With U.S. Treasury yields high, how can RWA assets inject decentralized innovation vitality into DeFi?

Author: Nelson

This article is the original content of IOSG, which is only for industry learning and exchange, and does not constitute any investment reference. If you need to quote, please indicate the source, please contact the IOSG team for authorization and reprint instructions. All projects mentioned in this article do not constitute recommendations and investment advice. We would like to thank Momir, Sid, Ray and Jocy from IOSG Ventures for their valuable comments and knowledge sharing.

Until recently, stablecoins were the only real-world asset (RWA) category that attracted attention. Stablecoins were introduced even before Ethereum was founded, replacing volatile cryptocurrencies as the standard medium of exchange on the blockchain. Currently, USDT leads with a market capitalization of $86.9 billion and USDC with a market capitalization of $24 billion, which together account for 7.5% of the entire crypto market’s market capitalization of $1.46 trillion.

In the past two years, when traditional finance abandoned the zero-interest rate policy, and the yield of Treasury bonds exceeded the native yield of DeFi, people understood that the story of RWA does not stop at stablecoins.

Let’s take a look at the structure of the RWA market, starting from the most stable aspects and extending to the benefits and risks, and gradually exploring its future development and trajectory.

Types of RWA

Industry Developments and Challenges

Stablecoins: The Pillar of RWA

In the ever-changing cryptocurrency landscape, stablecoins have become unsung heroes. These digital currencies are designed to remain stable by pegging their value to traditional assets such as the US dollar, and they play a key role in injecting real-world capital into the crypto market. Here are a few observations from the stablecoin space.

LUCRATIVE STABLECOIN ECOSYSTEM: A CRYPTO CASH COW

Stablecoins have proven to be a cash cow in the cryptocurrency industry, with a clear product-market fit and presenting significant monetization opportunities. In fact, they have become one of the most lucrative areas in the crypto space.

Consider, for example, Tether (USDT) - in the first quarter of this year, its profits surpassed those of the financial giant Blackstone, which achieved an impressive profit of $1.48 billion, compared to $1.16 billion for Blackstone. What’s even more noteworthy is that Tether manages 1/120 less money than Blackstone, which manages $70 billion compared to $8.5 trillion for Blackstone. Tether derives most of its revenue from reinvesting its fiat collateral, and more recently, their balance sheet has skewed toward Treasuries. Due to its network effect, as well as the fact that customers are only interested in the exposure of a stable product, Tether is able to capture 100% of the base yield, resulting in amazing profits.

However, this also begs the first question for existing stablecoin providers. Centralized stablecoins like Tether and Circle have been criticized for privatizing profits and losing socialization, raising issues of fairness. In March of this year, the market suddenly realized that holding stablecoins is not risk-free, and holders will face losses if they encounter any problems related to collateral management, but they are not compensated in any way for the risks they take.

In addition, there is a pervasive lack of transparency and exposure to undisclosed risks, as seen during the collapse of Silicon Valley Bank. At the time of the bankruptcy, the market was unaware that Circle had any exposure to SVB. On the other hand, while Tether has not been affected by the recent bankruptcies of traditional banks, Tether’s balance sheet remains exposed to an illiquid venture capital style as well as a lending business. These are clearly not risks that USDT holders are willing to take.

Both Circle and Tether were designed based on the assumption that their collateral would not depreciate and was 100% liquid, when in fact neither assumption was true. This makes both Circle and Tether vulnerable to bank runs during a black swan event. By luck alone, Circle avoided this after the collapse of Silicon Valley Bank.

Crypto-native stablecoins attempt to control these risks, however, each design ultimately encounters a stablecoin trilemma, which requires you to choose two of the following:

• Exchange Rate Linked (PEG)
• Decentralization
• Scalability

Connecting Traditional Finance and Decentralized Finance

The RWA space has been offering a variety of products and protocols for years, but until recently, it hasn’t received much attention beyond the previously mentioned stablecoins, which are more of a safe harbor in the crypto market than a funding tool. An important catalyst for the recent rise has been the policy of high interest rates.

The widening gap between DeFi native yields and traditional financial yields has sparked interest in solutions that can help bridge this gap. Again, stablecoins are the protagonists, but this time it’s the DeFi native stablecoin protocol - Maker DAO.

