Finding the Way to Balance: Navigating the Delicate Line Between Maximizing Financial Returns and Decentralization

Acknowledgment: Thanks to Momir, Ray, Sid and Jocy’s valuable review of the article.

Until recently stablecoins were the only Real World Asset (RWA) category that drew attention. Stablecoins, introduced even before Ethereum’s inception, replaced volatile cryptocurrencies as a standard medium of exchange on blockchains. Presently, USDT, boasting a market capitalization of $86.9 billion, and USDC, with a market cap of $24.0 billion, collectively account for 7.5% of the entire crypto market capitalization, which stands at $1.46 trillion.

A little while back, 2 years ago, when traditional finance abandoned the zero-interest regime and T-bill yield exceeded the DeFi native yields, it became clear that the story of RWA doesn’t end with stablecoins.

Let’s examine the RWA market structure, starting from the most stable aspect and progressing towards its future development and trajectory.

Types of RWA:

Developments and Challenges in the Industry

Stable Coins: The Backbone of RWA

In the ever-evolving landscape of cryptocurrency, stablecoins have emerged as the unsung heroes. These digital currencies, designed to maintain a stable value by pegging it to traditional assets like the US dollar, have played a pivotal role in injecting real-world capital into the crypto market. And below are several observations on the stablecoins vertical.

Here are a few observations on the stablecoin sector.

Lucrative Stablecoin Ecosystem: The Cash-Cow of Crypto

Stablecoins have proven to be the cash-cow of the cryptocurrency industry, boasting a clear product-market fit and presenting remarkable monetization opportunities. In fact, they have become one of the most lucrative sectors in the crypto space.

For instance, consider Tether (USDT) — in the first quarter of this year, its profits exceeded those of financial giant BlackRock, with Tether raking in an impressive $1.48 billion in profit vs BlackRock’s $1.16 billion. What makes this achievement even more remarkable is that Tether manages 120 times less money than BlackRock, with $70 billion under its management compared to BlackRock’s $8.5 trillion. The majority of Tether’s revenue comes from reinvesting the fiat collateral and as of recently, their balance sheet has been skewed towards T-bills. Due to its network effects and the fact that its customers are interested only in having exposure to the stable product, Tether is able to capture 100% of the underlying yield, hence astonishing profits.

This, however, also leads us to one of the first issues with existing stablecoin providers. Centralized stablecoins like Tether and Circle face criticism for concentrating profits while socializing losses, raising fairness concerns. In March this year, the market suddenly realized that holding stablecoins is not risk-free, and while holders are not compensated for any of the risk they are subject to suffering losses if any issue arises with regards to collateral management.

Besides, there is also a general lack of transparency and exposure to undisclosed risks, as seen during the SVB bankruptcy. At the moment of the bankruptcy, the market was blind to the fact that Circle had any exposure to SVB. On the other hand, although Tether remained untouched by the recent bankruptcies of traditional banks, Tether’s balance sheet still has exposure to illiquid venture-style investments as well as lending business. These are certainly not the risks USDT holders are willing to underwrite.

Both Circle and Tether are designed as if their collateral can’t lose value and is 100% liquid, when in fact neither is true. This makes both Circle and Tether vulnerable to bank runs in black swan scenarios. Only by luck, Circle has managed to avoid such a scenario post-SVB bankruptcy.

Crypto native stablecoins tried to control for the above risks, however, each design eventually bumps into stablecoin trilemma, having to choose two out of the following three:

• peg
• decentralization
• scalability.

Bridging TradFi and DeFi

The RWA landscape has been offering various products for years, but it hasn’t received much attention until recently excluding previously mentioned stablecoins, which function more like a safe haven in the crypto market rather than financing tools. The significant catalyst for this recent surge is the high-interest regime.

The widening gap between DeFi native yield and tradFi yield sparked interest in solutions that could help bridge this gap. Again, stablecoins are the main protagonist, however, this time DeFi native stablecoin protocol — Maker DAO.

