Drop The Dash

Highlights:

• The current generation of RWAs has challenges due to adverse selection bias and underdeveloped underwriting.
• Onchain finance will bifurcate into two markets, regulated permissioned environments where the majority of financial activity happens, and permissionless DeFi experimentation.
• RWAs are primitive and simply re-ledgered. Digitally native versions of the assets will come next, and bring novel advantages over these tokenized assets.
• Bringing more assets onchain can be thought of as stock vs. flow. How does this happen in normal markets? Look at reserve currency regime changes. Long time scales and flow build-up. Focus on building markets with high turnover and flow (such as commercial paper).

What are RWAs? What is Onchain Finance?

Real world assets (“RWAs”) are the current conversation in DeFi. What are people excited about? Tokenization. Whether it’s treasuries (Ondo, Backed, Flux, Hashnote, etc.), loans (Goldfinch, Maple, Centrifuge), or assets like homes and watches (Kettle) this is where the momentum lies.

The problem is that “tokenization” is more or less just a process of re-ledgering. What’s re-ledgering? I used to account for x here, and now I do it over there. So if we’re just making records on a new system, then we should take a step back and ask: is this the end game? Or maybe something more interesting is possible with all the building blocks of web3 tech and RWAs (nope)... on-chain (nope)... onchain finance.

In meme-form, RWAs encompass much more than just an accounting system for real assets onchain. Think of them as a representation of sustainable DeFi. An actual chain of financing related transactions based on cashflows, not just reflexive and unsustainable token games. Tangible profits from fiat land.

This is not to say some of the activity in DeFi was not based on cashflows. Protocols like GMX clearly demonstrate this is not the case - monetizing speculation via perps. Rather, very few in DeFi have sustainable cashflows while the broader picture is polluted by unsustainable economics. And so, it’s a great development, something the “adults” in the room have been waiting for. And that’s part of the problem.

Improvements (like RWAs) that bring global capital markets closer to onchain infrastructure are promising progress, but they need to mature. This is where skepticism is warranted. This form of onchain finance is just an early primitive as more digitally native versions of assets, novel or old, still need to emerge.

Two examples below show some recent failed RWA loans. Missteps are likely to be endemic in the first generations of loans and tokenized assets – as we flesh out the frameworks, underwriting processes and reliable legal infrastructure (both for workouts and asset structures). Their current weaknesses will be exposed and adverse selection bias made clear. Losses will force the next wave to iterate, and improve.

• 1754 Factory on Centrifuge - A microloans company late on repayment in its first series of loans, with concerns over leadership and past behaviour
• Goldfinch Kenya Loan - another microloans company focused on financing small motorcycles. The company took Goldfinch’s capital and provided loans to an affiliated entity (the main operating business in Uganda, not Kenya).

Every borrower sourcing funding from crypto-native providers should be both:

1. Savvy enough to identify a cost of capital arbitrage offered by crypto holders; and,
2. Willing to interact with defi/crypto to execute on that arbitrage

Or, those borrowers have identified an opportunity to take advantage of a nascent and naive industry. Lending is difficult. Lending in frontier and emerging markets is extremely difficult. Risk in these markets is often so difficult to price for the best institutional players that they choose not to participate at all.

The relative level of compensation required for the added risks, legal complexity, and borrower opacity is often untenable for those seeking capital. Smaller firms with higher risk tolerance and local knowledge tend to plug the most obvious gaps. Others just stay away and the gaps stay open. That’s the norm.

Many RWA teams will discover these baselines the hard way, undoubtedly off the back of participating in feel-good narratives. Lifting the most unfortunate, tapping into exponential growth, bringing fairness while turning a large profit.

“TradFi,” the amorphous, shadowy blob we blame for all things bad isn’t staying away from this lending activity because those organizations are controlled by a kabal of evil executives, they stay away because the market tells them they should not make those loans. A lesson learned repeatedly, over countless defaults and subsequent legal battles.

That doesn’t mean it’s impossible to make outsized returns lending to these markets. Rather, it is just extremely difficult for any foreign source of capital to do it well, at scale (high volumes), in an economically competitive way. Does re-creating these loans with tokens and autonomous software change the fundamentals?

Memoirs of a Tradfi Boomer

But how does this scale and interest TradFi? I spent some time at one of the largest institutional pools of capital in the world and can shed some light here. The funds are big.

Your size is not size

These organizations are complex. They have some unique needs, wants and constraints, and some experience-driven insight can be helpful for diving into how to create products that are attractive to them.

One of the best ways for us to start building out onchain finance is to work with higher-quality borrowers first. That puts large institutions on stable ground as lenders, borrowers, and traders. We need to deliver products that meet their needs where they are today. That’s the path to adoption as they can bring significant scale and volume to these new financial rails.

Blocktower’s structured credit funds on Centrifuge are probably the best current example of this type of product. Effectively products like this work by having institutional players (Hedgefunds like Blocktower) borrow money from crypto markets where that money is cheaper than the TradFi world and earn the spread by investing in higher yielding tradfi instruments. This might be the easiest way to spark interest and can work in both directions as differences in capital demand change. Nearly all of these institutions have large borrowing desks constantly looking for the best price on capital. Diversifying counterparties and lowering the aggregate borrowing rate is extremely attractive. It’s a goal whole departments of people dedicate careers to. That’s a real value proposition.

With all this said it’s probably worth noting that the future of onchain finance is not necessarily the future of DeFi. What we may end up with is crypto-native tradfi. But is it the future of DeFi?

