- Decentralized finance (DeFi) yields have dried up, inching closer to traditional finance (TradFi) yields.
- Increased tokenization of real world assets, including real estate and loans, is a new source of yield in DeFi, providing opportunities for higher yield and portfolio diversification.
- One concern around real world assets is the default risks faced by real world assets protocols due to undercollateralized loans.
The DeFi industry has boomed over the past few years, reaching the peak of $181.22 billion on 02 December 2021.
Nonetheless, given the black swan events that have occurred over the past year, including the fall of Luna and FTX, we have seen the TVL drop drastically. The poor tokenomics associated with most tokens have led to inflationary pressure, causing token value to drop by more than 90%. Coupled with these issues, we can see that the DeFi yields have also decreased significantly. The days of easy DeFi yield have passed, and the industry is at a point where DeFi yields are almost on par with that of TradFi yields. Given the lower risk that the TradFi market possesses, DeFi participants have started to exit from DeFi, pivoting their capital into the TradFi market for better risk to reward.
This has sparked discussions in the DeFi industry, with market participants sourcing for higher, and more sustainable yields, as well as exploring new trends and opportunities like liquid staking. In 2023, we’re seeing real world assets stepping up to attract the market’s attention, offering a different method to earn yield, as the name suggests, by tapping on real world assets such as loans. In this article, other than understanding about real world assets, we will look at some of the most prominent real world assets protocols, including Maple Finance, TrueFi, Centrifuge and Goldfinch.
What are Real World Assets?
These are tangible assets that exist in the physical world. Examples of these are real estate, commodities and art. Real world assets are a significant composition of the global financial value. The value of global real estate was $326.5 trillion in 2020 while the gold market capitalization is $12.39 trillion.
Evidently, real world assets are huge in the traditional finance industry. However, these assets are hardly tapped on in the DeFi world. This brings about the possibility of inclusion of real world assets in the DeFi industry, increasing the liquidity available, and offering a novel asset class for DeFi participants to leverage on for investment yield. In addition, it should be noted that with real world assets, the investment yield could be less affected by crypto’s volatility.
Real World Assets in DeFi: Credit Protocols
Over the past few years, and in 2022 particularly, the market has seen the rise of protocols tapping on credit markets in traditional finance. This comes as no surprise given that credit is the key to businesses growing.
Businesses typically use capital to invest in research and development, grow their team and carry out marketing efforts. They can access capital through either debt financing or equity financing. Debt financing is usually preferred by teams, given that it allows them to retain control over their business while gaining access to the capital required.
The emergence of on-chain credit protocols allows for such businesses to tap into the DeFi ecosystem, a $57 billion industry as of writing, for capital. This lowers the barrier to entry for businesses, especially that of emerging markets, to receive loans. This is supported by the chart shown below, indicating the number of loans given by on-chain credit protocols to each geographical region. As of the current point, businesses in Nigeria have achieved the most number of loans, 21 in total, followed by Mexico with 20 loans and Kenya with 19 loans.
Having understood what real world assets are and how on-chain credit protocols generally work, we can now dive into some of the biggest players in this particular sector.
Maple Finance (MPL)
Maple Finance is an institutional capital market infrastructure, creating the platform for institutional borrowers to tap on the DeFi ecosystem for loans.
There are three parties involved:
- Institutional borrowers: These are the participants who require loans
- Lenders: DeFi participants who deposit capital into the pools on Maple Finance
- Pool Delegates: Credit professionals that underwrite and manage the pools on Maple Finance.
This is how lending is carried out on Maple Finance:
- Pool delegates source for institutional borrowers. They will conduct due diligence, underwrite and negotiate terms with the institutional borrowers. This includes Know Your Customer (KYC) and Anti-Money Laundering (AML) processes.
- Once it has been established that these institutional borrowers are suitable for borrowing, the pool delegates will set up the pools on Maple Finance, which will be managed by them thereafter.
- Lenders will go onto Maple Finance and identify the pools that they wish to deposit into. This will be based on their risk appetite and whether they think that the terms set out in the pools are favourable for them.
- Once lenders have deposited capital into the pool, the institutional borrowers can now access the capital. Given that these borrowers have been whitelisted by the pool delegates, undercollateralized borrowing is made possible.
The protocol is focused on lending to real world businesses, and particularly, businesses within emerging markets. Goldfinch caters to a diverse range of businesses and offers attractive yields that go up to 30%, as apparent from their pools.
There are three parties involved:
- Borrowers: These participants propose Borrower Pools to seek capital financing through Goldfinch
- Investors: Participants that provide capital to borrowers. There are two types of investors: Backers and Liquidity Providers
- Auditors: Participants who conduct due diligence to ensure that borrowers on boarded onto Goldfinch are not engaged in fraudulent activities.
This is how lending is carried out on Goldfinch:
- Borrowers first undergo an audit by auditors to determine that they are eligible to loan.