Namely, MakerDAO, the third-largest DeFi protocol by total value locked (TVL), has made a strategic shift in its asset management by significantly increasing its exposure to Real-World Assets (RWAs). Essentially, Maker’s governance wasn’t happy holding unproductive and ‘risky’ USDC on its balance sheet when there was a productive and risk-free alternative. The main obstacle, however, was that enabling Maker to have direct exposure to T-bills required setting up a ton of off-chain infrastructure and legal gimmicks. Fortunately, Maker is one of the more resourceful DAOs that finally managed to build this bridge. So far this move has been nothing short of successful. Nearly 65% of MakerDAO’s fee revenue over the past year, amounting to $130 million, was generated from RWAs.

Distributing part of the underlying T-bill rate to the DAI saving rate (DSR) module, made tectonic shifts in the DeFi landscape, creating significant pressure on smaller competitors that couldn’t keep up with the yield, such as Liquity’s LUSD and AAVE’s GHO, and pushing overall rates in the stablecoin money markets up.

Blast, a recently announced L2 solution, aims to allocate all of the stablecoins bridged to their rollup to DSR, showing that Maker’s RWA strategy could kick off growth in DAI demand and adoption across DeFi protocols.

Yet, while the RWA strategy helps Maker achieve scalability and optimize its finances, it clearly pushes it farther away from the status of a trustless DeFi protocol.

Challenges with Tokenized T-Bills adoption in DeFi

No other DeFi project comes close to Maker’s $3B RWA balance sheet. One of the primary challenges for the wider adoption of RWA is the restricted transferability of tokenized T-bills within the DeFi ecosystem. The existing infrastructure often hinders their movement among different DeFi protocols and externally owned accounts (EOAs). Thus, tokenized RWA T-bills face limitations when it comes to their utility as collateral within the DeFi space.

When it comes to DAOs, the ability to directly get exposure to RWA is hindered by the legal complexities and the inherent risks associated with the absence of an off-chain representative. However, this issue is being addressed by innovative solutions like Centrifuge Prime. Centrifuge Prime establishes legal structures that enable DAOs and individuals to safely access tokenized T-bills, mitigating the risks and legal barriers traditionally faced in these transactions. This development represents a significant step forward in broadening DAOs’ investment capabilities in secure and regulated assets.

Credit Markets: Higher APR with Higher Risks

Credit markets try to serve those seeking more risky opportunities and diversity of solutions beyond T-Bills.

While DeFi protocols like AAVE and Compound try to build fully trustless and permissionless DeFi protocols, Centrifuge and Goldfinch-like projects introduce to stablecoin holders the opportunity to participate in off-chain lending markets. Abandoning trustless and permissionless character, allows them to achieve more capital efficiency, serve a wider set of use cases, and customize offerings to the individual borrowers.

Borrowers, typically off-chain asset originators, have to go through traditional due diligence and/or use some RWA collateral to support their borrowing activities. For instance, Goldfinch’s approach “trust through consensus” allows borrowers to prove creditworthiness via collective third-party evaluations. These projects, resembling fintech companies more than DeFi projects, mostly aim to fill the gap in emerging markets that lack access to financial infrastructure. However, there is a significant risk that these solutions end up attracting high-risk borrowers that traditional financial institutions reject to serve, essentially creating ‘lemon’ markets.

The recent high-interest rate environment also depressed some of the credit market activity and made lenders reluctant to participate in alternative markets (the high-interest rate environment has put some growth pressure on credit markets like Maple and invoice finance businesses like Centrifuge, as investors currently prefer direct participation in the bond market. This is also why Centrifuge and Maple, in addition to their main businesses, have set up additional pools for government bond investments to diversify and alleviate the growth pressure on their platforms). Overall, among the crypto audience, this direction still hasn’t proven product market fit and we see existing projects placing more emphasis on lower-risk alternatives, such as investment-grade bonds, high-grade structured credit, tokenizing commodities, or even real estate.

Understanding the demand side

Crypto-natives

Crypto natives have accumulated a significant amount of on-chain wealth over the past (almost) 15 years and have developed habits of keeping the majority of their wealth on-chain. For those used to using crypto rails, going back to the burdensome tradFi infrastructure becomes a fairly inconvenient process. Yet, many are looking to diversify their wealth into assets that are not correlated with crypto. The tokenization of RWA enables them to enjoy these diversification benefits while keeping the joy of the on-chain experience.

