DeFi’s Zero to One Moment: On-Chain Real-World Asset Lending

Tokenization of Global Illiquid Assets Estimated to be a $16 Trillion Business Opportunity by 2030

A large chunk of the world’s wealth today is locked in illiquid assets. In a survey conducted in the U.S. in 1997, 56%+ of assets held by taxpayers with a net worth of between $600,000 and $1 million were illiquid. All else being equal, illiquid assets typically trade at a discount vs. liquid assets. Primary examples of illiquid assets include real estate (incl. home equity), natural resources, land, commodities, public infrastructure like mines/ports, fine art, computing infrastructure, private equity, etc. On top of that, there are multiple other asset classes that are only accessible to limited wealthy investors/institutions due to constraints on ticket size, e.g., pre-IPO stocks, hedge funds, infrastructure projects, commodities and alternate investment instruments, and private credit. The total size of illiquid asset tokenization globally would be $16 trillion by 2030.

Key reasons for asset illiquidity include:

1. Limited affordability of mass investors given high ticket size ranging between $250,000 and $5 million, depending on the asset type (e.g., real estate, bonds, hedge funds)
2. Inability to fractionalize inherent utility (e.g., sharing living space in a house by 100 investors)
3. Lack of information to retail/high net-worth individual investors given the lack of wealth manager expertise (e.g., assets like livestock, plantation, alternate investments)
4. Limited access, restricted to elite cliques (e.g., fine art, vintage cars, vineyard, etc.)
5. Regulatory hurdles (e.g., limitations on investments in certain asset classes to only accredited investors, complicated process of tokenization & custody transfer of assets, strict guardrails on allowing foreign investors in capital markets of certain geographies e.g. Indonesia, and also asset classes that require ownership proof in governmental registers such as real estate where the ownership is recorded in the land register)
6. Complex user journeys for obtaining access (e.g., KYC and payment set up across multiple platforms with no single interface for the customers)
7. Lack of existing, scaled technological solutions to unlock liquidity in such assets

The concept of traditional asset fractionalization, however, has already existed for several years. Some examples are Real Estate Investment Trusts (REITs), Exchange Traded Funds (ETFs) (with over $5 trillion in assets under management), Mutual Funds, US stock tokenization, etc. Traditional asset fractionalization is more focused on vehicles like equity and real estate asset classes.

However, the key limitation of traditional fractionalization is that the impact can only be seen in public markets which are already fairly efficient and high-tech, but not in private markets that are manual, slow, opaque, and with high overheads. Additionally, the process of matching capital to investment opportunities in the private markets also involves several steps from finding and qualifying investors and investment opportunities, through the initial capital allocation to the opportunities, to secondary trading of the assets, and the management of the assets, leading to suboptimal customer experience and cost structures.

Real-World Asset Tokenisation in a Snapshot

• Real World Assets (“RWAs”) are assets that exist off-chain but are tokenized and brought on-chain to be used as a source of yield within DeFi.
• RWAs can offer yields to DeFi which are sustainable, reliable, and backed by traditional asset classes.
• RWAs can render DeFi to become more compatible with external markets, resulting in greater liquidity, capital efficiency, and investment opportunities.
• RWAs can represent tangible assets, such as gold and real estate, as well as intangible assets, such as government bonds or carbon credits.
• RWAs allow DeFi the ability to bridge the gap between decentralized financial systems and traditional financial systems.
• The main driving force behind bringing real-world assets onto the blockchain is the belief that, in the long term, DeFi will offer unique opportunities and market efficiencies to asset holders, which cannot be found in traditional financial systems.
• Fixed income is the predominant market in the RWA space.
• The ability to easily fractionalize and disperse RWAs in DeFi renders previously unfractionalized, total sum, private credit investments to become accessible to a new set of investors.

