Why we like primary redemption

Andy Singleton
Sweepr
Published in
7 min readOct 20, 2023

It’s 2024. Gary Gensler has just been elected president after other candidates were felled by bizarre gardening accidents. A classic financial panic has gripped the world of crypto. Holders of tokenized assets are rushing to redeem them for bank dollars. Liquidations into on-chain markets are jammed up and selling for big discounts. Holders of on-chain securities and tokenized treasuries are suddenly seeing the disadvantage of trying to sell into tiny on-chain markets, rather than the big liquid off-chain markets.

Even under these conditions, Sweep is responsible for delivering liquidity to sellers of SWEEP. It will be helpful to have a direct, automated way to sell tokenized collateral from the “Stabilizer” smart contract, into the big off-chain markets.

Assets that offer direct automated redemption will qualify for a lower margin requirement and bigger allocations.

Photo by Jeremy Bishop on Unsplash

Liquidity in depth

One of the main functions of Sweep is to provide liquidity. Sweep is buying and redeeming in an AMM in real time, while allowing several days to settle trades in the underlying assets. It is also moving money between blockchains and appchains to provide liquidity.

It is easy to provide liquidity by keeping lot of extra cash on hand. But, that cash is not invested. The challenge is to provide liquidity with only a small amount of un-invested cash.

Sweep can efficiently provide liquidity with a deep stack:

  • AMM discounts, which bring in arb money when cash is needed
  • DeFi strategies that can absorb and return money in one block
  • Tokenized versions of off-chain reverse repo placements that have one or two day settlement times, and won’t get jammed up if there is a dislocation in the securities market.
  • Tokenized versions of off-chain securities that put money to work in big, useful, short duration money markets, and require 3–5 day settlement times

Automated purchase and redemption is one tool for making it easier to provide liquidity at high volume, and under stress.

Primary buyers

A new generation of “tokenized treasuries” (tokenized money market funds) is designed so that tokenizers sell and redeem them with whitelisted buyers. These are the “primary” buyers. Buyers are qualified by their jurisdiction, level of sophistication, and anti-money laundering checks. After that, the liability tokens are transferrable. This is how stablecoins get bought and redeemed. This arrangement is now available for interest earning instruments in Switzerland, BVI, Bermuda, and at some level in the EU.

In some cases, tokenizers try to make the primary buyers responsible for US securities law compliance by asking them to promise to never sell to US persons. This is a ridiculous responsibility to dump on customers who buy an unpermissioned coin, but I digress.

Traditional DeFi margin lending and liquidation

A normal DeFi margin lending vault can acquire and liquidate assets without primary purchase and redemption.

A borrower works with a traditional DeFi margin lending vault by depositing tokens as collateral. The borrower can borrow some percentage of the collateral value. The vault uses an oracle or an active AMM to monitor the collateral value. If the value falls below a minimum, it can trigger a liquidation (a sale to an on-chain buyer) and pay off debt.

Fortunately, even slow reporting can provide acceptable market pricing on short duration money market instruments. They are designed to never gap down more than 0.5% (in the big off-chain markets).

Borrowers can increase their leverage by “looping” — depositing tokens, borrowing, buying more tokens, and depositing them. If there is a liquidation or a forced call, the protocol will run this process in reverse to sell tokens and pay off debt. This liquidation process requires an on-chain buyer.

Strategy vaults

Sweep Stabilizers can be custom programmed to buy and sell the collateral. I would describe them as “strategy vaults”. They hold collateral in the same way as simple token vaults, but they can be programmed to acquire assets and redeem them in more interesting ways.

Sweep Stabilizers also have a “call” feature. Sweep can ask for money back even if the conditions for a liquidation are not met. This allows Sweep to respond to users who are taking money back by selling SWEEP. The time allowed to respond to a call is negotiated. In the case of a security or liquid off-chain investment, it could be up to seven days. If the borrower does not respond to the call, then the protocol will force a sale.

These features give us the ability to automate the call process. A Stabilizer can be whitelisted as a primary buyer, under the control of a borrower, and it can take steps to redeem (sell into off-chain markets).

Does “primary” redemption make a difference?

On-chain liquidations can work. They will use whitelisted marketmakers who buy at a small discount on-chain, and redeem into the off-chain markets.

I might be completely wrong in suspecting that these marketmakers will run out of time and money during a liquidity panic, but why tempt fate? One of the goals of panic participants is to take money out of the hands of crypto marketmakers.