Besides, the growth in on-chain economies has resulted in multiple DAOs that manage 8–9 figure treasuries with a high level of concentration among volatile crypto assets. As a part of prudent treasury management, we expect to see more DAOs deploying parts of their balance sheets into RWA.

Could the RWA category attract to tradFi audience to crypto rails?

We believe, yes.

Some of the tokenized RWA are tradable 24/7 e.g. Backed tokens could be freely traded on DEXs any time. Thus, markets get another venue where they can react to the new information in real-time, even though the tradFi exchanges might be in the off-hours.

As crypto becomes a more mainstream asset class, the overlap between crypto and stock investors will only increase. TradFi holders may be interested in leveraging DeFi composability and innovation e.g. imagine a Liquity-like product that allows users to mint zero-interest loans against their retirement investment in S&P500 ETFs.

Concluding Remarks

Many people are pondering what changes might occur to the aforementioned protocols when there is a shift in the high-interest rate environment. We believe that generating revenue through high-interest rates is, in the short term, a temporary strategy for these protocols, but the ultimate focus should still be on their core business operations. We should view the current high-interest rate environment as a temporary phase that draws attention to Real World Assets (RWA) and encourages exploration of new opportunities within this domain. It’s important not to overly rely on this high-interest climate for long-term gains. Recent trends, such as the weakening of the USD due to anticipated interest rate reductions in 2024, underscore the need for a more strategic approach that looks beyond the immediate benefits of high interest rates.

For example, MakerDAO’s long-term focus continues to be on expanding the influence of their DAI (in terms of issuance volume and application scenarios). Although Centrifuge also earns some income from T-bills, its future efforts will mainly be on invoice finance-related activities (programmable decentralized invoice finance infrastructure). Similarly, Maple Finance, after some past missteps, is actively seeking a credit solution path that better balances risk and capital efficiency. The long-term value lies in excelling at credit lending and borrowing. Therefore, ultimately, everyone should return to their original business operations or extend from that foundation.

Additionally, since the rise of cryptocurrencies, Real World Assets (RWA) have gained significant attention within the crypto domain, especially with the success of stablecoins like USDT and USDC, which have become a lucrative sector in the crypto market. At the forefront of this evolution are stablecoins, emerging as major RWAs that have seamlessly integrated into the crypto market. Their widespread adoption signifies a proven product-market fit, providing a stable bridge between traditional financial systems and the dynamic world of Decentralized Finance (DeFi).

However, stablecoins also face challenges and risks, such as issues with value distribution, lack of transparency, and scalability. A deeper examination reveals a complex narrative. Centralized stablecoin entities, while investing the fiat entrusted to them and reaping substantial profits, require more investigations as they pass on the underlying risks of these investments to users, despite users not receiving any returns from the underlying assets. This dynamic reveals the delicate balance between the profitability of entities and treating their user community fairly and justly.

Tokenized T-Bills have also gained interest as a bridge between traditional finance and DeFi under the current advantageous situation, which also brings up the credit lending protocols into people’s sights. Tokenization of various assets like stocks, real estate, and commodities is expanding, offering more investment opportunities. DeFi protocols, despite facing limitations in incorporating RWAs, have made significant strides in building bridges to facilitate easier access. This evolution opens unique opportunities for the DeFi-native audience, who have amassed considerable on-chain wealth over the past decade.

The convergence of traditional finance (tradFi) products with blockchain technology promises innovation, unlocking novel financial instruments and strategies. As the overlap between traditional and crypto investors continues to grow, the synergies between these two worlds are poised to redefine the financial landscape. The potential for collaboration offers the prospect of unlocking previously untapped markets and creating novel, inclusive financial ecosystems.

In conclusion, the future of RWAs lies in the expansion of assets, capital, and resolving current challenges. This advancement is necessary for diversification, convenience, access to restricted geographies, and regulatory support. However, it’s essential to acknowledge that the process of RWA-ization, while opening new avenues, introduces a trade-off. The integration of productive RWAs inevitably compromises the trustless nature that has been a hallmark of the crypto space. Striking the right balance between innovation and decentralization will be a key challenge as we navigate this evolving terrain.