Why Real-World Assets Will Onboard the Next $1tn in Crypto

A very promising signal for RWAs has been rapidly growing interest from traditional institutional players. Some examples of recent RWA developments from the world of traditional finance:

• Feb 14 — Siemens issues its first digital bond, worth $60m, on the Polygon blockchain
• Feb 16 — Hong Kong issues its first tokenized green bond of $101m
• Apr 3 — Credit Agricole CIB and Sweden’s SEB begin to develop a blockchain-based platform for digital bonds
• Apr 14 — Bank of America details tokenization of RWAs like commodities, currencies, and equities as a key driver of digital asset adoption
• Apr 20 — Societe Generale introduces a Euro stablecoin, CoinVertable on Ethereum — the first institutional stablecoin deployed on a public blockchain
• Apr 26 — Mitsubishi UFG Trust and Banking Corporation develops a digital securities platform using IBC (cosmos) as the communication protocol and the Corda blockchain infrastructure

Real World Assets (RWAs) refer to the tokenization of physical assets such as homes, cars, real estate, stocks, bonds, and collectibles. By bringing these assets onto the blockchain, RWAs aim to connect decentralized finance (DeFi) with traditional finance. This bridging of the gap between the two financial systems has the potential to bring value into the crypto ecosystem.

Currently, the crypto market is mostly self-contained, with DeFi generating revenue from internal sources like swap fees and borrowing fees. However, by introducing real-world assets to the blockchain, RWAs can open up new avenues for capital, collateral, and revenue to flow into the crypto ecosystem. This expansion can bring liquidity to traditionally illiquid assets, lower the cost of credit, increase access to credit and collateral, and bring transparency to the financial system.

The impartial nature of blockchain and smart contracts allows capital assets to be utilized by individuals and organizations that previously wouldn’t have had the opportunity to do so. This maximizes economic surplus and productivity. RWAs also offer advantages to institutions seeking liquidity and efficiency. On-chain management of assets can significantly reduce operational costs for firms and intermediaries, leading to meaningful savings on their balance sheets.

Successful implementation of RWAs can serve as a framework for tokenizing other physical assets such as supply chain inventory, identity, and taxes. These opportunities present potential growth areas for the crypto industry.

What does the RWA landscape look like and where is it going?

The biggest use of RWAs has been through stablecoins, which tokenize US treasury bonds into US dollar units on-chain. This demonstrates a growing demand for tokenized RWAs. Additionally, gold and stocks have also been tokenized on-chain, either as stablecoins pegged to their price or as mirrored assets for trading. Projects labeled as RWAs primarily focus on tokenizing credit, such as real estate or automobile loans. These tokenized credit assets serve as interest-bearing assets for lenders and provide liquidity, often in the form of stablecoins, for borrowers. On-chain securitization allows for easy buying and selling of these loans and includes built-in interest distribution mechanisms through smart contracts. It facilitates efficient risk transfer for lenders and enables borrowers to raise capital for business ventures. Real-world yields, which are often higher than on-chain yields, further increase the value proposition of RWAs.

Major players in the RWA space

• MakerDAO (MKR) allows Huntingdon Valley Bank (HVB) to access up to $100m in liquid DAI in exchange for collateralized loans on various types of assets.
• Centrifuge (CFG) is an open financing platform with over $206m in active loans that back DAI via MakerDAO. It enables businesses to create collateralized asset pools for investors to provide liquidity and earn interest.
• GoldFinch (GFI) focuses on building credit markets for emerging markets, providing credit for businesses in Africa, Southeast Asia, and Latin America. Approval votes from auditors who stake GFI tokens ensure an alignment of incentives.
• Maple Finance (MPL) has over $135m in active loans and uses pool delegates to manage lending pools. These delegates attract global capital and provide funding to vetted borrowers based on investment strategies, credit quality, reputation, and industry. Loan proposals are reviewed by pool delegates to determine interest rates and collateral ratios.

How Can SMEs Benefit from Alternative Finance through Blockchain?

Traditional finance (TradFi) may not be the best financing solution for small and medium enterprises (SMEs) due to limitations and constraints, leading to a widening lending gap for SMEs. Traditional finance providers have narrow criteria, such as a track record of revenue and profitability, which can make it difficult for new or emerging SMEs to access financing. They also have limited lending solutions and slow approval processes. SMEs face difficulties in accessing financing due to a lack of collateral, limited credit history, and the perception of higher risk by lenders. They may struggle to produce financial statements and negotiate favorable loan terms.