Specifically, MakerDAO, the third-largest DeFi protocol by total value locked (TVL), has made a strategic shift in asset management, significantly increasing exposure to real-world assets (RWAs). Essentially, the point of dissatisfaction with Maker’s governance is that when there are productive and risk-free alternatives, it will hold unproductive and “risky” USDC on its balance sheet, which will expose Maker directly to the treasury bonds, which will require the establishment of a large amount of off-chain infrastructure and legal means. Luckily, Maker is one of the more resourceful DAOs that eventually managed to build the bridge. So far it has been successful. Over the past year, nearly 65% of MakerDAO’s fee revenue, amounting to $130 million, was generated by RWAs.

Allocating a portion of Treasury yields to the DAI Savings Rate (DSR) module has caused a huge change in the DeFi space, against smaller competitors like Liquity’s LUSD and AAVE’s that can’t keep up with yields[GHO] (This has caused significant pressure and driven up overall interest rates in the stablecoin money market.)

Blast, the recently announced L2 solution that aims to allocate all stablecoins bridged to its rollup to DSR, suggests that Maker’s RWA strategy could trigger growth in DAI demand and adoption in DeFi protocols.

However, while the RWA strategy has helped Maker achieve scalability and optimize its finances, it has clearly moved it away from the status of trustless DeFi protocols.

Challenges of Adoption of Tokenized T-Bills in DeFi

Among DeFi projects, no project has a comparable RWA balance sheet to Maker’s $3 billion. One of the main challenges to the wider adoption of RWA is the limited transferability of tokenized treasury bonds within the DeFi ecosystem. Existing infrastructure often hinders their flow between different DeFi protocols and externally owned accounts (EOAs). As a result, tokenized RWA treasury bonds face limitations in terms of their utility as collateral within the DeFi space.

For DAOs, the ability to gain direct exposure to RWA is hampered by the inherent risks posed by legal complexities and lack of off-chain representation. However, innovative solutions like Centrifuge Prime are solving this problem. Centrifuge Prime establishes a legal structure that enables DAOs and individuals to securely access tokenized treasuries, mitigating the risks and legal hurdles traditionally faced in these transactions. This development represents a significant step forward in expanding the ability of DAOs to invest in safe and regulated assets.

Credit Markets: Higher APYs Comes with Higher Risk

Credit markets try to serve those looking for higher risk opportunities and diversified solutions that go beyond Treasuries.

While DeFi protocols like AAVE and Compound attempt to build fully trustless and permissionless DeFi protocols, projects like Centrifuge and Goldfinch introduce stablecoin holders to the opportunity to participate in the off-chain lending market. Abandoning trustless and permissionless features allows them to achieve greater capital efficiency, serve a wider range of use cases, and tailor products to individual borrowers.

Borrowers, typically off-chain asset sponsors, must go through traditional due diligence and/or use some RWA collateral to support their borrowing activities. For example, Goldfinch’s “trust through consensus” approach allows borrowers to prove credit through collective third-party evaluation. These projects are more like fintech companies than DeFi projects, and their main purpose is to fill the gap in the lack of financial infrastructure in emerging markets. However, there is also a significant risk that these solutions will end up attracting high-risk borrowers who are denied service by traditional financial institutions, effectively creating a “lemon” market.

The recent high interest rate environment has also suppressed some credit market activity and discouraged lenders from participating in alternative markets.

The high interest rate environment has put some growth pressure on credit markets like Maple and Centrifuge’s invoice finance business, as investors now prefer to participate directly in the bond market. That’s why both Centrifuge and Maple have added additional pools of treasury investments in addition to their main businesses to diversify the growth pressure on the platform

Overall, this direction has yet to prove its product-market fit among the crypto audience, and we’re seeing more emphasis on low-risk alternatives such as investment-grade bonds, senior structured credit, commodity tokenization, and even real estate.