Centralized, permissioned applications and assets on top of decentralized rails. Where does one draw the line? Perhaps Decentralization is more like the original spirit of academia - an unfettered playground of experimentation and philosophical inquiry, while permissioned solutions gain mass adoption - Bifurcation. People can continue to experiment and tinker with the limited set of participants willing to risk it on the frontier, while tradfi becomes “onchain finance”.

DeFi in its current form is fundamentally unable to cater to such clients due to the strictness of compliance, AML regulation, and general disinterest in the potential of theft of assets. Imagine explaining losing 100m in assets to your board due to north koreans phishing a random secretary in the building. And while I’m sure the potential for higher investment yields or lower borrowing costs may entice them, they are red lines not meant to be crossed. This is where the bifurcation happens. Centralized issuing entities capable of blacklisting and reissuing, or pseudo private permissioned chains become the key figures in onchain finance catering to the clientele of RegFi.

Crypto can leverage the products and assets these bring to become increasingly intertwined with the physical world. And while this may not be the version of mass adoption we like the look of, these types of solutions do end up supporting crypto native rails underlying such as Ethereum and Solana.

Putting It All Together

Going back to the current form of RWAs, tokenization means keeping the current system in place, with all its operational overhead, and making a second copy on newer, more powerful and efficient crypto infrastructure. And while re-ledgering ushers in some new advantages, it is still a duplication of effort with dubious legal foundations. It is more likely to come with a greater number of disadvantages and frictions, as the transmission between the world on paper and the world of bits is clunky. But it is not the end state, it’s a starting point until digitally native standards become the defacto method of ledgering.

The simple tokenization of a treasury is a beginning, but the real potential is in blockchain-native assets. The ability to source financial information from the asset, to have the asset manage its own lifecycle. To realize the potential, we need to create a crypto-native version of the core assets that drive most of the volume in our global financial system.

Is this Innovation?

What makes for an interesting thought exercise, are the many examples in the real world of re-ledgering. Reserve Currencies. People love to FUD the US Dollar. If you spend time on Twitter you are no doubt inundated by the neverending theses where a collapse in the US economy leads to a global wholesale switch to the Yuan. They can come from very smart people who see elaborate chain reactions but simultaneously fail to understand the high switching costs.

They also typically ignore the response function of governments with reserve-currency power. Not to mention the brand value of the greenback with populations struggling with unstable currencies. But what the de-dollarization theses do offer us is an interesting discussion about how the “re-ledgering” of assets happens.

Assets can be thought of as having stock (loans, assets, etc.) and flows (trade). In the case of reserve currencies, this re-ledgering typically happens via flows build up over long time horizons. Setting aside whether one thinks the Yuan ever replaces the dollar, we can focus on how the flows build up over time.

People doing trade with China find it advantageous to hold Yuan to conduct their trading activity, as this trading grows (flows build), so does their need to have yuan on hand (stock). Eventually, maybe it is also advantageous to borrow in yuan matching your liabilities with your assets and access new capital pools (stock builds). As a result, Yuan trade flows re-ledger assets from USD to Yuan and build up stock. But this happens over extremely long time scales. One can even look towards the last reserve currency and its surprising enduring relevance in the face of the fact that outside its major city, its people are poorer and less economically active than those in Mississippi. This is meant to demonstrate that while economically rather irrelevant, the British Pound remains a (shrinking) central bank holding in most countries.

UK jabs aside, this teaches us important lessons about what we should aim for with RWA protocols and DeFi aspirations. Creating additional flows onto our new ledgering system is imperative. What are the easiest ways to do this? Look at markets with higher turnover (issuance) and where digital efficiency is still low and thus productivity gains can be achieved.

Programmatic money, meet programmatic assets.

Let’s apply information theory to assets. Bandwidth. Financial communication. What does that do to scale finance? Institutional investors need cashflow timing and repayment details? Query the loan itself. Real time covenant monitoring? Yup. Connect it all together with code. This is programmatic assets in autonomous environments managing their own lifecycles.

The goat is always relevant

How does this look in the wild? Let’s go on a walk down a somewhat esoteric section of the traditional finance lane.

Commercial Papers (CP). For those who don't know (which should be just about everyone), commercial papers are unsecured short-term loans issued by corporate borrowers for financing short-term liabilities. Cash management by treasury departments. And yet, the CP market is over a trillion dollars in outstanding loans and turns over every few days. Average maturity at issuance is around 28 days.

A good friend is currently leading a project to rebuild debt capital markets in a digitally native way, not just to tokenize existing instruments. These digital assets will natively include the information described above and run their own operations through the loan lifecycle. Why? Because CP is part of the plumbing of financial markets. Huge, invisible flows, are relegated to the basement of financial markets because they lack excitement and generate no opportunity to take outsized fees.

Much like a cost of capital arbitrage, this is a value proposition of digitally native assets. A fundamental shift of workflows and speed leveraging the most valuable characteristic of open systems - composability, autonomous operations, and digital scalability and composability. Other rules-based verticals can fast follow on top, leveraging the composability to bring securitization. Repackaging the loans and creating new financial products.

Nonetheless, it can start with something innocuous like commercial paper markets and demonstrate the value of being able to interact with more expressive assets in an autonomous environment. Executing CP auctions and delivering the best possible prices in a privacy-preserving manner with constant operational cost savings across the lifecycle of the loan. Explicitly this means lower cost of origination, management, and personnel costs that can translate into lower spreads being charged to the borrowers. Composability-wise, this means these assets can be programmatically repackaged into securitizations where the waterfalls can be defined and manage themselves. Again, translating into cost savings and increasing the yield to the buyers of the securitizations.

So, extrapolate. The future should be filled with crypto-native assets, not just re-ledgered ones. Issuers and investors will benefit deeply from the information and efficiencies added. Not to mention the increase in velocity that can come from near-instant settlement times.