Riding on MakerDAO’s back, Centrifuge has emerged as a leading provider of on-chain credit. Learn all about the underlying service provider for Real-World Assets (RWA) in this article.
Surging on the Strength of MakerDAO, Centrifuge Rises as a Top Provider of On-Chain Lending. Discover the Crucial Role of this Real-World Asset Service Provider in Our Comprehensive Guide.
Dedicated to becoming the infrastructure for RWA, how does Centrifuge achieve real asset collateralized lending?
Original author: flowie
Original source: ChainCatcher
MakerDAO, which has been steadfastly investing in RWA assets for the past six months, increased its RWA assets by $100 million in just one week last month and currently holds over $3.3 billion in RWA assets.
As the underlying technology service provider for MakerDAO’s expansion of RWA assets, Centrifuge has also successfully capitalized on the opportunity this year and has become the most active on-chain credit protocol in terms of loan amounts. According to the RWA.xyz data platform, the active loan amount for Centrifuge was approximately $84 million on January 1, 2023, and it has now grown to over $240 million, an increase of 286%, far surpassing the previous credit leaders Maple and TureFi.
According to the crypto data platform RootData, Centrifuge has completed four rounds of funding, raising a total of $15.8 million, with investors including Coinbase Ventures and IOSG Ventures.
Despite being favored by top DeFi projects like MakerDAO and well-known investment institutions, Centrifuge, like Maple and TureFi in the past, cannot avoid defaults and bad debts. Earlier this year, it was revealed that about $5.8 million in loans from two lending pools at Centrifuge were overdue. In August, there were also claims in the community that defaulted loans would put MakerDAO’s $1.84 million investment at risk. According to RWA.xyz, Centrifuge currently has accumulated over $15.5 million in unpaid loans. The MakerDAO community even proposed to stop providing loans to the tokenized credit pool on Centrifuge.
As the fastest-growing on-chain credit protocol this year, how does Centrifuge operate? And what mechanisms are in place to handle controversial defaults and bad debts?
RWA: The New Lifeline for On-Chain Credit, Centrifuge Leading the Way
In addition to on-chain U.S. Treasury bonds, on-chain lending has also played a catalytic role in the RWA track. Well-known DeFi projects like MakerDAO, Compound, Frax, and Aave have all entered the field. In addition to these established DeFi projects, some on-chain credit protocols have also benefited from the RWA narrative. According to RWA.xyz data, on-chain credit has increased by over $200 million from January 1st to September 30th, with a growth rate of over 80%.
However, compared to traditional credit loans, which have a large market share in the traditional financial sector, the development of credit in the crypto space is just beginning. Around the end of 2021, institutional on-chain credit protocols such as TrueFi and Maple emerged. Instead of the traditional DeFi overcollateralization lending model used by Compound and Aave (where one type of asset is borrowed by overcollateralizing another type of digital asset), they primarily provide low collateral or even uncollateralized lending services to institutional investors, market makers, and other trading-focused entities in the crypto space. However, these institutions need to submit certain information for credit review, such as monthly reports with balance sheets and annual independent audit financial statements. Even on Maple, borrowers are required to register with the credit risk data platform Credora, which provides real-time information to lenders to help them assess the risk levels accumulated by borrowers on different cryptocurrency trading platforms.
With the low collateral or even no collateral credit lending model, many institutional clients have been attracted to participate, such as Alameda Research, Wintermute, BlockTower, and more. In mid-2022, Maple’s active loans on the Ethereum chain alone reached nearly $1 billion, and TrueFi also peaked at nearly $500 million. Goldfinch, the second largest active loan platform after Maple and TrueFi, raised $37 million in three rounds of financing from large crypto risk funds such as a16z and Coinbase Ventures, as well as angel funds like Balaji Srinivasan, Ryan Selkis, and Tarun Chitra.
However, as the crypto market entered a deep bear market and CeFi witnessed a wave of bankruptcies, institutional lending protocols like Maple and TrueFi suffered from significant defaults and bad debts. For example, after the Terra and Three Arrows Capital bankruptcy incident in June last year, Maple Finance officially stated that it might face short-term liquidity challenges and cash flow problems after Babel Finance, another crypto lending company, went bankrupt and defaulted on a $10 million loan.
