Quality of Collateral: Digital Assets in DeFi
DeFi has demonstrated a tremendous pace of growth in terms of adoption, total value locked, stablecoin issuance, and chain activity. The space spent two and a half years achieving the billion dollar mark in terms of value locked, and it only took the following 6 months to hit $2 billion. This growth has been largely driven by the emergence of yield farming, where the combination of leverage and extrinsic rewards have incentivized behavior within these decentralized systems to drive adoption.
Eventually the space will enter its next phase of growth beyond that which was spurred through incentive token distribution models. Before that’s possible, some of the risk factors limiting growth today must be addressed.
DeFi Today suffers from a number of risks. Beyond the ever-present protocol and smart contract risks, the decentralized administration of traditional financial services and products will be limited in the near term due to collateral volatility and correlation that lead to systemic risks and heightened cost of credit. This can be mitigated through widening eligible collateral types to include a range of tokenized assets that exhibit lower price volatility and share lower correlations with existing eligible collateral types.
Collateral is in the Eye of the Beholder
Currently, eligible forms of collateral are USD-pegged stablecoins, or Ethereum based tokens.
USD stablecoins do not have a hard peg, and don’t always represent $1.00 — particularly in periods of volatility or heightened fund flow. For example, Dai has been struggling for months to regain it’s soft peg.
Additionally, cryptocurrencies and tokens notoriously have high price volatility. When used as collateral, these types of assets are perpetually at risk of devaluation that can lead to liquidation. Further, the lack of market depth among cryptocurrencies can compound these risks in a downside scenario.
Cryptocurrencies that can be used as collateral additionally suffer from significant market correlation. While correlation has been slowly decaying as markets have matured, cryptocurrencies and tokens still tend to have out-sized correlations compared to traditional assets.
This can lead to a cascading effect in a downside scenario, which poses a systemic risk as positions that are unwinding in liquidation can cause additional liquidations through market effects.
Collateral Quality and Digital Assets
These risk factors can be mitigated through the use of tokens that represent real assets as collateral. The addition of real estate, fund interest, private shares, and debt as eligible collateral in DeFi protocols infers a number of benefits.
These assets have widely accepted valuation methodologies, which is reflected in market value. In the context of cryptocurrencies and tokens, this drives comparatively low volatility and low correlations.
Diversifying DeFi’s shared risk pools through the addition of real world collateral would lower collateral volatility and correlation, which would partially offset systemic risk. Further, it provides a stronger foundation on which to build better retail services, financial products, and decentralized monetary banking.
Why Does this Matter?
Solid credit creation is imperative to monetary systems.
“Credit creation is money creation, and short-term credit is generally extended by private agents against collateral. Money creation and collateral are thus joined at the hip, so to speak. In the traditional money creation process, collateral consists of central bank reserves; in the modern private money creation process, collateral is in the eye of the beholder.” ~Stella and Singh, 2012
One of the key reasons centralized banking models exist is for the purposes of credit extension and money creation. The reason DeFi exists is to deliver financial services and products without a central party. Financial products are intertwined with the money creation process, and benefit significantly from the robustness of collate.
As the DeFi industry continues to develop blockchain-based frameworks for financial and monetary systems, it is important to recognize where these worlds overlap to improve on existing models. There is much to be gleaned from modern central banking models that can reduce both systemic risk and the cost of credit that is passed on to the user in DeFi.
As such, Vertalo is developing frameworks for bringing tokenized assets to DeFi. We believe bringing lower velocity, less correlated, and less volatile collateral assets to DeFi platforms would provide additional stability to borrowing and lending platforms and stablecoin networks. As the basis of stablecoin issuance and potentially a large portion of shared risk pools, the this would reduce systemic risk through lower rates of liquidation and lower rates of systemic loss resulting from cascading liquidations.
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.
