RWA & Private Credit Pt 1: Market Opportunities for On-Chain Private Credit & Trade Finance

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HashKey Capital Insights

12 min readFeb 23, 2024

Introduction

The state of Blockchain today is often compared to the early days of the Internet, when people were still looking for the “killer use cases” that would bring the masses online. Honestly, crypto has had very few breakthroughs in providing real utility to average people. The last bull market was plagued by Ponzi schemes and inflationary token economic designs that generated yield without providing inherent value, other than powering what were effectively speculative betting markets with liquidity. The truth is, crypto in the last market was a casino for gambling degenerates — myself included.

Disillusioned with the state of DeFi, I spent a lot of time this year pondering the question — what can we do with this technology to make it useful? Especially to Regular Joes who aren’t crypto-native. There are many answers to that question (as we all know… that’s why most of us are here, right?). I could spend a page listing them out, but you clicked this article to learn about a very specific topic, which Citibank referred to as the “killer use-case” for blockchain: tokenization of real world assets (RWA).

RWA is going to be a major driver of fresh capital into on-chain markets in 2024 and beyond because, unlike many projects arising in the Cambrian explosion of blockchain applications, RWA tokenization solves real problems for real businesses that provide actual goods and services to non-crypto-natives. Also, without pulling off-chain value on-chain, it will be very difficult for crypto markets to expand beyond their previous all-time highs by market cap.

This article offers an overview of RWA, delves into opportunities for disruption within private credit markets, and explores how blockchain can address existing challenges in TradFi.

The next article in this series will give some insight into the rising RWA landscape and my views as an investor, and the third and final post in this series will discuss institutional developments in RWA.

The Tokenization Revolution

What is “RWA” in Crypto?

Let’s start with the basics. Real-World Assets (RWA) in crypto broadly refer to any assets that derive their value from some place other than the blockchain, which are then tokenized and brought on-chain. The potential here is pretty much endless: debt instruments, commodities, real estate, art, collectibles, intellectual property, energy, and pretty much anything else you can imagine. Heck, Magic Eden is even tokenizing Pokemon cards.

This is not a new concept, by any stretch. In the last crypto market, we saw plenty of RWA protocols rise and fall, and MakerDAO derives most of their revenue from T-Bills and other forms of RWA.

But let’s begin with the hottest topic in RWA right now: tokenized Treasuries.

Tokenized Treasuries

As you can see via this chart from RWA.xyz, demand for the on-chain “risk-free rate”, or tokenized Treasuries, continues to rise, surpassing $860M at the time of writing:

With U.S. Treasuries paying ~5%, it’s no wonder investors are turning to the lowest risk yield-bearing asset available. The total stablecoin market cap sits at ~$129B, with USDT and USDC composing the lion’s share. That’s a lot of capital parked in a type of risk-off asset that doesn’t appreciate or provide a yield on its own.

“US treasuries may have lower yield but likely higher risk-adjusted yield than DeFi considering how frequently smart contracts can be exploited,” said Jack Tan, co-founder of WOO Network. “It’s a lot more scalable to have $10B assets generating 5% sustainably in RWAs than on-chain, as anyone who witnessed the events of 2022 will attest.”

Why Tokenized Treasuries?

Treasury Debt grew >750% in 2023 because it is the lowest possible risk for any on-chain yield-bearing asset. The collapse of the cryptocurrency market, shrinking DeFi yields incommensurate with the underlying risk, and a global monetary tightening cycle ramping up interest rates created a perfect storm for the rise of the on-chain risk-free rate. Investors, DAO treasurers, crypto-native hedge funds, and wealth management firms are using on-chain treasuries as the logical first step in testing the waters for low-risk sources of sustainable yield.

Which intrinsic traits make Treasuries (especially T-Bills) so perfect for this?

Short-term and fairly liquid: T-bills come in terms of 4, 8, 13, 26, and 52 weeks. They are also extremely liquid, meaning they can be bought or sold on secondary markets before their maturity.
Effectively Risk-Free: Backed by the faith and credit of the U.S. government, Treasuries are generally considered “risk-free”, meaning there is effectively no risk of a default.

It’s no wonder the clear frontrunner in the on-chain treasury market is Franklin Templeton, a TradFi global asset manager with $1.3T+ AUM. Their BENJI tokens represent shares in its Franklin OnChain US Government Money Fund (FOBXX) on the Stellar and Polygon blockchain networks. Their domination of this market indicates a clear bias toward a heavily-regulated firm with a long-standing reputation in traditional finance that investors are likely to view as the safest option.

BENJI’s competitors, like Ondo and Matrixdock, are steadily growing as well, indicating a cautious return to crypto for institutional investors via low-risk products. But as the market heats up and DeFi begins offering more competitive yields, the RWA vertical is going to need other avenues to remain competitive — especially when interest rates finally go down.

As investors become more comfortable with on-chain finance again, they’ll begin to move along the risk curve toward assets with higher risk/return profiles. So the question then is, what’s next?