With the collapse of FTX, Maple Finance faced even larger defaults. Maple Finance defaulted on the M11 credit pool, which had a due date of December 4, 2022, and could not repay the loan due to the impact of the FTX incident, resulting in a default amount of $36 million. Nexus Mutual, Sherlock, and other institutions that deposited funds into Maple Finance’s lending pool were affected. TrueFi also suffered a default from BlockWater. By the end of 2022, both Maple Finance and TrueFi had dropped significantly to around $20 million.
By 2023, with the rise of RWA narratives, the online lending sector experienced a turning point and the market landscape changed significantly. Apart from Maple, the once-leading credit lending protocol that experienced a recovery in the amount of active loans on the chain, there was also Centrifuge, a low-profile online credit protocol that saw rapid growth, surpassing Maple and becoming the new leader in the credit industry. Goldfinch, favored by numerous prominent investors such as a16z, has been steadily growing without much fluctuation.
Previously devastated by the lack of collateral credit model, Maple expanded its lending models to include real asset-backed loans and over-collateralized loans. In addition, Maple launched an online US bond lending pool in April this year, relaunched the lending pool on Solana, and went live on the Base network. During this period, Maple completed a $5 million financing round in August. Maple’s active loans on the chain have now grown from over $20 million at the beginning of the year to nearly $100 million.
Compared to Maple, Centrifuge, which has been committed to real-world asset-backed lending, has grown significantly. Currently, Centrifuge has grown to over $240 million in active loans on-chain, nearly three times the growth since the beginning of the year, making it the largest protocol for on-chain credit lending.
MakerDAO Boosts Centrifuge to Become a Leader in On-Chain Credit
Centrifuge is actually an early on-chain lending protocol, founded in 2017. Unlike Maple, TrueFi, and other credit protocols that cater more to crypto financial institutions, Centrifuge emphasizes lending against traditional real-world assets, making it one of the earliest players in the realm of real-world assets (RWA).
As early as 2020, Centrifuge, as a technical service provider, helped MakerDAO establish the RWA vault with the 6s Capital project, which uses real estate development-guaranteed loans as collateral. This year, the rapid growth of Centrifuge’s active on-chain loans is mainly attributed to MakerDAO’s layout in RWA assets.
According to Centrifuge’s official website, among the six lending pools, eight are related to MakerDAO. For example, New Silver series that invests in bridge loans for real estate, BlockTower series that invests in structured credit, Harbor Trade Credit series based on accounts receivable loans, and more, all have MakerDAO as the priority investor in the pool. (Later, we will explain in detail Centrifuge’s hierarchical investment mechanism). In terms of statistics, the funds related to MakerDAO currently amount to approximately $200 million, accounting for 80% of Centrifuge’s total TVL (approximately $250 million).
Looking at the MakerDAO asset inventory statistics, BlockTower S3 and BlockTower S4, integrated with Centrifuge, were both established this year and have provided $70 million and $56 million in DAI supply respectively. In other words, MakerDAO has provided Centrifuge with loan funding support of over $120 million this year.
The APR of the funds related to MakerDAO’s pool currently ranges from 4% to 15%, mostly higher than the DeFi average APR of 4%.
In addition to MakerDAO, Centrifuge also became a technical service provider for Aave’s investment in RWA assets in 2021. Aave and Centrifuge jointly established a lending pool dedicated to RWA, which operates separately from the Aave lending market. The current fund size is approximately $5.5 million.
Compared to MakerDAO, Aave’s investment in RWA assets through Centrifuge is still relatively small this year. However, with the rising popularity of RWA narratives, Aave also plans to increase its investment in RWA assets. In August this year, Aave passed a proposal to cooperate with Centrifuge Prime to invest in US government bonds. Aave initially invested $1 million in USDC, with the goal of increasing the investment amount to 20% of the stablecoin holdings. Perhaps Aave’s continued investment in RWA will bring a new wave of growth for Centrifuge.
How does Centrifuge achieve real asset collateralized lending? What is the default risk mechanism?
As a preferred RWA technology service provider for top DeFi protocols like MakerDAO and Aave, what problems does Centrifuge solve and how does it work?