Reference

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CoinGecko. “What Are Real World Assets? Bringing Real-World Loans on-Chain for Alternative Investment Yield.” Accessed October 17, 2023. https://www.coingecko.com/learn/what-are-real-world-assets-exploring-rwa-protocols.

Crypto.com. “Real-World Assets: Bringing Real-World Value to DeFi.” Accessed October 17, 2023. https://crypto.com/research/real-world-assets.

RedStone. “RWA Report: The Deep Dive into 2023 Market — RedStone Blog,” August 30, 2023. https://blog.redstone.finance/2023/08/30/rwa-report-the-deep-dive-into-2023-market/.

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Appendix

Expanding Horizons: Tokenized Stocks, Real Estate, and Beyond

Our exploration of RWAs reveals a diverse landscape encompassing classes such as stablecoins, tokenized T-bills, credit market, stocks, and real estate. This multifaceted ecosystem is poised for remarkable transformations, and the future directions are indicative of the promising developments on the horizon. And the development can be concluded in two directions: classes of RWAs and UX acceleration.

Classes of RWAs:

• Coins Backed by Different Fiat Currencies: Coins Backed by Different Fiat Currencies: The prevailing trend in cryptocurrency shows a dominance of USD-backed coins, like USDT, particularly in emerging economies. Despite the potential for coins backed by a variety of fiat currencies to enhance the valuation of local assets, many of these economies show a preference for trading in USD coins. Research on USDT adoption in Latin America underscores this trend. Furthermore, USD coins benefit from network effects and contribute to the further dollarization of the global economy, aligning with U.S. interests. This was evidenced in Circle’s congress hearing, where the positive role of USD stablecoins in the global economy was highlighted. However, the future could see an increased representation of EUR and other major currencies on-chain, fostering opportunities for 24/7 forex trading and information arbitrage during global market downtimes. The shift towards a more diverse currency representation in the digital asset space might challenge the current USD-centric model, balancing the global economic influence.
• Tokenized Stocks: Digital representations of company shares are revolutionizing access to the stock market, democratizing participation. While many protocols have attempted to achieve this, legal risks still remain a significant concern.
• P2P Finance: Analyzing the setbacks in P2P finance, two primary issues emerge: stringent regulation and inadequate information flow. Blockchain technology, with its inherent traits of minimal regulation and enhanced information transparency, can potentially revolutionize this sector. It offers real-time tracking of borrower activities and alerts for unusual behaviors, instilling greater confidence among lenders. A notable example of these principles in action is SOLV. Unlike traditional platforms where borrower activities are opaque, SOLV integrates centralized custody solutions. This ensures that even when funds move to centralized exchanges, they are handled only through approved custodians, allowing lenders to consistently monitor the Net Asset Value (NAV) of the borrowers and maintain better oversight of their investments.
• Real Estate: Tokenized real estate enables global property investment, providing benefits such as diversification and liquidity. Although progress has been made in this field, it is still limited compared to the volume of traditional finance.
• Commodities and Beyond: The potential for RWA tokenization extends beyond traditional assets to include commodities, intellectual property, fine art, and more. This broadens the range of investment opportunities available.

UX Acceleration:

The future of Real World Assets (RWAs) hinges on expanding assets and improving the user experience (UX). By diversifying asset classes and creating user-friendly platforms, RWAs can enhance accessibility, attract a wider range of participants, and revolutionize finance. By prioritizing UX, RWAs can streamline processes, simplify interactions, and provide a seamless trading environment for tokenized assets, making the adoption and utilization of RWAs more convenient and appealing to users.

• Accessibility for Investors: Tokenization of various RWAs democratizes investment access, meeting corporate needs such as currency hedging.
• Liquidity Boost for Borrowers: The implementation of enhanced Know Your Customer (KYC) processes and the involvement of professional creditors are pivotal in reducing collateralization demands. This shift enables borrowers to obtain larger loans with less collateral, enhancing capital efficiency in the DeFi sector
• Unified Platforms: Platforms like Tangible play a critical role in integrating traditional financial sectors with DeFi protocols. These platforms act as a bridge, creating a seamless trading environment for tokenized assets. By offering a single platform that supports various functionalities, they simplify the user experience, making interactions with blockchain and traditional finance more fluid and less daunting for users.