The recent GameStop Short Squeeze brought decentralized funding (DeFi) to the general public consciousness. Well-known crypto influencers like Caitlin Long have advocated a decentralized exchange as an alternative to traditional clearing and settlement infrastructure. Others, including myself, have suggested that decentralized credit markets can reduce systemic risk by making financial markets more transparent.
Ajit Tripathi, a CoinDesk columnist, is the head of institutional business at Aave. Previously, he was a fintech partner at ConsenSys and a co-founder of PwC’s UK blockchain practice.
In this article, we examine some of the key considerations for transitioning from crypto-native decentralized markets to decentralized real asset markets at the institutional level.
Institutional interest in DeFi
In my experience, institutional interest in DeFi is currently much stronger than generally assumed. There are five main reasons for this:
First, unlike blockchain projects and proofs of concept for companies, which I believe have struggled to achieve a return on investment, the public, non-approval DeFi logs have provided clear evidence of value that can be found in DeFi trading volumes, market liquidity and the Reflect fee income.
Second, custodians, secure wallets, and neobanks who built the rails for Bitcoin’s institutional rollout have already done much of the effort required to gain access to DeFi.
Third, family offices, proprietary hedge funds, and cashless corporate bonds actively seek returns in a low or zero interest rate environment, and the digital asset crypto lending environment allows for returns of 5% to 20% on any given day.
Fourth, centralized pools of liquidity require much more liquidity than they can currently find.
Fifthly, decentralized lending offers far more transparency in terms of risk and capital position than centralized lending platforms.
Off-chain assets and NFTs
I really don’t like the term “real assets”. This is because crypto assets or digital assets are as real to me as a paper dollar bill or a stock. Therefore, I prefer the terms crypto-native assets to off-chain assets. That’s the terminology I’ll use in the rest of this article.
Most off-chain assets, unlike money tokens and listed stocks, are not fungible.
Most people into crypto use non-fungible tokens (NFT) and digital art interchangeably. This amalgamation is understandable given that CryptoKitties, a collection game that pretty much overloaded the Ethereum network at its peak, was the most hyped application of NFTs in the previous bull run. In the current Crypto Bull Run, 24-by-24 gifs called CryptoPunks have scored nearly $ 1 million.
See also: Ajit Tripathi – Why I’m Long Crypto, Short DLT
NFTs aren’t just digitally signed gifs and videos that you can own and show to friends, however. Non-fungible tokens can refer to any asset that is non-fungible. For example, unlike publicly traded stocks, almost every private equity contract contains bespoke, idiosyncratic terms and conditions. The same applies to bonds with tailor-made, contract-specific restrictions and covenants. This “idiosyncratic” or “specific” nature of an asset makes almost anything a non-fungible token. In fact, most financial assets, and not just non-financial assets like art and music, are NFTs and not fungible tokens like money tokens or publicly traded stocks.
This “idiosyncratic” or “specific” nature of an asset makes almost anything a non-fungible token.
The most relevant application of NFTs that I have personally worked on is the UK Land Register PoC with HMLR. In fact, my house is irreplaceable by my neighbour’s house, and even if it is the same in shape, design and size, they appeal to different people and sell at different prices. What makes NFTs even more interesting is that you can use a fungible token, e.g. B. fractional real estate, can bind to a non-fungible token, ie to a token that represents Buckingham Palace. DeFi protocols prove a number of these concepts and deliver value with native digital assets and add overlays to already boot the off-chain asset markets.
The challenge
Let me start off by saying that the main complexity in delivering off-chain assets to on-chain markets is not technology. While decentralized technology can vastly improve transparency, automation, and efficiency, three other factors are much more difficult to consider. These factors are a) bootstrapping the market, b) implementing a solid legal framework for property rights and custody, and c) maintaining assets. Let’s examine these one by one.
