Société Générale — MakerDAO: banking refinancing as the first collaboration between TradFi and DeFi
On 2021 October 1st, Forge, the subsidiary of the French banking group Société Générale, issued a MIP (MIP6 or MakerDAO Improvement Proposal 6) to the MakerDAO protocol to refinance tokenized marketable securities by pledging them. This subtype of PoC (Proof of Concept) represents the first interaction between the traditional financial world (TradFi) and DeFi, a financial ecosystem in which traditional financial dynamics are replicated through distributed architecture, i.e., through blockchain.
In this regard, and before explaining the structuring of the transaction, it should be noted that the efficiency sought by leveraging on DeFi in terms of reducing transaction costs is offset by the lack of protection mechanisms provided for by prudential regulations. These mechanisms can be classified as proactive (accounting standards, reporting obligations, auditing systems) or reactive (investment guarantee funds, deposits or liquidity facilities of last resort or ELA[1]) and allow participants to maximize the profit margins derived from traditional operations, in exchange for contributing via expenses to the creation of these mechanisms. In the DeFi ecosystem, when operating with unregulated subjects, or even with entities lacking legal personality, such as DAOs, supervision schemes are not applicable, and therefore, operations are structured through a degree of collateralization above 100% that guarantee a sufficient margin call to close the position without losses.
Subscribe to Coinmonks Youtube Channel to get daily crypto news.
Analysis of the underlying
The underlying asset of the transaction is an EUR 40M covered bond under French law, backed by residential mortgage loans. The bond is issued by the parent company and subscribed by the subsidiary Forge and pays fixed interest of 0%. Therefore, the instrument to execute the refinancing transaction meets the definition of a financial instrument, as set out in the international accounting standards IFRS 9 [2], relating to financial instruments. However, and just for accounting comprehension, as no interest is paid and the transaction is intra-group — the results and balance sheet items are eliminated in the consolidated accounts of the parent company — it should be treated as a capital contribution by the subsidiary and as a dividend distribution transaction by the parent company, and not as a sole debt issuance and subscription.
In any case, it cannot be classified as a transaction with cryptoassets but with financial instruments, since they are governed by the principle of technological neutrality (the characteristics of the instrument do not vary despite the registration system applied), and they are not regulable under MiCA regulations[3], but under MiFID II[4]. In other words, they fall into the category of STOs (Security Tokens Offering) as tokenized financial instruments.
The STO analyzed is part of a set of previous issues already executed since 2019, which aim to validate the operational and regulatory burden generated in an STO, as well as the anticipation of the supervisory expectation. These operations, structured as simple debt issues subscribed by the entity itself, simulate current capital market infrastructures under blockchain technology, although the operations are limited to the primary market.
They are as follows:
- 04/18/2019: issuance of a 100 million covered bond on Ethereum by Société Générale, fully underwritten by the parent company, and rated AAA by Moody’s and Fitch.
- 14/05/2020: issuance of a 40 million covered bond on a public blockchain (not specified) by Société Générale, fully subscribed by the parent company, and paid through CBDCs issued in turn by Banque de France on a public blockchain.
- 15/04/2021: issue of a 100 million structured bond on Tezos, fully subscribed by the parent company.
The challenge for STOs, once they have demonstrated the technical, operational and regulatory capacity to build a primary market, in which securities are issued and underwritten, is the creation of the secondary market, especially in the banking sector.
Characteristics of the operation
The analyzed operation can be classified as the first known interaction in the regulated world with DeFi, and consists of refinancing an issue of secured bonds (OFH Tokens) by pledging them. These tokens, which were previously issued by Société Générale in operations already mentioned, are transferred to Forge through the Ethereum blockchain, in exchange for a loan in USD. To do so, and after the transfer of the tokens, Forge opens a CDP (Collateralized Debt Position) in MakerDAO to pledge the aforementioned tokens in exchange for DAI, since the issuance of DAI (stablecoin) is always conditioned to the previous collateralization. The DAI obtained by Forge would be traded for USD through an exchange (it has not been revealed who it is), proceeding to the granting of the loan to Société Générale.
Upon repayment of the USD loan from Société Générale to Forge, the USD received by DAI is exchanged to unwind the Vault’s position in MakerDAO, which in turn allows for the release of the collateral (OFH Tokens).
Ultimately, Forge underwrites the financing launched by its parent company Société Générale and, subsequently, MakerDAO refinances Forge’s position through the collateralization of Forge’s securities.