Alternative financing options, including crowdfunding, peer-to-peer lending, and blockchain-based financing platforms, have emerged to help SMEs overcome these challenges.

• Global Lending Gap: The global lending gap, which refers to the difference between the demand for financing and the available supply, is estimated to be around $1.7 trillion. This gap disproportionately affects SMEs and is expected to widen further in the coming years, potentially reaching a value of $5–7 trillion.
• Potential Growth of the Lending Gap: There are estimations that the lending gap for SMEs will continue to expand in the next few years. This is particularly significant for emerging businesses that may struggle to meet the criteria set by traditional finance providers.
• Benefits of Blockchain-based Financing: Blockchain-based financing solutions offer various advantages for SMEs, such as improved access to liquidity, faster access to funds, reduced transaction costs, increased transparency, and access to a global market of investors and lenders. This helps build trust between SMEs, investors, and lenders.

Citi highlights the same benefits as per the above in a March 2023 report for institutional clients entitled Money, Tokens, and Games: Blockchain’s Next Billion Users and Trillions in Value.

A Hidden Gem Converging RWA Tokenization and DeFi to Streamline Business Financing

As a digital asset investor, it is crucial to stay ahead of the curve and identify the ever-evolving trends in the market. The realm of Web3 is constantly evolving, presenting a multitude of opportunities and challenges. In this environment, I believe it is imperative to proactively seek out and handpick not only the narratives most likely to drive growth and adoption but also the blockchain companies within these narratives that are positioned for growth and success.

I don’t normally go this far down the market cap spectrum (c.$2m at the time of writing), but I do believe that this team has what it takes to succeed. Insert Defactor.

Defactor Labs innovates at the intersection of Real-World Assets (RWA) Tokenisation and Decentralised Finance (DeFi) by simplifying and reducing the time to market for businesses to get financing.

Defactor operates at the convergence of Real-World Assets (RWA) and Decentralised Finance (DeFi), working to simplify and expedite the process for businesses to enter the market. Defactor Labs is active in integrating real-world assets into the blockchain sphere, aiming to push forward the DeFi field. It has already processed $30 million in transactions and funded $2M in pilots over the previous 3 months, with no recorded loan defaults. The business model of Defactor Labs includes secured liquidity provision and the development of innovative financial structures, like the Alpha Series.

Defactor Labs allows investors to access DeFi investments securely and compliantly through the Alpha Series, which is noted as one of the first securitization vehicles of its kind in Europe. This effort aims to bridge the gap between traditional finance and DeFi by emphasizing operational efficiency, transparent on-chain collateralisation, and high-level security.

Defactor Labs employs tokenization of real-world assets, splitting them into smaller divisible units. Each unit is representative of fractional ownership of the underlying asset. When investing in the Alpha Bond, funds are added to Defactor Labs’ liquidity pools, which are then allocated to asset owners for more efficient access to capital.

The processes of tokenization and loan collateralization are recorded on the blockchain, aiming to provide increased security and transparency for all parties involved.

Unveiling the Core: Strong Teams Drive Succes in Web3

Just as in traditional markets, due diligence in researching the teams behind businesses is crucial for identifying promising Web3 companies of the future. The people behind a business are fundamental to its potential success, as their expertise, vision, and track record can significantly influence the trajectory of the company. Therefore, understanding the backgrounds, skills, and reputations of the individuals leading a Web3 company can provide critical insight into the company’s ability to navigate the complex and rapidly evolving digital landscape and become a successful enterprise in the future.

Core Team: Defactor’s team boasts impressive credentials across finance and DeFi domains. CEO Alejandro Gutierrez is an industry veteran with robust experience in supply chain management, procurement, and supply chain finance, recognized for his contributions to DeFi and the adoption of real-world assets at Maker DAO and Centrifuge. Chief Commercial Officer Maurice Tracey enriches the team with over 25 years of experience in senior roles in the financial sector, offering profound knowledge in trade finance and structuring in both traditional and decentralized finance contexts. Head of Growth Teresa Song adds her significant background in investment banking and alternative investments to the mix, offering extensive knowledge that aids Defactor in delivering a sustainable and competitive product. Collectively, this team combines diverse expertise and experience, positioning Defactor strongly for growth and innovation within the DeFi space.