Bootstrapping the market
In order to strengthen the market, buyers and sellers or borrowers and lenders must be found and motivated, who must use a new, more efficient and more transparent infrastructure that DeFi makes possible.
This is a bit complicated. Crypto market participants who are familiar with the Crypto user experience and self-custody generally have much higher return expectations and risk tolerance than those in off-chain markets.
See Also: Paul Brody – Corporations Would Use DeFi If It Wasn’t So Public
For example, a 10% annual return on token invoices is very exciting for participants in the invoice finance market. In crypto markets, expectations can be 10x, which of course reflects the market risk of the crypto asset class. Conversely, few in the bill finance markets are familiar with using MetaMask, paying Ethereum gas fees, or experiencing 10% daily price volatility.
To overcome the inertia of older financial institutions, innovators working with off-chain assets need to focus on finding early adopter segments where they are.
Property rights and custody
In crypto, the idea of self-management, that is, “not your keys, not your crypto”, is axiomatic. However, the concept doesn’t work as well for owning off-chain assets such as real estate, accounts receivable, stocks, or bonds. In the off-chain world, having private keys is generally not sufficient proof of ownership, and property rights must be enforced through contracts, regulations, arbitration, and legal proceedings.
In both the off-chain and on-chain worlds, custody is not just ownership of a private key, but a legal obligation to hold assets on behalf of a customer. The licenses and permissions required by US crypto custodians are largely similar to those required by securities custodians. This makes the role of custodians very critical in the emerging decentralized markets for off-chain assets.
Recording systems
In information management, a “System of Record (SOR)” is the relevant data source for a certain data element or certain information. For crypto-native tokens such as ERC-20 tokens or NFTs, the public Ethereum blockchain is generally the final official ledger on who owns what and what transactions the change of ownership will cause. This provides efficiency in transferring crypto-native assets and locking assets in smart contracts for basic DeFi elements such as algorithmic stablecoins, vaults, secured loans and liquidity mining.
For off-chain assets, the on-chain ledger is generally not necessarily the system of record. That means locking an asset in a smart contract requires an off-chain legal framework that takes the concept into account in the off-chain world. In the off-chain world, there is generally an appointed authority such as the land register that is enshrined in national law and has the role of maintaining the integrity of the general ledger.
Asset service
All assets include the expectation of future benefits, which are usually included in a contract. For example, a stock in a company often pays a dividend, can be split, tendered, and so on and so forth. Likewise, a rental property hopefully offers a source of income in the form of rent.
Asset Service’s job is to process these “events” and provide the owners of such assets with benefits throughout the life of the asset. In the securities markets, this role is normally performed by regulated intermediaries such as custodians. In on-chain markets, smart contracts are written to automatically provide such benefits in the form of tokens, native protocol tokens, rebasing, etc.
The way forward
The biggest advantage of decentralized financial protocols is that they are like an open path to innovation. To date, key DeFi protocols have implemented many asset agnostic primitives, such as: B. Secured Loans, Automated Market Making, and Material Derivative Contracts. Essentially, the foundation stone for the market infrastructure was laid.
DeFi entrepreneurs working with off-chain assets can use all of this open source technology and on-chain liquidity to innovate and there is ample venture capital to do that. Unlike corporate blockchain projects that require large budgets and recurring approvals for funding, as well as endless bureaucracy, innovators can combine these DeFI staples and their liquidity with their expertise in markets outside the asset chain. It’s already happening today.
See also: DeFi Dad – Five years later, DeFi is now defining Ethereum
The most important thing is not to bite too much too soon and to iterate quickly.
This “compilation” of markets using existing DeFi protocols is exactly what DeFi innovators are doing today. When they demonstrate the value of their innovation, they will begin to provide the economic evidence needed to change the rules that were created for older technologies.
To sum up, DeFi 1.0 for crypto-native assets is here, and it’s a spectacular achievement in technology. DeFi 2.0 will be incredibly exciting, and will involve off-chain asset markets and legal technology.