- Once approved, borrowers can create borrow pools and determine the credit terms, which includes metrics such as interest rate, limit, payment frequency, term and late fee.
- Investors can now come in to supply capital.
- Backers supply capital directly to the borrower pools and are the first loss capital. Hence, they receive a higher return.
- Liquidity providers supply capital to Goldfinch, which is then allocated across all borrower pools.
The protocols mentioned above have all been a good example of incorporation of real world assets into the DeFi ecosystem. However, they are all focused on the credit aspect. To bring more colours into the on-chain credit ecosystem, Centrifuge comes around to allow for more forms of real world assets to be brought onto the ecosystem, and has a slightly different mechanism by incorporating Non-Fungible Tokens (NFTs).
There are two parties involved:
- Asset Originators: These are the borrowers that tokenize their real world assets into NFTs
- Investors: These are the lenders.
Centrifuge’s decentralized application (dApp) is known as Tinlake, serving as a marketplace and investment dApp.
This is how lending is carried out on Tinlake:
- An asset originator bridges a real world asset using Tinlake. This asset is converted into an NFT, which includes relevant legal documentation.
- Asset originators can now create asset pools using the tokenized real world asset NFT as underlying collateral.
- Upon pool creation, two tokens are created: DROP tokens and TIN tokens.
- Investors can decide which pool to provide capital into based on their individual risk profile, buying either DROP or TIN tokens.
- DROP token holders have a guaranteed return, determined by a fee function that has a fixed interest per pool, compounded every second.
- TIN token holders, on the other hand, do not have a guaranteed return. They receive a variable yield that is based on the investment returns from the pool, which could be higher than the returns from holding DROP tokens.
- TIN token holders borne a higher risk as they take the first loss in the event a borrower defaults.
Advantages of Credit Market Protocols
There are a variety of advantages brought about by credit market protocols. There are two angles to view this.
1. DeFi Participants
As of this current point, the yields offered by credit protocols are higher than that of most DeFi protocols. The APY provided by each of the protocols are as follows:
- Maple Finance: 8.31%
- TrueFi: 2.08%
- Centrifuge: 9.31%
- Goldfinch: 8.31%
In addition, DeFi participants will be able to diversify their portfolio, given that institutional borrowers that run real world businesses are less correlated to that of the crypto market.
2. Emerging Markets
It is typically difficult for businesses in emerging markets to receive undercollateralized loans. This is because of the higher requirements that have been set in stone in the traditional markets. Such regulations make it extremely difficult for small businesses to scale, given that they are unable to access capital and even if they were able to, it would come at a huge cost to them, undermining their runway to scale.
The DeFi ecosystem presents a new source of loans, and increases their capital efficiency given that undercollateralized lending is made possible. This is also a benefit that results from the removal of middlemen and utilization of smart contracts for certain operations.
In addition, by borrowing on-chain, these businesses are building their on-chain credit profile. By paying their loans on time, they will be better positioned to receive more loans in the future, and these loans can even be of a higher quantum.
Disadvantages of Credit Market Protocols
The greatest risk that exists would definitely be the default risk posed by the borrowers. Given that these are undercollateralized loans, the lender will not be able to receive their full capital in the event of default. This has been an ongoing problem, apparent from some protocols:
- Maple Finance: $69.3 million
- TrueFi: $4.4 million
- Centrifuge: $2.6 million
It should also be noted that despite the protocols reducing the amount of crypto volatility faced by lenders because of the usage of stablecoins, it is still subjected to the bigger fallouts in the industry. This is very evident from Maple Finance’s case where close to half of its default came after the FTX fallout.
Other than the impact on lenders, protocols could also suffer from bad debt, undermining the protocol’s longevity.
The other inherent flaw with the current credit protocols would be that of human bias. The KYC and AML process, along with the whitelisting of borrowers, are being determined by humans.
Real World Assets Protocols’ Token Performance
So how have the credit protocols performed? All the native tokens have underperformed Ethereum by more than 20%. The following table shows the drop in price since their all-time highs:
Despite the adoption of credit protocols, with 1,481 loans issued, total loan value of $4,421,679,320 and active loan value of $422,314,511, the protocols have yet to perform well on the token front as of time of writing.
Real world assets is an interesting vertical with lots of potential, given how huge the market is in traditional finance. We have seen the space being occupied by multiple credit protocols, each with a twist on how they run the protocols.
However, it should be noted that despite the advantages that it brings about such as diversification of portfolio and higher yields, the risk of default is an area that has yet to be addressed successfully. The only exception would be Goldfinch, which has not faced a single default since starting.
In addition to the credit market, there are also other real world aspects that have been gaining market interest. An example of which would be the tokenization of real world assets such as real estate or art. With the digitalization of such assets on-chain, fractionalization of the asset is made possible, allowing people to have partial ownership.
This will be an exciting space to watch, given the rapid developments done by the protocols and we can look forward to more adoption from the market.