, this kind of receivable assets has the highest default rate of all financial assets, some small corporate loans may face 50% default rate, and some underlying assets even cannot be liquidated, resulting in bad debts. Apparently DeFi users are vulnerable to large losses and unfamiliar risks they have never dealt with before.

Under extreme circumstances, a traditional P2P firm will also adulterate junk assets into the asset package, fabricate non-existent underlying assets, and even set up a shell company for self-financing or misappropriate users’ funds to personal accounts of founders, which are totally financial fraud events. However, because of the asymmetry of information, and the lack of legal compliance and regulatory jurisdiction, investors basically have no control over the underlying assets and off-chain business. DeFi can not eliminate these core risks fundamentally and technically.

As a result, we need to rely heavily on Centrifuge, Naos, ShuttleOne, Persistence’s expertise comes from limiting moral hazard and controlling the authenticity and quality of the underlying assets off-chain. Secondly, in the event of breach of contracts, investors can only rely on DeFi protocols and its partners to dispose and liquidate collaterals in real world.

Therefore, users should carefully consider the risk-return characteristics of the underlying assets when choosing such real-world assets. Protocols may advertise low default rates of their assets, but this argument is hard to prove and is not sufficient as a valid reference, so we need to pay more attention to the risk control measures introduced by DeFi protocols for these risks.

Centrifuge has introduced the over-collateralization of NFT value and mitigate the credit risk of the senior investors in a structured finance way; and Naos has introduced the design of Insurance Mining Fund to insure the underlying real-world assets and carried out the credit enhancement. Moreover, Naos has obtained the licenses in Southeast Asian countries to adapt to the compliance and regulatory requirements of business development. These risk measures can help both DeFi and investors control risks in the early stages of development.

In summary, the competition among these new DeFi players will be extremely complex. Beyond the technology, product, and asset management expertise, it will require competition over the access to users and capabilities to acquire assets, the quality and credit risks of the assets, and the ability to cope with regulation, compliance, and risk management. We firmly believe that DeFi must embrace real-world assets. When DeFi and CeFi collide in FinTech realm, it will be the Big Bang for the next generation of mobile finance infrastructure.

Disclaimer: Incuba Alpha was an early investor in NAOS.Finance, holding an interest in NAOS.Finance