Board Members: Defactor’s Board exhibits a wealth of expertise across various domains. Pete Townsend, an early-stage startup investor, and advisor, brings a wealth of experience in fostering web3 startups and working with large corporations such as Coinbase, BNP Paribas, and Fidelity Investments. Stephen Browne, a seasoned legal professional and entrepreneur, merges his passion for blockchain with substantial experience in regulated services like Security Token Offerings and digital wallets, extending Defactor’s global reach through his extensive business network. Ernesto Vila complements this team with his proficiency in the Global Logistics industry and business development, backed by his education on Blockchain from the University of Oxford. This collective knowledge and diverse skill set position Defactor’s leadership remarkably well for success in their respective field.

Partners: Black Manta Capital Partners is a one-stop agency providing comprehensive services in tokenisation across various sectors, including SMEs, Real Estate, and Start-ups, distinguishing itself as the pioneering BaFin-regulated Tokenisation as a Service (TaaS) investment platform. ConsolFreight revolutionises the shipping industry by merging industry knowledge with technology, uniquely financing real-world assets with decentralised finance capital, and expanding its capabilities through strategic partnerships. Centrifuge unlocks economic opportunities by creating a transparent marketplace for borrowing and lending, reducing borrowing costs for businesses, and providing DeFi users with a stable yield source. Zaisan, leveraging a dynamic skill set, pushes boundaries in blockchain and NFT innovations across diverse industries and offers comprehensive support for tokenisation projects, ensuring businesses thrive in the technology-driven landscape.

Commercial Strategy: The Key to Unlocking Blockchain Application Potential

While having cutting-edge technology is vital in the development of blockchain applications, possessing a commercial mindset can often provide a critical edge. A commercial mindset ensures an understanding of market dynamics, customer needs, and competitive landscapes, which are essential in shaping an application that solves real-world problems and delivers tangible value. While advanced technology serves as the foundation for building innovative blockchain applications, it is the commercial perspective that aligns technology with viable business models, strategic partnerships, and user engagement strategies. Therefore, a commercial mind can ultimately be more influential in determining the success of blockchain applications by ensuring they meet market demands, foster user adoption, and achieve sustainable growth.

The Defactor team has been laser-focused on raising awareness about the benefits of lending and borrowing through blockchain powered solutions as a form of alternative financing. Recent events they have attended include: Solana Hacker House NYC, Money 20/20, London Blockchain Finance Summit, Bitcoin 2023 (Miami), Blockchain Ireland Week, among others.

Europe’s First Institutional-Grade DeFi Product Backed by Real-World Assets

HIGHLIGHTS

• The securitization vehicle allows Defactor Labs to cater to an institutional investor base in a legally compliant manner.
• Diversification of investment portfolio achieved through Defactor Labs active diversification requirements and investor’s portfolio construction across pools on-chain.
• Quality assurance supported by rigorous proprietary due diligence process.
• Defactor’s Internal Risk Scoring (IRS) is developed in-line with traditional frameworks.
• A proven MVP validated with the issuers own capital.
• The portfolio consists of the underlying assets of receivables, trade finance and inventory finance.
• The legally compliant funding structure, backed by Black Manta Capital Partners, offers investors a secure and reliable entry point to the exciting world of DeFi with a target APY of 10%.

Alpha Bond Offering

Small and medium-sized enterprises (SMEs) globally are faced with an estimated annual trade financing gap of $1.5 trillion, which has been further exacerbated by the economic disruptions due to the pandemic. One of the significant hurdles these businesses face is access to capital, which is sometimes constrained by traditional banking institutions. These institutions often apply the same stringent lending criteria to SMEs as they do to larger corporations, which can limit SMEs’ ability to secure the necessary funding, curtail their growth potential, and restrict their competitive edge.