Opportunities for Evolution in Private Credit

Traditional private credit is an area with massive latent potential for disruption via blockchain. First, I’ll explain why there’s such a huge opportunity. Then, I’ll discuss how these opportunities have been explored in the past, and what I see as the logical next steps.

Private credit has become one of the most attractive asset classes globally, offering great returns for lower-than-market risk. Private senior and unitranche loans can offer a premium of 150–300 bps compared to publicly traded loans, with significantly larger premiums for more opportunistic markets. In some markets, rates can be in the double digits. Even better, these loans are usually floating-rate instruments, the borrowers’ interest payments rise with interest rates, protecting the lender.

As a result, private credit grew from $71B to $224B AUM between 2012 and 2022.

What conditions created such opportunistic markets? One big factor is Basel III.

Basel III Regulations and SMEs

Basel III is the set of global banking regulations established in response to the Great Financial Crisis in 2008, requiring higher capital adequacy standards on banks. For example, the minimum size of public debt market issuances were increased significantly, while the amount of credit public lenders are able to issue was decreased. You can see where that might create problems for SMEs (Small and Medium Enterprises) in need of credit.

Additionally, under Basel III, banks must group their assets by risk category (e.g. retail mortgage, rated corporate, sovereigns, etc.) and apply a minimum risk weight to each. These rates determine the lower bound of required capital for each type of asset.

You can find a list of risk weights here — just note that “RWA” in this context is “Risk-Weighted Asset”.

So higher risk weight means higher capital requirements for that particular asset (as in, more money needs to be held by the bank). The more money the bank needs to hold, the less its earning on that capital.

In summary, banks can issue (a) fewer loans that (b) must be larger in size and © are more expensive to issue to SMEs than large enterprises. The incentives for capital allocation are clear here, and as a result banks have reduced their SME lending.

According to the International Finance Corporation (IFC), ~65 million firms, or 40% of micro, small, and medium enterprises in emerging markets, have unmet financing needs of $5.2 trillion annually, which is 1.4 times the current level of global MSME lending. Half of formal SMEs lack access to formal credit.

Rampant Inefficiencies in Private Credit

It’s important to note that this is a very inefficient market. Electronic infrastructure to support transactions, collateralization, administration, and reporting are extremely limited, as is transparency on factors like performance, cost, and underlying investments. Additionally, reconciliations and settlement failures are expensive and time consuming, making lending to SMEs even more costly.

Trade Finance

What is Trade Finance?

Trade finance presents a massive opportunity to produce stable yields sourced from fundamentally strong businesses. What is “trade finance”?

Trade finance refers to the processes, technologies, and financial instruments used to facilitate (namely, fund) international commerce — especially in reference to importers and exporters. The WTO estimates that trade finance is fundamental to supporting 80–90% of international trade, and the trade finance market is expected to grow from ~$8T in 2022 to nearly $12T by 2029.

It’s important to know that there are many methods of financing cross-border transactions, including (but not limited to):

Letters of Credit — A formal letter to the seller from the buyer’s bank laying out terms of credit and guaranteeing payment.
Documentary Collection — The exporter’s bank forwards documents to an importer’s bank and collects payment for shipped goods.
Factoring — The lender purchases the borrower’s unpaid short-term invoices/receivables at a discount, meaning the creditor handles payment collection. When the payment is collected from the buyer, the lender disburses any remaining amount due (after interest and/or fees) to the borrower.
Forfaiting is basically the same thing, but with medium- and long-term receivables.
Discounting — Similar to factoring, except the business remains responsible for collecting payments from customers and pays the lender after collection, minus any fees or interest.

For the most part, factoring and discounting seem to be the most popular rising trends with on-chain trade finance. They are likely the easiest to bring on-chain due to the following characteristics (and note the overlap with T-Bills):

Receivables are short-term: Payment terms are typically 30, 60, or 90 days, meaning payment is due 30, 60, or 90 days after the goods or services are delivered.
Low risk: The International Chamber of Commerce (ICC) places the obligor-weighted default rate for export financing (such as invoice factoring) at 0.97%. Combined with credit insurance (the cost of which is typically relayed to the borrower), the risk for the investor becomes negligible.
[Caveat: This assumes proper underwriting and risk mitigation… more on that later.]
Consistency: Trade finance as an asset class is marked by low volatility, consistent returns, and low correlation to the larger financial market. Because of the massive unmet demand for credit in this market, even a moderate downturn would leave a significant amount of funding required (especially as public lenders continue to decrease approvals).
High Returns: SME invoice factoring operations in the current market typically generate 18–22% on their assets under management or advisory. Higher-risk lending can produce even greater returns.

For these reasons, I believe trade finance will be the next stop on the risk curve for low-risk investors in crypto.

Rampant Inefficiencies in Trade Finance

Trade finance is a category of private debt, so many of the same issues apply. However, the cross-border aspect of trade finance makes the process even more complex and involves additional intermediaries.