Advantages of the operation
The structuring of the transaction through blockchain might reduce transaction costs, i.e., operational and technical costs. The calculation of these must be analyzed ad hoc, ad hoc, and there are as yet no comparable transactions that allow such an exercise to be carried out. However, the replacement of relevant participants in such a transaction, such as post-trade systems (clearing, registration, and settlement), by the processing capacity of blockchain, and the automation of debt refinancing processes via DeFi as opposed to traditional negotiation in the banking sector, allows to infer an improvement in the overall profitability of the transaction.
Additionally, this operation offers the possibility for MakerDAO to open CDPs with instruments other than stablecoins (USDC, Tether, etc.) or other types of cryptoassets (BAT, Ethereum). Although it has not yet been defined in the protocol, the degree of collateralization required in the opening of CDPs could vary depending on the types of assets that act as collateral, as well as the interest required for the application of the Stability Fee or the penalty in case of closing the position. This is because the characteristics and risks of the collateralized instrument are different.
However, the protocol establishes that the CDPs act as pledging chambers, in such a way that the breach of contractual obligations entails the execution of the position, and the use of the funds obtained in the sale for the payment of the amounts owed by the participating node. Under no circumstances does the protocol allow MakerDAO to subrogate itself in the ownership of the collateralized instruments.
The examples of Ethereum, USDC and OFH Security Tokens are given in order to understand the range of risks and benefits that entails the usage of those assets:
- Ethereum: traditional cryptoasset, without collateral backing for its issuance or additional guarantees. Ethereum is subject to price risk, as it is a highly volatile asset.
- USDC: an off-chain collateralized stablecoin, the issuance of which is subject to the prior deposit of currency, in this case USD. The backing of the currency guarantees the stability of its value, which mitigates price risk. A fall in the value of USDC until the degree of collateralization required by MakerDAO is breached would result in the execution of the pledged position in the CDP, i.e., the closure of the CDP. This would lead to a price arbitrage, in which USDC token holders could redeem their tokens against USDC per fiat, recovering USD 1. The arbitrage automatically increases the demand for USDC, which in turn raises its price until 1 USDC equals 1 USD, and the opportunity closes.
- OFH Tokens: covered bonds are tradable debt instruments issued by credit institutions and backed by a portfolio of eligible residential mortgage loans (subject to certain requirements), which have a four-fold guarantee: the cash flows derived from the portfolio of eligible mortgage loans, the properties that collateralize the eligible loans in the portfolio, a series of replacement assets required by mortgage regulations and the solvency of the issuer of the covered bonds. This pool of collateral increases investor appetite and guarantees the stability of its value.
Also, for the purposes of calculating capital, i.e., the denominator of the capital adequacy ratio, which requires the calculation of the risk of unexpected loss associated with each asset, the different CDPs are weighted according to the collateral securing them. In this sense, and to optimize the risk management strategy, the structuring of the CDPs may be subject to quantitative limits, so that MakerDAO only allows a certain volume of CDPs with Ethereum collateral, another volume with stablecoins and another with Security Tokens. The possibility that the future European regulation of cryptoassets will require stablecoin issuers to meet capital requirements is high, as they pose risks to financial stability by potentially altering the monetary policy transmission mechanism and deposit-based bank funding models. And Société Générale has brought one more option for the calibration of those CDPs, which are the key elements that leverage the whole MakerDAO financial dynamic.
Conclusion
The structuring of traditional financing operations through blockchain presents advantages in terms of transaction costs, which are inferred from the distributed nature of blockchain as opposed to the centralized nature of the traditional banking world, as well as the automation of processes, and allows the incorporation of new regulated and tokenized financial instruments to the pool of collateralizable assets, which increases the use case of MakerDAO in the world of TradFi.
[1] Emergency Liquidity Assistance
[2] International Financial Reporting Standard
[3] Market in Crypto Assets: proposed regulation not yet approved, which develops the first legal framework in the European Union on the treatment of cryptoassets.
[4] Markets in Financial Instruments Directive II: European Union Directive to increase transparency in financial markets and standardize regulatory reporting requirements for investment services firms and credit institutions. As it is a Directive, it must be transposed into national law by means of a national law and offers a certain level of discretion in its application.
[5] Explanatory diagram of the MIP6 proposed by Forge. It can be found here: https://forum.makerdao.com/t/security-tokens-refinancing-mip6-application-for-ofh-tokens/10605
Join Coinmonks Telegram Channel and Youtube Channel learn about crypto trading and investing
