Originally posted by forbes on Mar 16, 2023.
What Happened
Over the last few months, traditional funds and asset issuers have launched programs to tokenize alternative assets via public crypto networks. Recent asset issuances have renewed interest in bringing real-world assets (RWAs) on-chain, and galvanized new opportunities for yield generation within decentralized finance (DeFi).
Private-equity firm Hamilton Lane partnered with Securitize, a digital asset issuance platform, to tokenize a portion of its $2.1 billion flagship equity fund on the Polygon network. The fund requires a minimum investment of $20,000, far below the typical minimum buy-in of $5 million for private-equity investors.
Hamilton Lane is one of the largest private-equity managers, having invested over $37 billion in private markets in 2021. It manages $824 billion of assets.
Similarly, the Monetary Authority of Singapore (MAS) announced Project Guardian, a pilot program to tokenize bonds and deposits that can be used in various DeFi strategies.
A bank participating in the program would be able to tokenize bonds and deposits that could be used within permissioned liquidity pools. This capital could be lent out on DeFi applications such as Aave and Compound to earn interest, or serve as collateral to access credit. The pilot has enlisted JPMorgan, DBS Bank and Marketnode as initial partners.
Broader Context
Since the first DeFi protocols began gaining traction in 2020, they have been a driving force in attracting users and traders to the crypto space. Experimentation within DeFi delivered innovative financial applications such as decentralized automated market makers, stablecoins, lending, insurance, swaps, synthetic assets, and derivatives.
Total value locked (TVL) within DeFi applications, loosely translated as the amount of capital under management, skyrocketed to a peak of $248 billion in December 2021 as asset prices rose and new users engaged. TVL has been bolstered by liquidity mining programs, in which protocols bootstrapped growth by temporarily juicing yields offering users token rewards of the protocols’ native tokens (i.e. Compound rewarding lenders with COMP tokens).
These returns were unsustainable as token prices fell and general interest in crypto waned during the 2022 bear market. The historical lending rates of the stablecoin USDC peaked in December 2020 at 18% on Aave and 8% for Compound. These yields have respectively declined to 0.75% and 1.62% today.
DeFi yields have been falling LOANSCAN.IO
With the one-year U.S. Treasury bond yielding about 5%, investors have flocked to the safety of government paper. Treasury yields have exploded as the Federal Reserve abandoned its zero interest rate policy, with the one-year note up from its yield of 0.3% in December 2021.
Treasury Yield have been surging with increasing rates CNBC
As the risk-free interest rate in traditional finance rose and DeFi yields decreased, investor participation in the latter has dwindled substantially in recent months, with TVL declining 73% from its December 2021 high to $66 billion today.
DeFi's TVL has been dropping since its 2021 peak DEFELLAMA
In order to attract fresh capital, DeFi protocols are starting to embrace RWAs as a source of collateral or for new investment opportunities, providing more consistent returns for investors.
The tokenization of real-world assets, such as real estate, commodities, private equity and credit, bonds and art, is a concept that has been quietly percolating since 2018. Formerly referred to as “security tokens” or “tokenized securities,” tokenized RWAs take advantage of blockchain technology to bring traditional assets on-chain.
Tokenizing RWAs offers tangible benefits including lower investment minimums and increased access through fractional ownership, increased trading of previously illiquid assets, enhanced transparency and security as the blockchain records an immutable record of transaction history, and automated ownership management and compliance.
Key Quote
“Tokenized RWAs benefit DeFi by allowing it to serve businesses and customers who are not crypto native. DeFi lending is capped as long as we only accept Bitcoin or Ethereum as collateral. Being able to accept tokenized real estate or security over the property of a company reduces the risk for crypto lenders and investors because it makes it possible for businesses in the real world to use DeFi.” – Sidney Powell, CEO & co-founder of Maple Finance
Key Stat
When aggregating seven of the largest RWA private credit blockchain protocols, historical loan value equals $4.2 billion and active loans stand at $456 million. These protocols use DeFi to provide private loans to businesses and include Maple, Centrifuge, Goldfinch, Credix, TrueFi, Clearpool and Ribbon Lend. They offer an average APR of 12.63%.
DeFi loans have also been falling RWA.XYZ
Outlook and Implications
DeFi must offer higher yields than traditional investments to remain competitive and attract capital. DeFi applications such as Maple Finance, Goldfinch, and Centrifuge pool funds from crypto holders and lend them out to generate yield through various strategies.
Maple Finance is a platform for institutional borrowers to tap the DeFi ecosystem for undercollateralized loans. Pool delegates are credit professionals that underwrite and manage pools on the platform, and they source institutional borrowers, structuring the terms for each loan pool. Lenders are then able to deposit crypto funds to the pools they wish to back, lending out their assets in exchange for yield. Maple has facilitated nearly $1.8 billion in cumulative loans to date.
Goldfinch is focused on facilitating loans to real-world businesses in emerging markets. Borrowers must undergo an audit to determine their eligibility for loans. Once approved, they can create pools and determine the loan terms, such as the interest rate, loan amount, term, and late fee. Lenders can choose to supply capital to individual pools and are the first in line to suffer capital losses on impaired loans, thus receiving a higher return. Alternatively, liquidity providers can supply capital that is allocated across all the borrower pools, earning a lower yield with less risk of capital loss.
While Maple and Goldfinch focus on private credit, Centrifuge enables more forms of real-world assets to be brought into the DeFi ecosystem, such as real estate loans and cargo invoices. On Centrifuge’s marketplace, called Tinlake, an originator converts a real-world asset into a non-fungible token (NFT) and includes the relevant legal documentation. Asset pools are created using the NFT as collateral representing the RWA. Investors can then provide capital to the pools that match their risk preferences.
Tokenizing real-world assets allows DeFi to tap into some of the largest financial markets. Global real estate was valued at $327 trillion in 2020 and non-financial corporate debt at over $87 trillion in 2022. These are colossal markets to which tokenization can bring enhanced liquidity and new investors.
Decision Points
When evaluating yield-generating opportunities, investors should look at the track record of existing DeFi applications that leverage real-world assets. Have they suffered defaults? What is the underwriting and due diligence process and how do they manage risk? Underwriters that require overcollateralization from borrowers, have access to insurance or have backstop mechanisms in place in case of default may exhibit the best performance over time.
Notably, Maple Finance had a $36 million loan default in one of its lending pools in December 2022. The borrower, Orthogonal Trading, suffered losses due to the FTX failure. In response, Maple launched its 2.0 version, which introduced a more immediate default and liquidation process for loans that sour. This points to the need for better risk parameters and sector diversification among borrowers for undercollateralized DeFi lending platforms like Maple.
Instead of lending capital directly, investors can also bet on the success of RWA-focused DeFi protocols by buying their native tokens. The prices of these tokens will be correlated with the rest of the crypto market, but may exhibit greater appreciation for winning platforms.