In general, Centrifuge, as a lending platform, is primarily responsible for connecting two parties: the investment parties who want to earn returns through lending, mainly DeFi protocols in the crypto field such as MakerDAO and Aave; and the borrowers who want to raise funds, typically start-up companies or organizations with real-world assets such as real estate, accounts receivable, and invoices. In order to bridge the gap between the real world and DeFi in terms of asset flow, Centrifuge needs to provide legal and asset on-chain support.
Due to the involvement of multiple processes and the interaction between on-chain and off-chain worlds, the process is relatively complex. Let’s take a look at the operation process using the New Silver Series 2 lending pool as an example.
The New Silver Series 2 lending pool is initiated by New Silver as the asset issuer, providing financing for a portfolio of bridge loans in the real estate sector. These loans are provided to real estate developers and have a term of 12 to 24 months. According to the introduction, New Silver is a non-bank lending institution established in 2018, mainly providing bridge loans for the real estate industry to help borrowers pay for new real estate before selling their existing properties.
As the asset demand party, New Silver first needs to initiate a Pool Onboarding Proposal (POP) on the Centrifuge forum, clearly stating their purpose, credit situation, and fund usage, etc. (However, the POPs displayed on the forum seem to be incomplete, and the pool application proposal for New Silver Series 2 is not visible.)
The submitted Pool Onboarding Proposal (POP) will enter the due diligence stage and undergo risk assessment and legal review conducted by third parties to produce an analysis report. After the evaluation is completed, it moves on to the final discussion, where Centrifuge’s Credit Risk Group and CFG token holders vote for selection.
Once selected, the asset issuer and investors need to initiate based on Centrifuge’s off-chain legal risk framework and on-chain asset tokenization.
Off-chain: The asset issuer, New Silver, needs to establish a special purpose vehicle (SPV) as the entity for this financing, separating the assets to be collateralized from the company’s other assets. In addition, a third-party professional team is engaged for asset valuation, auditing, and trust services to further enhance security. The borrower signs a financing agreement with the special purpose vehicle.
And for investors, Centrifuge needs to conduct KYC and anti-money laundering on them. Currently, Centrifuge mainly collaborates with Securitize to complete this process. In addition, investors also need to establish a special purpose vehicle (SPV) with New Silve and sign a subscription agreement.
On the blockchain side, the first step is to store data on-chain. Using the Centrifuge P2P messaging protocol, New Silve, the asset issuer, can access all off-chain real asset data on the Centrifuge Chain. This chain is developed based on the Substrate framework, which allows for the sharing of Polkadot network security and is already bridged to Ethereum. New Silve can package the data into NFTs on the Centrifuge Chain and use them as collateral to initiate borrowing from Centrifuge’s Tinlake lending pool (on the Ethereum Chain), providing stablecoins to investors.
So, how can investors participate in the Tinlake lending pool? What is the risk mechanism for loan defaults? Centrifuge has implemented a risk classification system and issued two different ERC20 tokens, DROP and TIN, offering different risk and reward profiles for investors with different risk preferences.
Investors need to purchase DROP and TIN tokens with DAI. Holding DROP tokens gives priority in profit distribution from the asset pool, with a fixed interest rate. In the event of risks (such as loan defaults), DROP token holders will bear losses later and typically have lower risk and lower rewards. For example, New Silve’s DROP token holders enjoy a fixed interest rate of 7%. Holding TIN tokens, on the other hand, entitles one to profit sharing with a floating interest rate but bearing losses first, usually providing higher rewards and risks.
To be more specific, let’s assume the asset issuer/borrower borrowed $1 million, with DROP token holders providing 20% of the funds and TIN token holders providing 80%. Additionally, the asset issuer/borrower needs to pay a 10% interest. DROP token holders are entitled to a fixed interest rate of 5% as agreed.
In the end, the asset issuer/borrower only repaid $600,000. Therefore, DROP token holders will receive their principal of $200,000 plus $10,000 in interest at the agreed 5% rate. From the repayment, there will be $390,000 left for TIN token holders, but they initially invested $800,000 and can only recover a portion of their principal amount.