The trade finance market involves lots of duplicated manual processes, paperwork, custom legal work, and potential for forgery. It is exceedingly labor-intensive and expensive, often requiring third-party mediation. Many SMEs might struggle to even afford the legal and administrative overhead involved in this process. For lenders, the loan amounts (and therefore returns) are so low that the costs of underwriting and origination often outweigh potential returns.

How Blockchain Can Revolutionize Private Credit

So far, we’ve learned about the lucrative opportunities in private credit, regulations holding back the liquidity of giant institutions from this asset class, and why trade finance is an especially attractive form of private credit for crypto markets. Now let’s talk about how Real World Assets can solve Real World Problems.

Liquidity and Accessibility

If you’ve read anything about crypto (or if you’ve got a crypto-evangelist friend or relative), then you’re aware of the commonly-stated theorized use case of building “more inclusive markets”. So far, that “inclusion” has mostly involved what are essentially research projects facilitating the transfer of wealth from savvy traders to unsavvy traders, Ponzi schemes, and straight-up scams. Tokenizing debt has the potential to include retail in an asset class from which they’ve historically been excluded, and, as a result, bring massive amounts of much-needed liquidity to the market.

How can tokenization increase accessibility to retail?

Decreasing Financial Barriers to Entry: SEC regulations and/or minimum investment check sizes can make investing into private credit funds difficult. Fractionalization can significantly lower investment minimums, and also make it easier to withdraw funds.
Providing Interfaces for Access: Without Web3, how would you even find an opportunity to invest in private credit? Typically, such opportunities are only accessible to institutional clients, high-networth individuals, and insiders. You probably get half a percent interest on your money at your bank. If you had easy access to 5–10% fully-regulated and insured fixed yields through centralized custodians (i.e. neo-banks and exchanges), all without ever needing to interact with a blockchain, why wouldn’t you take it?
Appealing to Youth: Traditional finance (TradFi) players can expand their reach by using crypto to appeal to younger, technologically-inclined investors who otherwise might never consider this investment class.

“Web2.5” Could Be Even Better For RWA Than Web3

Double-digit APYs aren’t uncommon when fully on-chain. Heck, on Stargate right now, you can pull in 17.11% APY supplying USDT alone. During the peak of DeFi Summer, you could even secure 30% APY on Curve with just stablecoins. 5–15% APYs offered by RWAs are certainly appealing in a bear market, but who is going to accept those rates in a bull market with such a massive opportunity cost?

The reality is that most people prefer not to engage directly on-chain. The cryptocurrency industry often makes headlines for the wrong reasons, like Terra/Luna, FTX, 3AC, etc., contributing to its negative reputation among the mainstream audience. Constant exploits and subpar user experiences further deter many from venturing into on-chain operations. There’s an inherent risk in operating on-chain that most people (especially institutions) prefer to avoid — but they do want the benefits. This is why many exchanges, custodians, and neo-banks are now extending Web3 yields to their “Web2.5” users, bridging the gap between traditional and blockchain-based finance.

Rather than sourcing fully on-chain liquidity, a number of innovative trade finance projects like OpenTrade and Credbull (pronounced Cred-i-bull) have begun forming partnerships with these centralized crypto providers to bring their yields to users who otherwise would likely never think to look for them — a massive source of AUM from pre-KYC’d customers, without requiring the customers to access any new interfaces.

The key here is making yields just as accessible as buying USDC on a CEX to decrease the barrier to entry. I could never teach my dad how to use MetaMask, but using Coinbase is as easy as buying stocks on Schwab. Imagine how much additional liquidity could enter RWA if accessing yields was just as easy.

Programmable Money

In private credit markets, a lot of the work is still very manual. Every deal is unique, and the lack of standardization has inhibited significant automation. Creating a standardized, modular framework for credit with programmable money would massively reduce the need for manual processes, lowering overhead costs. Smart contracts reduce human intervention and reliance on third parties to verify that terms of a contract have been met.

To gain a deeper understanding of the transformative possibilities of programmable money, I reached out to Michele Bisceglia of FiveSigma, a UK-based asset manager specializing in private debt, for his thoughts:

“At Five Sigma we have built tech to systematise [sic] different parts of the private debt work, particularly on the asset management side, but the way money flows through a structure (what we call the waterfall) is still limited by outdated banking technology. I believe programmable money, and in particular stablecoins, have the potential to automate waterfalls, making them more efficient, and also limit cash drag associated with long times to draw funds; it could also make structures and particularly money flows more visible which will allow for higher transparency. Overall, I’d expect these effects to result in lower structural costs and consequently lower financial product costs to the borrowers in the economy.”

Looking Ahead

This article has provided an overview of RWA, explored opportunities for disruption in private credit markets, and highlighted how blockchain technology can address existing challenges in TradFi. In our next installment, we’ll delve deeper into the evolving RWA landscape, offering insights from an investor’s perspective. The third post will focus on institutional developments within the RWA sector.