By Teej (TJ) Ragsdale - Real World Assets, MakerDAO - @Lempheter
The world of finance stands at the precipice of change. On one side, we are seeing decentralized finance (DeFi) pushing beyond crypto to make a real-world impact. Simultaneously, traditional capital markets (TradFi) are drifting towards crypto as more and more assets are tokenized. A tectonic shift to the plates of finance is afoot—when the quake stops, the distinction between DeFi and TradFi will be no longer.
Deterministic Utopia
Daubo, a (hypothetical) mid-size Nigerian FinTech, seeks to raise capital to finance a marketing campaign in Tanzania. Within hours it has raised 150,000 dollars not from VCs, but by issuing a tokenized bond on the Ethereum blockchain. Behind the scenes, the bond token is packaged with hundreds of similar African fintech bonds and sold programmatically into different capital pools. These bonds are denominated in DAI, a stablecoin pegged to the US Dollar.
Daubo’s finances, like all borrowers in the pool, are reflected 24/7 on-chain for anyone to see. As Daubo’s revenue and expenses fluctuate, the token price moves accordingly. Loans are automatically modified to reflect changes to credit risk. With second-by-second reporting on their positions, investors are warned if loan health is deteriorating—such that they may adjust their exposures accordingly. Because Daubo benefits from an on-chain DeFi credit score of 6 (out of a possible 7), it borrows at a slick 7% compared to the average of 14% for African fintechs.
This miracle of capital markets is managed, without human oversight, by a program called a smart contract. It’s 2030 and investment banks, FICOs, and trustees are but relics of a pre-crypto era.
The Medium is the Message: Ledgering Assets in A Better Way
As these more automated capital markets come to fruition, the distinction between so-called “Real World Assets” (RWAs) — such as stocks, bonds, and real estate — and crypto assets — like Ether, Bitcoin, and Solana — will become blurry. As blockchains become the de facto ledger and trading venue for capital markets, assets living outside blockchains will be the exception rather than the rule. Untokenized assets will be at a huge disadvantage.
Whereas the internet created a better standard for how text, photos, audio, and video were exchanged, DeFi will create a better standard for how assets are exchanged. Not only will stocks, bonds, and real estate be re-ledgered on blockchains, but the newer, better standards put forth by crypto capital markets will unlock completely novel capital assets.
To grok how better standards can transform capital formation, we need only look to the success of securitization in the 1990s. Securitization is just a technology—a protocol for originating, compiling, packaging, and distributing risk. By putting forth a standard that assets conform to (duration, risk etc.), we boosted liquidity and originations by volumes. Securitization mobilized and institutionalized mortgages (MBS), corporate loans (CLO), and consumer loans (ABS), driving cheaper capital for home buyers, businesses, and consumers.
Source: European Central Bank
30 years later, securitization remains largely unchanged—capital markets have not adapted to the internet. Due to a chain of middle men—investment banks, trustees, rating agencies, servicers, etc.—borrowing costs are higher than they should be. Most assets cannot be securitized because they don’t fit into a neat origination box. Most business owners are still excluded from international capital markets. Basic wealth-building blocks like insurance are still hard to come by in Africa and Asia. This begs the question: from where does the creative destruction needed to truly digitize capital markets come?
Securitization was to the 1990s as … is to the 2020s?
With the inception of distributed ledgers, Decentralized Finance (or DeFi) is the next substrate upon which a better standard for value exchange will be built. The Fintech revolution focused on the customer-facing technology (the front end), but it is DeFi that will fundamentally restructure the pipes of finance (the back end).
To succeed, DeFi must focus on building a bridge between crypto and the real world. In nascence lies opportunity; while crypto is very small ($1T), the universe of real-world assets is huge (>$600T). So it stands to reason that for crypto to make an impact on how business is done, it must address this sea of value. As opposed to remaining stubborn toward traditional finance, DeFi should decentralize access to capital markets by laying out the red carpet.
Trustless or bust?
Introducing existing credit assets to blockchain environments clashes with a sacred principle of DeFi, that of trustlessness. A trustless system is one who’s design obviates the need to trust another human to uphold an agreement. When lending against a crypto asset like Ether, for example, a lender can automatically seize the collateral in the case of default. Real-world assets are much messier for now (even when tokenized) — DeFi lenders will still need to lean on traditional legal and commercial processes for recovery. But just because on-chain RWAs are not “pure” does not imply that they should be avoided, quite to the contrary.
The Nature of Real Innovation
Building a wholly better system is a slow, iterative process that is worth it in the end. RWA tokenization suffers from the cold-start problem, as any burgeoning network does. Because the tokenization, reporting, servicing, and financing infrastructure is still nascent, RWA liquidity is minimal. And because the origination and liquidity of on-chain RWAs is minimal, the incentives to build out the infrastructure aren’t yet high.
But the DeFi sector is rapidly expanding, and the players with the power to release this deadlock and jump-start a new era for capital markets already exist today. As we know from the flimsy push for renewable energy, real change only occurs when the “right” thing and “economical” thing are the same. DeFi leaders must deploy their balance sheets strategically, to incentivize RWA markets to ledger themselves more truthfully. By creating the conditions so that economic actors benefit from, rather than are punished by openness, the market will follow suit.
Unlocking a New Frontier for DeFi
Crypto is a generational opportunity to build a better financial system from scratch. One that ledgers and finances the best collateral, crypto or RWAs in an open and efficient way; and one that is based on merit rather than status — a network that threatens the Old Boy’s network.
Rather than a sacrifice on the principles of decentralization, the pursuit of real-world assets represents an enhancement of what decentralization is meant to achieve: resilient, permissionless access to technology. Whereas DeFi first sought to bring credit to retail, now it must grow outside its comfort zone and do the same for business.
Teej Ragsdale is part of the Real World Assets core unit within MakerDAO, the decentralized autonomous organization (DAO) that powers the longest-standing DeFi lending protocol and enables the creation of DAI, the original decentralized stablecoin.
The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.
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