However, assuming DROP token holders provide 80% of the funds and TIN token holders provide 20%, and the asset issuer does not default or have bad debt, with other conditions unchanged, DROP token holders will receive their principal of $800,000 plus $40,000, while TIN token holders can receive $200,000 in principal and $50,000 in interest at an interest rate of 25%, surpassing the fixed 5% interest rate offered to DROP token holders. Therefore, for investors, they can choose either the DROP token or the TIN token to achieve risk and reward hedging.
In addition to hierarchizing risks and returns, Centrifuge’s funding pool is cyclical, allowing for investment and redemption at any time, but ensuring that DROP tokens are redeemed before TIN tokens and that TIN tokens do not fall below the set minimum ratio. When the issuer repays the financing amount and interest upon maturity, the pledged NFT will also be returned to their hands.
Centrifuge is committed to becoming RWA infrastructure.
Overall, Centrifuge, as a platform that bridges DeFi and real-world assets, has several core products and components in its ecosystem.
First, Tinlake protocol for the C-end lending platform, which is currently deployed on Ethereum. It converts real-world assets into ERC-20 tokens and provides access to decentralized lending protocols. Tinlake deducts 4% of the total supply in each lending pool as a service fee.
Second, the Centrifuge P2P messaging protocol, which allows collaborators to securely and privately create, exchange, and verify asset data, and tokenize the assets into NFTs.
Third, Centrifuge Chain, which is developed based on the Substrate framework and can share the security of the Polkadot network and has already been bridged to Ethereum. Currently, the main use of Centrifuge Chain is to turn real assets into NFTs.
Centrifuge Chain also has its native token CFG, which is mainly used to incentivize network and ecosystem development, as well as community governance. CFG can also be bridged to Ethereum and used as an ERC20 token.
CFG is mainly used to pay for transaction fees on Centrifuge Chain; to incentivize nodes for maintaining the security of the Centrifuge Chain network and to stake CFG to qualify for financing and participate in governance, etc. Since the Tinlake protocol is currently mainly on the Ethereum network rather than the Centrifuge Chain, the use cases and value capture ability of CFG are limited. However, this year, backed by MakerDAO’s active loan growth on-chain, its token performance has also increased. According to data from CMC, the current price of CFG is $0.54, which is more than triple the price of around $0.15 at the beginning of the year. However, compared to its record of over $2 during the bull market in 2021, there is still a significant gap.
In terms of the use cases of CFG, in March 2022, Centrifuge announced its roadmap to launch and expand the real-world asset pool on the Centrifuge Chain, replacing the Tinlake protocol on Ethereum, and expanding the use cases of CFG, including fee mechanisms and pledge mechanisms, etc. However, the migration of the Tinlake protocol has not yet been completed.
As the demand for RWA in the crypto space grows, Centrifuge has also updated some products and expanded its business this year, aiming to become the infrastructure for RWA. The Tinlake lending application announced a new round of upgrades in May this year. In addition to improvements in the user interface and KYC experience, it has also expanded integration with multiple public chains and wallets. In addition, in July of this year, a lending credit committee was established, consisting of experts in the financial and lending fields, to review and assess the risks of Centrifuge lending pools, etc.
In addition, Centrifuge also announced in June this year the launch of its RWA infrastructure product, Centrifuge Prime, which mainly provides a full range of legal framework and technical services to connect real-world assets to DAO and DeFi protocols. In August of this year, Aave passed a proposal to invest in US bonds through Centrifuge Prime.
However, despite being favored by leading DeFi protocols such as MakerDAO and Aave, Centrifuge, like the previous Maple and TureFi on-chain protocols, is not immune to default and bad debts. Centrifuge has been continuously hit by default and bad debts this year, with a total of over $15.5 million in unpaid loans. In August, the community even proposed to stop providing loans to the tokenized credit pool on Centrifuge, which would put MakerDAO’s $1.84 million investment at risk. MakerDAO community has also suggested stopping loans to Centrifuge.
Compared to the on-chain risks, the evaluation and liquidation of asset issuers/borrowers offline can pose a major challenge. In the traditional financial world, P2P lending has caused considerable harm to investors and even the financial industry. When trying to lower the financing threshold for real-world SMEs and organizations, how can on-chain credit agreements avoid being exploited by malicious actors, and establish investor protection mechanisms through legal and technical means? It may be a long and challenging road.