Enabling Permissionless Debt Financing in DeFi
Initial Debt Financing Offering(IDFOs) to change the landscape of early stage financing and fair launches
Debt finance may be traced back to medieval times when money lending services were made available to traders from the city of Venice. This was followed in the 18th century by the establishment of international banking, driven by the Rothschild family.
Cut to today, small businesses struggle with financing to get started, let alone continue their operations. As a result they resort to borrowing from personal sources, as is typical of small and medium-sized organisations (SMEs), or from impersonal sources such as banks and other financial institutions, as is typical of big corporations.
Cheaper debt fuelled by rapid money printing by central banks has led to a large credit expansion cycle leading to asset price inflation around the world as of today. It’s safe to say that today, credit makes the world go round. Love it or hate it, credit forms a crucial component to fuel the growth of businesses and the economy when rightly managed and is often the cheapest source of capital for a business. While crypto markets have heavily relied on equity financing to date, owing to the maturity of the industry a robust credit market is beginning to form.
Crypto Financing So Far
To understand the model of financing used by most companies, we have to know the Weighted Average Cost of Capital model.
The weighted average cost of capital (WACC) measures a company’s total cost of capital, including common stock, preferred stock, bonds, and other kinds of debt. If a company’s stock is particularly volatile or its debt is deemed hazardous, its WACC is likely to be higher as investors expect larger returns for the risk. This is particularly pertinent for crypto because volatility is an inherent risk investor take on in crypto markets. So, maintaining a safe margin for operations to continue becomes crucial to both the team and any investors involved.
Traditionally, most crypto projects have taken the path of equity financing to jumpstart their business. The average dilution in a funding round runs between 20% and 40%, depending on your company strategy, jurisdiction, and ability to market the value to investors. As a result, most enterprises’ access to finance was essentially confined to equity, and the cost of equity was high.
In 2017, investors began to consider ways to fund firms with short-term working capital requirements. It didn’t make sense to raise extremely dilutive, high-cost equity capital to fund a short-term demand caused by a cash flow timing mismatch. Because some businesses already had crypto on their balance sheets, lending against that crypto collateral provided a low-risk manner of extending loans at low rates to fund development prospects. Trading desks with cash on their balance sheets were in an excellent position to begin supplying short-term money to these firms, particularly if they were already investors through their venture strategy.
The market for crypto collateralized debt expanded substantially as bitcoin and other assets became superfluid collateral. Early-stage firms in an investment portfolio with insufficient liquidity on their balance sheets were able to finance working capital in an innovative method, thus creating a debt market. As a result, a crypto debt market emerged, and the cost of debt was established. Furthermore, as the loans were collateralized by highly liquid assets, the risk of illiquidity remained relatively minimal. It should come as no surprise that today’s crypto collateralized loan rates are not significantly higher than other forms of corporate financing, and in certain cases, crypto enterprises may obtain funding at lower rates than other types of technology startups.
In short, the cost of debt has come down in the crypto space, to the extent that taking on debt is more advantageous than losing control of one’s project to investors.
Debt financing in a decentralized ecosystem
The current size of the DeFi ecosystem measured by TVL is over $200 billion. This is a more than sufficient size to need a completely decentralized money market where participants can form their own lending / borrowing pools.
The market right now is serviced by several money markets such as Aave and Compound. And the lending sector itself is worth nearly $48 billion, counting only the top 20 projects in the sector according to Defi Llama.
Shortcomings in DeFi money markets
However, nearly all these money markets have a few deficiencies that make them unsuitable for the decentralized vision we are pursuing.
- Permissioned borrowing — Most of these protocols are only permissionless insofar as they allow borrowers to interact with any pool. For actually setting up a pool, a complex governance mechanism must be followed. Thus, it is not permissionless for all parties, leaving out crucial stakeholders in any money market.
- Reliance on oracles — Most of these protocols rely on oracles to make sure their parameters are within acceptable limits. This leaves a crucial vulnerability on their design and an external dependency that cannot be moderated by the project. This can lead to hacks that drain funds and cause a massive loss.
- Liquidation risk — Most of these protocols operate with liquidations as a feature. In a volatile environment like the crypto market, this exposes borrowers to unnecessary risk and impedes their ability to plan long term.
Timeswap Decentralizes Debt Financing
The addressable market for debt securities itself is huge and presents a novel opportunity for DeFi to capitalize on. Right now, the way to secure debt financing in most jurisdictions is cumbersome and filled with major compliance burdens and ICOs have been stymied in the face of major legal opposition and the possibility of being classified as securities. Instead, projects could opt for an IDFO (Initial Debt Finance Offering) to make the token launch fair, while still gaining funding.
A permissionless protocol that can be leveraged by traditional funds, institutional investors and even retail investors to supply capital to projects in crypto in the form of debt financing would make the market more efficient and effectively, lower the cost of capital. This does not have to be restricted to just crypto-native projects, SMEs in various jurisdictions can also take advantage of our permissionless pools to fund themselves, especially if they are situated in distressed economies like Venezuela and Zimbabwe where traditional investment pathways are not as mature. In this, all stakeholders are equally appreciated and can participate in the development and adoption of Timeswap.
Rari Capital’s Fuse pools and other similar lending protocols do offer a semblance of this, but they are still reliant on Oracles, making them unsuitable for new projects that have low liquidity and no data feeds by prominent oracle services like Chainlink. While a project could place its treasury in a Fuse pool to finance themselves, they are now taking on additional risk as compared to a Timeswap pool: liquidation risk and oracle manipulation risk. Because Timeswap operates without the aid of an oracle, it cuts down on the attack surface needing to be monitored and the lack of liquidations enhances the ability of a team to build out their product instead of being distracted by debt servicing.
Initial Debt Financing Offerings(IDFOs)
Despite the market maturing to include debt instruments, many early-stage projects still elect for equity financing, even when they have investor backing. This is because, without a working product to show for, major funding is hard to secure. And in a space like DeFi, where products are built around financial metrics, being able to seed enough liquidity into the system is crucial for success.
With Timeswap, project treasuries can now elect to conduct an IDFO instead of selling chunks of the treasury itself. Pairing the project token with a stablecoin and enabling lending on such a market allows the project to have a revenue stream to build out its product. Borrowers get early exposure to a new project without many of the downsides of buying the token itself and liquidity providers gain a new market to earn fees from.
The community can now self-organise with the help of decentralized protocols like Timeswap, trade on Uniswap and form a DAO to decide the future of the project they are invested in.
In terms of community, this allows for a wider appeal because there is no vesting schedule from early investors and no strictures to be followed by the team. This leads to an organic growth approach that is more sustainable for the long term.
Advantages of Debt Financing
Bringing debt financing to the crypto landscape is not only the introduction of a new primitive but also one that comes with its unique advantages.
- The most significant advantage of debt financing versus equity financing is the ability to retain ownership. In comparison to equity financing, debt financing is only transitory. When the loan is paid off, the borrower is no longer obligated to the lender. Unlike equity financing, there is no dilution of ownership.
- Obtaining and effectively repaying debt funding can assist improve a project’s credit rating and make it simpler to acquire loans in the future.
- Because credit conditions and payments are known in advance, debt financing can assist a firm in estimating its future cash flows.
- Interest payments for debt financing may be considered a tax-deductible business cost. This means that debt finance interest payments may reduce the amount of tax due by a firm.
- Fair launches are important for trust in a project. Timeswap enables projects to choose a different route (IDFOs), instead of opting for dilutive equity financing.
The case for debt financing is strong. And, Timeswap only makes it stronger by introducing a frictionless manner of raising capital for projects & communities.