This article will go through the mechanics of the entire real world asset tokenization protocol. At some point we will wrap this together into a whitepaper.
The key items we will cover are:
1. What assets can be tokenized?
2. Why you should tokenize Assets (on-chain representation)?
3. How Assets can be tokenized?
4. Where to borrow against tokenized Assets (the need for an open, fully decentralized and censorship resistant money market)?
5. How to grade real world assets on-chain?
6. How to execute on any defaults on repayments off-chain?
We have previously written about what type of assets can be tokenized
Recently we repositioned ourselves from a Securities Tokenization platform to an Asset…
Securities are a subset of Assets. All assets are securities, but not vice versa.
TLDR: Only peer to peer contracts which are not already recorded in a centralized fashion can be tokenized.
We also wrote about why you should tokenize:once these assets are represented on-chain you can now borrow against them on-chain.
And we also discussed how to represent the assets on-chain.
Asset Tokenization Protocol: High level architecture
Estate Baron identified a clear niche in the market in the form of covering the equity funding gap for real estate…
We also spoke about how we would need a forked version of Compound in order to allow for it to accept our assets to be used as collateral to borrow against.
This article is primarily written for the benefit of the internal team at Konkrete to further their understanding of…
What has now become clear is that there is a need for a more open source money market.
Compound has built a money market which works beautifully but it does restrict which tokens can be used as collateral.
In our opinion that should be left to the lender.
It is the lenders money and it should be upto them to determine which assets they accept as collateral. The role of a money market protocol should be to facilitate and not dictate.
So step 1 would be to build a more open version of Compound but with the same underlying mechanics. Such an open compound would allow the lenders to determine which collaterals would they accept.
Any one should be able to build a front end interface on top of such an open money market backend dApp. Different players will then be able to provide their own flavors where some will only allow selective assets via their front end for their lenders to participate in, others will allow its users a dynamic selection of assets and so on.
Such an open Compound thus turns into a censorship resistant back end that can be used by any team that wants to create its own lending portal. They can tokenize their own assets and put it on here and as long as lenders accept that as collateral it is fine.
Open Compound would not be in the control of Konkrete or any other single group and would be operated as a public good. The closest analogy would be Uniswap which operates on similar censorship resistant principles.
For a simple explanation of what Uniswap does and why it is such a big deal, check out this article
Uniswap: Decentralized liquidity
This article is written primarily for the benefit of the internal team at Konkrete. It is second in a series of…
We have addressed the 4 main points from the start of the article so far:
1. What assets can be tokenized
2. Why you should tokenize Assets (on-chain representation)
3. How Assets can be tokenized
4. Where to borrow against tokenized Assets (the need for an open, fully decentralized and censorship resistant money market)
The 2 remaining items are:
5. How to grade real world assets on-chain
6. How to execute on any defaults on repayments off-chain
These are also the most contentious problems and those for which there are unlikely to be answers which would satisfy everyone.
We will however be guided by our operating principle which is:
The role of a protocol should be always to build a set of processes that anyone should be able to leverage to achieve their own end goals.
Applications built on this protocol could cater to certain niches and may service only a certain clientele which agrees with their operating model. Those who disagree with that operating model should be able to create their own flavors of the model which they can try to push.
The protocol should be flexible enough to support this.
The operating principle is freedom to do your own thing as long as it does not hurt someone.
Let’s consider a few solutions that various parties may use:
Real world broker, direct asset tokenization
Grading of real world assets is a well established industry. Valuation reports, independent expert reports that establish the value of a particular asset have been around. Whenever someone borrows against a certain asset in the normal banking world, they often have to get a valuation report of the asset and the banks would then lend against a fraction of that collateral.
A similar system would work here, whereby different lending agencies/brokers would do the due diligence on various loans and create the loan documents and security charges against the asset.
All that is changing is their source of funds.
They would tokenize this collateral by representing it in the form of ERC20 tokens and would then borrow against it on Open Compound. The responsibility of grading it and enforcing defaults on the borrower goes to this party.
If this system sounds a bit centralized and dependent on real world actors to enforce and liquidate real world collateral then the answer to that is yes it is.
It depends on the integrity of the real world lender. Let’s use the term anchor going forward for this. It is a non ideal solution, but it is a simplistic model. Here is how this solution can be improved.
In this model, the Anchors put an equivalent amount of collateral as security from their side in the form of BTC or ETH or a number of other high grade assets. So if an Anchor wants to make a loan of $1 Million to a real world asset, then they would take the security on the real world asset and put up $1 Million worth of ETH as security on Compound.
Which means that in the event that the Compound lenders are insulated from the vagaries of the real world borrower. If there is a default the Anchor would be enforcing it and recovering the proceeds. From the Compound lenders perspective it is a loan against standard collateral like anything else.
In such a model assuming high grade collateral was used there is no real need for an Open Compound as such and the regular Compound can still be leveraged.
This model also assumes there is a spread between the rates that are charged to the real world borrower and the interest due on the high grade collateral on Compound.
Pooled Collateral + Anchors
The issue with having the Anchors collateralized loan requests is that they would not necessarily have the required amounts of collateral. An improved model would allow others to participate in a pool by chipping in collateral that can then be placed into Compound. Participants in the collateral pool would get a prorated portion of the spread between the Compound lending rates and borrower rates alongside the Anchor.
Decentralized Pooled Anchors
A more systematic way of doing this would be to create a real world legal entity that takes the real world security. Standard corporation or Managed Investment Scheme model can be used here. Internally the entity would be operated as a DAO where its stakeholders would get MKR style tokens that allows them to participate in governance via voting. The MKR style tokens would serve as a backstop on-chain collateral against any loans this DAO makes in the real world.
Instead of having to create a pool of investors anytime a borrowing request comes in, the system would have a mechanism where accredited lenders (who also hold MKR style tokens) would create a real world loan, take security on behalf of the real world entity and stake a small percentage of the loan using their own MKR style tokens.
The entire balance of the MKR style tokens value would serve as the pooled collateral against which money can be borrowed from the Open Compound as and when needed (when loan requests emerge).
In the event of a default the security is in the name of the DAO entity, so there is less of a chance of a dependence on a real world anchor defrauding the system. The fraction of the loan amount that the real world Anchor had to stake in the form of his tokens to initiate the loan would be slashed first in the event of a liquidation. All spread would flow to the token holders.
The system would always only make loans that are less than equal the overall value of the governance tokens. In the event of a default, the real world security would be first enforced and generally speaking it would never have any impact on the Open Compound lenders who will be insulated via the governance token as collateral.
If the real world security does not prove enough to recover the proceeds, then the staked governance tokens get liquidated up until the Open Compound lenders are able to recover what was due to them. More governance tokens may need to be minted in the event that the existing tokens are not enough to recover the default. This would have the impact of diluting the stakeholders, or the same result of issuing more shares on the stock market when the company needs more capital.
More governance tokens may also be minted by a vote of the existing token holders to make it possible to do bigger loan amounts.
It is essentially a system of self governance for the real world lender.
Others may create other formulas for operating their governance models that are similar or radically different to what is proposed above.
We will operate as DAO as described above as one of the real world lenders and we will also open source our own governance technology for others to create their own DAOs independent of us and operate in parallel and competition to us.