A Framework for Considering Digital Asset Collateral in DeFi
The past few weeks have been filled with conversations with DeFi platforms, teams building DApps, and existing and potential clients who are interested in the intersection of DeFi and Digital Assets. While technical integrations and regulatory discussions have been illuminating, I want to focus on the most common conversation I’m having:
“What asset classes are most suitable for defi?”
In my view, the convergence of DeFi and digital assets must occur in stages. It is necessary to allow the requisite development timelines for teams to build acceptable solutions to regulatory compliance, pricing oracles & external data sources, and a period for building trust between centralized entities and decentralized communities.
Key Drivers
Each asset class requires different data handling approaches, and the nuances in asset subclasses add further complexity. In this framework, the ‘complexity’ of managing this data is described from the standpoint of regulatory requirements, use of internal vs external data sources, quantitative vs qualitative data types, and likelihood of community uptake.
The combination of these factors has led us to build a framework for thinking about the various types of digital assets that are most likely to be onboarded over the near, mid, and long term. This ranges from short-dated private credit instruments to more complicated forms of debt to equity and fund interest.
Simple Private Credit
Short-dated, single-tranche private credit instruments are likely to be the first asset sub-class that becomes eligible collateral on major DeFi platforms. In this group, I’d include inventory financing, invoice factoring, short-dated promissory notes, unsecured debt, and p2p loans.
These types of instruments, while varying in risk profile due to collateral characteristics and borrower’s credit profile, should be relatively easy to understand and implement. Inventory financing and invoice factoring are prime candidates as these credit instruments have short-dated maturities, limited borrower risk, and underwriting is largely formulaic. Events of default for these instruments are largely binary outcomes — the borrower pays or doesn’t. The best part about debt is you can calculate all payments via an amortization schedule at loan origination. This eliminates the need for external data sources for market pricing, covenant adherence, or cross-asset dependencies seen in more complex structures.
Further, these instruments are not considered securities under US securities law, which lowers the up-front threshold from a compliance standpoint. Only in liquidation, when these instruments change hands under an auction model, would these instruments become securities. To date, the DeFi industry remains in development stages as to compliant liquidation mechanisms for this asset profile.
Secured and Structured Private Credit
Secured debt and structured credit facilities are likely to be the next few debt subclasses that will be accepted as eligible collateral. These types of instruments would be similar to simpler private credit instruments from a compliance perspective, and they are similarly formulaic at underwriting under an amortization schedule. Where these instruments differ significantly are the series of more qualitative variables including covenants, security interest, and reporting.
Structured debt tends to include a series of conditions of what the borrower can and can’t do. These collectively constitute positive and negative covenants. Tripping one of these covenants, in most cases, would constitute an event of default and entitle the creditor to undertake corrective measures as outlined under the associated loan security agreement.
Not all covenants are created equal though, and there is room for creditor discretion in assessing the severity of a borrower’s event of default. In the regulated world, the US legal system is the ultimate settlement layer, and a creditor’s degree of prudence and reasonableness is usually viewed kindly in the eyes of a court. This paradigm becomes much more rigid in a DeFi environment and would require either borrower acceptance of stringent programmatic enforcement, a trusted central party to administer or service, or a new solution to circumvent the issue.
Loan security agreements also detail the level of security interest that the creditor has on borrower’s assets. Borrowers of structured credit facilities will report on regular intervals, usually with financial and business updates and a signed document assuring adherence to covenants and status of secured or perfected collateral. In DeFi, this would require an external data source that needs to be fed to the lending protocol to enforce risk parameters.
Finally, defaulted loans in liquidation require a party to recoup and monetize collateral. In the case of inventory liquidation it is a relatively straightforward process. However, in the case of IP or other hard-to-value assets, liquidation would require extended cycle times and activity that occurs outside of a trustless permissionless environment.
Art, Real Estate, Fund Interest, Other Real Assets
Real estate, fund interest, and other assets such as art represent the next phase of assets likely to be considered for eligible collateral. These instruments are fundamentally equity instruments, or they would require the use of interest in a SPV that owns the assets. This would require investor eligibility pairing, or a closed environment. While there are various exemptions from registrations that are commonly used — Reg D 506(b) or 506(c) — they require knowledge of the investor, and come with various restrictions for solicitation. Pairing identity with blockchain addresses is a key limiting factor to this extent.
Private Equity
Private equity poses a particularly interesting problem, as it carries the same complexity factors as previously discussed asset classes/subclasses. Further, it is significantly more difficult to value. The addition of privately held shares as acceptable collateral in DeFi would require additional external data sources for valuation, continuous reporting, and similar identity and acceptable liquidation mechanisms as previously mentioned subclasses.
Trading Debt and Public Equities
Publicly traded debt and public equities represent the holy grails of DeFi + Digital Assets integration. There are significant barriers to building technology that maps to reporting requirements, eligibility requirements, trading behavior restrictions, and documentation. These types of securities will likely be made available under SPV’s far before the assets themselves are available through blockchain native tokens.
Parting Thoughts
This is an incomplete list, and there is also opportunity for commodities, royalty instruments, exotics, energy financing, credit derivatives, and other fun stuff as potential collateral types. This framework is more or less how I like to think through the spectrum of implementation complexity, given the risk profiles of each potential digital asset collateral type. These categories primarily relate to accessing community governance driven platforms, such as Maker or Compound.
I think there’s also a good likelihood of closed-loop stablecoin issuance ecosystems that accomplish similar goals at a smaller scale. As these closed systems establish a track record of community engagement and good governance, it’s possible they integrate with larger public platforms using that stablecoin as collateral. I also think it’d be likely that the clean lines I draw between these classes will be obscured through the use of cross asset pooling, which will lead to unique risk profiles and may sufficiently dilute the shared community risk. In this case, those asset classes may come to market sooner than this framework would suggest.
ABOUT BLAKE
Blake Richman is an investor and entrepreneur focused on building fintech solutions for the next generation of private capital markets. He currently serves as VP of Finance at Vertalo, a leading data management platform connecting and enabling the digital asset ecosystem. Blake invested in Vertalo while at NovaBlock Capital, a blockchain-based capital market infrastructure focused venture fund, where he previously served as Chief Investment Officer and remains a Partner. Blake entered the blockchain world while serving at Hercules Capital (NYSE: HTGC), a $2.3B public BDC, where he assisted with the structuring and underwriting of $135M in debt and equity transactions. Blake has previously held various positions in venture capital, asset management, and debt capital markets, and holds a BA in Economics from University of Maryland.
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ABOUT VERTALO
Launched after their own March 2018 STO, Vertalo is a B2B SaaS company founded to map the gaps between primary and secondary trading of digital securities offerings. As the ‘Operating System for Digital Assets’, Vertalo is focused on connecting and enabling the digital asset economy, providing an industry-leading cap table and investor onboarding solution that facilitates direct ownership and direct listing of any private asset. In addition to offering direct issuance services to private companies, Vertalo also offers white-label, licensed, and joint venture opportunities to capital advisors, broker-dealers, and investment banks. A subsidiary of SeriesX, Vertalo is headquartered in Austin, TX with offices in New York City and Seoul. Learn more about SeriesX and Vertalo at www.vertalo.com.