The scale of liquidation panics is often surprising. We can place $100M into boosted DeFi strategies that pay better than treasuries. However, DeFi is a tiny market and it can only absorb small amounts before yields collapse. If we want to place more than $100M, we have to go off chain. The whole goal of “tokenized treasuries” is to use a market that is so big that it can absorb large amount of purchases (and sales). The volume of US treasury trading is about $3T per month. DeFi intends to tap into this liquidity to place about $10B over the next year. When there is a run on the bank, a big percentage of this could be redeemed out in one day. During the run on Silicon Valley Bank, redemptions hit $30B in one day. This incident severely damaged Circle, a stablecoin vendor with $50B in assets and extensive liquidity planning. The marketmakers who are planning on dealing in on-chain securities are reserving sums like $5M, which is .005 $B.

Some tokenizers are issuing term bonds without a channel to sell them off chain. Instead, you buy a zero-coupon bond, and you wait for it to pay out at the end. This tactic exposes the economics. On a bad day, how much of a discount will you take if you want to sell them on-chain? How does this compare with the time, fees, and spreads of redeeming to an off-chain market? We will see.

It’s possible that a bond that can’t be redeemed into its home market is always worse than a bond that can. We might find that bridging assets outside of their native liquidity pools is always and everywhere a temporary phenomenon. For an example, consider the trade that cracked crypto — Grayscale’s stuck bridge of BTC into equity markets.

Credit analysis

We worry about the mechanics of getting money back at a good price. We should first worry if we will get money back at all. When acquiring tokenized securities, we will ask some questions about the tokenizers:

  • What are the underlying assets, and how effectively do they keep to their mandate?
  • Is there a regulated chain of custody to handle money off-chain?
  • Do token holders have a bankruptcy-remote claim to assets held by a securities custodian?
  • If we don’t get money back, is there a single venue where we can make a legal claim? Some tokenizers use multiple jurisdictions.

Meeting the needs of tokenizers

Tokenized treasury vendors have concerns about offering purchases and redemptions to smart contracts. They prefer to sell and redeem their tokenized format assets by accepting deposits from end user wallets, and managing the workflow through a customer portal.

They are concerned about security and compliance. For compliance reasons, they need to be sure that their primary buyers are qualified. For security reasons, they need to be sure that they are not sending money to hackers. This is easier if they only accept transactions with externally owned accounts (people and MPC wallets). If they transact with smart contracts, they need to analyze the security of the contracts.

They are also concerned about workflow and cost. Processing redemptions and trading is expensive compared with their fees. They offer purchase and redemptions through their customer portal. Adding an on-chain UI adds up-front cost.

Margin lending with on-chain liquidations, at a price

Sweep will run Stabilizers that accept tokens from on-chain markets. The related Stabilizer accepts deposits of collateral from borrowers. It can be programmed to liquidate into on-chain pools, or to make sure that liquidations of restricted securities go to qualified primary buyers. However, these Stabilizers will require some extra capital to cover slippage in a liquidation. And, the loan limits will be lower, sized to match the absorption capacity of the small on-chain markets.

Margin lending with primary purchase and redemption rights

Some Stabilizers qualify for primary purchase and redemption. The Stabilizer can lend the full allowed amount and purchase the asset, with no looping. If it needs a liquidation or a call, it can start the redemption process, without finding a liquidator that has spare capital.

The Stabilizer vault is owned and controlled by a qualified primary buyer. That buyer is the at-risk person who contributes junior tranche equity. Sweep proposes that the Stabilizer be whitelisted as one of the buyer addresses.

Some tokenizers will transact with multisig wallets. Multisig wallets are smart contracts that represent a primary buyer. It’s a small step from supporting multisig wallets, to supporting Stabilizers with appropriate security workflow.

The smart contract adds risk. Tokenizers need to make sure that the smart contract is not the victim of a hack or a mistake. It’s important to verify this before they send out money from a redemption. We propose to add some sort of second factor to allow them to check their instructions, before they release money.

A 4626 vault can implement an on-chain workflow for purchase and redemption, while allowing for delays to settle trades. Maple, Centrifuge, and Circle have released workflows that use the 4626 interface. Tokenizers can run a simple version of this process with a human trader who moves assets in and out of the tokenizer side of the vault. We will help with implementation.

Conclusion

We hope to engage with partners to add liquidity and automation.

Please stay in touch through Discord or Twitter.

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Andy Singleton
Sweepr

Software entrepreneur/engineer. Building DeFi banking at Maxos — https://maxos.finance . Previously started Assembla, PowerSteering Software, SNL Financial.