US bond yields remain high, how can RWA assets inject decentralized innovation vitality into DeFi?

With US Bond Yields at a High, How Can RWA Assets Infuse DeFi with Decentralized Innovation?

Author: Nelson

This article is original content from IOSG and is only for industry learning and exchange purposes. It does not constitute any investment reference. If you need to quote, please indicate the source and contact the IOSG team for authorization and reprint notice. All projects mentioned in this article do not constitute recommendations or investment advice. Thanks to Momir, Sid, Ray, and Jocy from IOSG Ventures for their valuable editing suggestions and sharing of related knowledge.

Until recently, stablecoins were the only category of real-world assets (RWA) that attracted attention. Stablecoins were introduced even before the establishment of Ethereum, replacing volatile cryptocurrencies as the standard medium of exchange on the blockchain. Currently, USDT with a market value of $86.9 billion and USDC with a market value of $24 billion dominate the entire crypto market with a market value of $1.46 trillion.

In the past two years, when traditional finance abandoned zero-interest rate policies and government bond yields exceeded DeFi native yields, people realized that the story of RWA goes beyond stablecoins.

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Let’s examine the market structure of RWA, starting from the most stable aspect and extending to yield and risk, gradually exploring its future development and trajectory.

Types of RWA

Industry Development and Challenges

Stablecoins: The Pillar of RWA

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

Profitable Stablecoin Ecosystem: The Money Tree of Cryptocurrency

Stablecoins have proven to be the money tree of the cryptocurrency industry, with clear product-market fit and significant monetization opportunities. In fact, they have become one of the most profitable areas in the crypto space.

For example, consider Tether (USDT) – in the first quarter of this year, its profit exceeded that of financial giant Blackstone Group. Tether achieved an impressive $1.48 billion profit, while Blackstone Group had $1.16 billion. What’s even more noteworthy is that Tether manages funds that are 120 times less than Blackstone Group. Tether manages $70 billion while Blackstone Group manages $8.5 trillion. Most of Tether’s revenue comes from reinvesting its fiat collateral, and recently, their balance sheet has tilted towards government bonds. Due to its network effects and the fact that customers are only interested in exposure to stable products, Tether is able to capture 100% of the underlying yield, thus earning amazing profits.

However, this also brings up the first problem with existing stablecoin providers. Centralized stablecoins like Tether and Circle have been criticized for privatizing profits and socializing losses, raising issues of fairness. In March of this year, the market suddenly realized that holding stablecoins is not without risk, and holders would face losses if they encountered any issues related to collateral management, but they would not be compensated for the risks they took.

In addition, there is also a widespread problem of lack of transparency and exposure to undisclosed risks, as seen during the collapse of Silicon Valley Bank. When the bankruptcy occurred, the market had no idea that Circle had any exposure to Silicon Valley Bank. On the other hand, although Tether was not affected by the recent bankruptcies of traditional banks, Tether’s balance sheet is still exposed to illiquid investment styles and lending business. These are obviously not the risks that USDT holders are willing to take.

Both Circle and Tether were designed based on the assumptions that their collateral would not depreciate and would be 100% liquid, but in reality, neither of these assumptions holds true. This makes both Circle and Tether susceptible to bank runs in black swan events. It was only by luck that Circle avoided this situation after the collapse of Silicon Valley Bank.

Crypto-native stablecoins attempt to address the aforementioned risks, however, each design will ultimately face the stablecoin trilemma and have to choose two out of the following three:

• Peg
• Decentralization
• Scalability

Connecting Traditional Finance with DeFi

The RWA space has been offering various products and protocols for years, but until recently, it hasn’t received much attention, with stablecoins acting more like safe havens than financing tools in the crypto market. The recent catalyst for change has been the high-interest rate policy.

The increasing gap between DeFi-native yields and traditional finance yields has sparked interest in solutions that can help bridge this gap. Again, stablecoins take the spotlight, but this time it’s DeFi-native stablecoin protocol – MakerDAO.

In particular, MakerDAO is the third-largest DeFi protocol by Total Value Locked (TVL), and it has undergone a strategic shift in asset allocation, significantly increasing exposure to real-world assets (RWAs). Essentially, where Maker’s governance was dissatisfied is when there are productive and riskless alternatives, its balance sheet would hold unproductive and “risky” USDC, thus directly exposing Maker to government bonds, which would require a significant amount of off-chain infrastructure and legal work. Luckily, Maker is one of the more resource-rich DAOs and ultimately managed to build this bridge. So far, it has been successful. Over the past year, MakerDAO generated nearly 65% of its fee income, reaching $130 million, from RWAs.

Allocating a portion of government bond yields to the DAI Savings Rate (DSR) module has caused a massive shift in the DeFi space, putting significant pressure on smaller competitors who cannot keep up with the yield, such as Liquity’s LUSD and AAVE’s GHO, and driving up overall interest rates in the stablecoin money market.

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

However, despite the RWA strategy helping Maker achieve scalability and optimizing its finances, it clearly distances it from the position of being a trustless DeFi protocol.