In this context, Defactor Labs has emerged, offering services that seek to bridge these gaps. They propose a decentralized finance (DeFi) approach to business lending, aiming to better address the needs of SMEs globally. Defactor Labs works with businesses looking to grow and fund their operations by offering them the opportunity to secure loans using real-world assets as collateral.

Through the Defactor Labs platform, these real-world assets are tokenized, and divided into smaller units, with each token representing fractional ownership of the underlying asset. The company manages liquidity pools, and when an investment is made, the funds are added to these pools. This approach seeks to facilitate a more efficient allocation of funding to asset owners, thus helping them access capital more efficiently.

The processes of tokenization and collateralization are recorded on the blockchain network, aiming to provide a higher level of security and transparency for all involved parties. To date, Defactor Labs’ pilots with traditional asset originators have financed $2M over the past three months with no defaults.

How to acquire Alpha Bonds

Step 1: Registration and qualification as professional investor

Step 2: Know Your Customer (KYC) and Anti-Money Laundering (AML) Compliance

Step 3: Subscription process

Step 4: Purchase of Alpha Tokens

Step 5: Receiving Alpha Tokens (self-custody or institutional custody)

Token Classification

The Alpha Bond Token is based on the Polygon blockchain — a framework for building and connecting network infrastructures benefitting from Ethereum’s security.

The bonds are represented in electronic form, and issued, registered, and maintained by the Investment Platform. They are represented by tokens issued by the issuer in a smart contract, with each token bearing a targeted 10% semi-annual coupon. The tokens are indivisible and directly transferable between users.

The tokenized bonds are contractual, identically-structured claims whose ownership is inseparably linked to the tokens representing the bearer rights themselves.

Defactor Going from Strength to Strength

SME Lending Protocol Defactor tokenizes $100M in Bonds

On June 6, Defactor Labs, a decentralized finance (DeFi) lending platform, announced the tokenization of $100 million worth of Alpha Bonds using the ERC-3643 token standard on the Polygon Network. These bonds will be loaned to small- and medium-sized enterprises using real-world assets like receivables as collateral.

Defactor Labs collaborated with law firm CMS for legal guidelines and selected Luxembourg as the jurisdiction for the instrument. Black Manta Capital Partners provided broker-dealer services and a marketplace for Alpha Bonds, powered by Tokeny’s ERC-3643 tokenization engine.

The ERC-3643 standard, developed in 2021, facilitates identity registry, storage, and compliance of tokens on regulated exchanges, and it has been used to tokenize over $28 billion worth of instruments across more than 180 jurisdictions, according to Tokeny.

Defactor Labs developers claim that over $30 million worth of Alpha Bonds has been transacted during its pilot testing, with $2 million going into project financing. Alejandro Gutierrez, CEO and co-founder of Defactor Labs, commented:

“By leveraging the ERC3643 standard to tokenize $100 million worth of bonds, Defactor Labs aims to not only allow institutional investors to compliantly access DeFi, but also provide them with liquidity options in an open network.”

In a 30-second video, Gutierrez said the project is about bridging traditional finance with DeFi, exploring the tokenization of real-world assets, and building partnerships with startups and large corporations. Defactor is currently part of the Huawei International Scale-Up Program in Ireland.

Defactor Joins Top 10 Scale-ups in Huawei’s International Accelerator Programme

A leading global provider of information and communications technology (ICT) infrastructure and smart devices, Huawei has a strong track record of investing in innovative technology for a fully connected, intelligent world.

Using blockchain technology, Defactor has developed a solution for digitalizing assets that currently cannot be used as collaterals for loans. “The idea is to bring in traditional financial players and teach them to use the liquidity that is now trapped in the DeFi environment,” Gutierrez says. DeFi, he explains, stands for decentralized finance. “We tokenize real-world assets to use them as collateral for financial services.” Launched in February 2021, the Irish company also has operations in Portugal and India.