Explore the demand side of RWA

Crypto Native Users

Over the past nearly 15 years, crypto-native users have amassed a significant amount of on-chain wealth and developed the habit of keeping most of it on-chain. For those who are used to using crypto tracks, it becomes quite inconvenient to go back to cumbersome traditional financial (tradFi) infrastructure. However, many people are looking to diversify their wealth into assets that are not related to cryptocurrency. The tokenization of real-world assets (RWAs) allows them to enjoy these benefits of diversification while maintaining the fun of the on-chain experience.

In addition, the growth of the on-chain economy has led to multiple DAOs managing 8-9 digit budgets, most of which are focused on highly volatile crypto assets. As part of prudent fiscal management, we expect to see more DAOs deploy a portion of their balance sheets into RWAs.

Can the RWA category attract traditional financial audiences to the crypto track?**

For us, yes.

Some tokenized RWAs can be traded around the clock, eg[Backed] (Tokens can be freely traded on decentralized exchanges (DEXs) at any time.) As a result, markets get another place where they can respond to new information in real time, even though traditional financial exchanges may be out of business hours.

As cryptocurrencies become a more mainstream asset class, the overlap between crypto and stock investors will only increase. Traditional finance holders may be interested in leveraging the composability and innovation of DeFi, for example, by imagining a Liquity-like product that allows users to issue zero-interest loans against their retirement investments in S&P 500 ETFs, which is bound to have a certain audience.

Summary

Many people are wondering what kind of changes will be made to the agreements when the high-interest rate environment changes, and we believe that the high-interest rate environment is actually a stopgap measure for the above-mentioned agreements to generate revenue in the short term, but the ultimate focus is on the main business of each agreement. For example, the long-term focus of MakerDAO is still how to expand the influence of their DAI (issuance and application scenarios), although Centrifuge also has a T-bills business to bring them some revenue, but the main focus in the future is to do things related to invoice finance (programmable decentralized invoice finance infrastructure); and Maple In the same way, the long-term value is to do a good job of credit lending and borrowing (after some wrong decisions in the past, Maple Finance is actively looking for a credit solution path that can better balance risk and capital efficiency), so everyone has to return to their original business or build on it.

In addition, since the rise of cryptocurrencies, real-world assets (RWAs) have gained significant traction within the crypto space, especially with the success of stablecoins like USDT and USDC, which have become a lucrative area of the crypto market. RWA’s landscape within the crypto space is undergoing a transformative journey, presenting a delicate picture of challenges and opportunities. At the forefront of this evolution are stablecoins, which, as the main RWA, have been seamlessly integrated into the crypto market. Their widespread adoption marks a proven product-market fit, providing a stable bridge between the traditional financial system and the vibrant decentralized finance (DeFi).

However, stablecoins also have challenges and risks, such as value distribution, lack of transparency, and scalability issues. A deeper look reveals a complex narrative. Centralized stablecoin entities face scrutiny while investing in fiat currencies entrusted to them and making handsome profits because they pass on the underlying risks associated with these investments to users, even though users do not receive any returns from the undersquad. This dynamic reveals the delicate balance between an entity’s profitability and treating its user community fairly and equitably.

Tokenized Treasury bonds are also of interest as a bridge between traditional finance and decentralized finance (DeFi) in the current favorable circumstances, which also brings credit lending protocols into the spotlight. The tokenization of various assets such as stocks, real estate, and commodities is expanding, providing more investment opportunities. Despite facing limitations in integrating RWA, DeFi protocols have made significant progress in building bridges to make them more accessible. This evolution opens up unique opportunities for DeFi native users who have amassed significant on-chain wealth over the past decade.

The convergence of traditional finance (tradFi) products with blockchain technology heralds innovation, unlocking novel financial instruments and strategies. With the growing overlap between traditional and crypto investors, the synergies between the two worlds are poised to redefine the financial landscape. The potential of collaboration offers the prospect of developing previously untapped markets and creating novel, inclusive financial ecosystems.

Overall, the future of RWA lies in the expansion of assets, capital, and solving current challenges. This advancement is necessary for diversification, convenience, access to restricted geographic areas, and access to regulatory support. However, it is important to recognize that the process of RWA, while opening up new avenues, also introduces a trade-off. The integration of effective RWAs inevitably undermines the trustless nature of the crypto space that has always existed. Finding the right balance between innovation and decentralization will be a key challenge for us in this ever-evolving space.