Defactor was one of only ten projects selected for this accelerator and has developed a solution for digitalising assets that currently cannot be used as loan collaterals. “The idea is to bring in traditional financial players and teach them to use the liquidity that is now trapped in the DeFi environment,”

Tokenomics

Before there was Defactor Labs, there was Defactor DAO (decentralized autonomous organization). This DAO has launched two years ago and issued governance tokens as a means of financing its business. It built the tech underpinning Defactor Labs’s business, including writing the smart contracts.

Supply & Demand Breakdown

Token Allocation Breakdown

Defactor has a fixed supply of 300,000,000 tokens. These tokens are allocated for various purposes within the ecosystem. Firstly, a portion of these tokens is allocated to the association with the intent of incentivising the overall ecosystem’s growth. Secondly, a set amount of these tokens were reserved for the initial sale, where interested buyers had the opportunity to participate in the pre-launch and launch sale of the tokens. Next, staking rewards are given through specific contracts where token holders lock their $FACTR tokens for a predetermined time period to receive rewards. For ecosystem growth and partnerships, both existing and future partners may be rewarded or compensated in $FACTR tokens, promoting further development within the ecosystem. These tokens are vested and become liquid only after the delivery of the agreed-upon milestones. Lastly, the team and advisors, including contributors, are entitled to bi-annual token rewards that are subject to an 18-month vesting period.

Token Vesting Schedule

Offering Lender Incentives Using the FACTR Token: For example, the minimum investment for the Alpha Bond is $100,000, but the team prefers investors write checks of at least $1 million. To encourage this, they are distributing FACTR governance tokens to larger investors. If Defactor Labs is a hit, the value of those tokens should rise. Therefore bondholders get both an attractive yield as well as a potential, equity-like upside.

Final Thoughts

The tokenization of real-world assets offers numerous benefits for both individual investors and institutions. By leveraging blockchain technology and smart contracts, illiquid assets can be easily fractionalized, enabling broader participation from investors of all sizes. This democratization of access brings liquidity to traditionally illiquid assets, lowers the cost of credit, increases access to credit and collateral, and introduces transparency to the financial system.

The interest and involvement of traditional institutional players in the tokenization of real-world assets further validate its potential. Established institutions, including Siemens, Hong Kong, Credit Agricole CIB, Bank of America, Societe Generale, and Mitsubishi UFG Trust and Banking Corporation, have already made notable developments in the field, such as issuing digital bonds and exploring the tokenization of various asset classes.

The implementation of real-world asset tokenization also serves as a framework for further innovation within the crypto industry. Beyond the tokenization of traditional assets like homes, real estate, and stocks, there is potential for tokenizing supply chain inventory, identity, taxes, and more. These opportunities pave the way for continued growth and expansion of the crypto ecosystem.

Moreover, small and medium enterprises (SMEs) stand to benefit greatly from blockchain-based financing solutions. Traditional finance often imposes strict criteria and limited lending solutions, leaving SMEs with limited access to capital. Blockchain-based financing, including crowdfunding, peer-to-peer lending, and blockchain-based platforms, offers SMEs improved access to liquidity, faster funding, reduced transaction costs, increased transparency, and access to a global market of investors and lenders. These alternative financing options help bridge the global lending gap, which is estimated to reach trillions of dollars and disproportionately affects SMEs.

As the adoption of real-world asset tokenization and blockchain-based financing solutions continues to gain traction, the financial landscape is set to transform significantly. The integration of DeFi with traditional finance, coupled with the advantages offered by blockchain technology, has the potential to unlock new opportunities, market efficiencies, and value within the crypto ecosystem. The journey towards a more inclusive, efficient, and transparent financial system has begun, and the tokenization of global illiquid assets plays a crucial role in shaping its future.

RMPaun is Head of Research at Dragonfly Asset Management.

Disclaimer: This content is for EDUCATIONAL AND ENTERTAINMENT PURPOSES ONLY and does not constitute financial or investment advice. You should do your own research and only invest what you can afford to lose. Any reference to an investment’s past or potential performance is not, and should not be construed as, a recommendation or as a guarantee of any specific outcome or profit.