The challenges of adopting Tokenized T-Bills in DeFi

No other project’s RWA asset balance sheet in the DeFi space can match Maker’s $3 billion. One of the main challenges for wider adoption of RWA is the limited fungibility of tokenized T-Bills within the DeFi ecosystem. Existing infrastructure often hinders their flow between different DeFi protocols and externally owned accounts (EOA). As a result, tokenized RWA bonds face limitations in their utility as collateral within the DeFi space.

For DAOs, the ability to directly access RWA exposure is inhibited by legal complexities and the inherent risks of lacking off-chain representation. However, innovative solutions like Centrifuge Prime are addressing this issue. Centrifuge Prime establishes legal structures that enable DAOs and individuals to safely access tokenized T-Bills, mitigating the risks and legal barriers traditionally faced in such transactions. This development represents an important step forward in expanding DAOs’ investment capabilities in secure and regulated assets.

The credit market: Higher yields come with higher risks

The credit market seeks to serve those seeking higher risk opportunities and diversification beyond government bonds.

While DeFi protocols like AAVE and Compound attempt to build fully trustless and permissionless protocols, projects like Centrifuge and Goldfinch introduce opportunities for stablecoin holders to participate in off-chain lending markets. By sacrificing trustlessness and permissionlessness, they are able to achieve higher capital efficiency, serve a wider range of use cases, and tailor products for individual borrowers.

Borrowers, typically the initiators of off-chain assets, must undergo 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 their creditworthiness through collective third-party assessments. These projects resemble more like fintech companies than DeFi projects, with the main goal of filling the gaps in financial infrastructure in emerging markets. However, this also comes with a significant risk of ultimately attracting high-risk borrowers that traditional financial institutions refuse to serve, effectively creating a “lemon” market.

Recently, the high interest rate environment has also suppressed some credit market activities and made lenders reluctant to participate in alternative markets.

The high interest rate environment has brought some growth pressure to credit markets like Maple and Centrifuge’s invoice finance business, as investors currently prefer to directly participate in the bond market. This is why Centrifuge and Maple have both added pools for government bond investments in addition to their core businesses to diversify the growth pressure on their platforms.

Overall, in the cryptocurrency community, this direction has not yet proven its product-market fit. We see existing projects focusing more on low-risk alternatives such as investment-grade bonds, senior structured credits, commodity tokenization, and even real estate.

[image source](https://blockchain.miximages.com/cdn-img.panewslab.com//panews/2022/11/28/images/1d4bb9c956ad4bf85649e97364762c88.png)

Exploring the demand for RWA

Crypto native users

In the past 15 years, crypto native users have accumulated a significant amount of on-chain wealth and developed a habit of keeping most of their wealth on-chain. For those accustomed to using crypto rails, going back to the cumbersome traditional financial (tradFi) infrastructure can be quite inconvenient. However, many people are seeking to diversify their wealth into assets unrelated to cryptocurrencies. The tokenization of real world assets (RWA) allows them to enjoy the benefits of diversification while maintaining the on-chain experience.

In addition, the growth of the on-chain economy has led to multiple DAOs managing eight to nine-digit budgets, with a majority focused on volatile crypto assets. As part of prudent financial management, we expect to see more DAOs deploying part of their balance sheets into RWA.

Can RWA categories attract traditional financial audiences to shift toward crypto rails?

For us, the answer is yes.

Some tokenized RWAs can be traded around the clock, for example, tokens such as [Backed](https://backed.fi/) can be freely traded on decentralized exchanges (DEXs) at any time. This provides the market with another venue where they can respond to new information in real-time, even outside traditional financial exchange hours.

As cryptocurrencies become more mainstream asset classes, the overlap between crypto and stock investors will only increase. Traditional financial holders may be interested in leveraging the composability and innovation of DeFi. For example, imagine a product similar to Liquity that allows users to issue zero-interest loans for their retirement investments in a standard & Poor’s 500 index ETF. Such a product will certainly have a certain audience.

Summary

Many people are wondering how the above-mentioned protocols will change when the high interest rate environment changes. We believe that the high interest rate environment is actually a temporary measure for these protocols to generate revenue, but the ultimate focus is still on their core businesses. For example, MakerDAO’s long-term focus is still on expanding the influence of DAI (circulation and application scenarios); although Centrifuge’s T-bills business also generates some income for them, their main focus in the future is still on invoice finance (programmable decentralized invoice finance infrastructure); similarly, Maple Finance’s long-term value lies in doing well in credit lending and borrowing (after experiencing some past mistakes, Maple Finance is actively looking for credit solutions that can better balance risk and capital efficiency), so ultimately everyone will return to their core business or expand upon it.

Furthermore, since the rise of cryptocurrencies, Real World Assets (RWA) have gained significant attention in the crypto field, particularly with the success of stablecoins like USDT and USDC, which have become a lucrative area in the crypto market. The landscape of RWAs in the crypto field is undergoing a transformative journey, presenting a delicate canvas full of challenges and opportunities. At the forefront of this evolution are stablecoins, as the main RWAs, seamlessly integrating into the crypto market. Their widespread adoption signifies a validated product-market fit, providing a stable bridge between traditional financial systems and the vibrant decentralized finance (DeFi).

However, stablecoins also pose challenges and risks, such as value allocation, lack of transparency, and scalability issues. A deeper examination reveals a complex narrative. Centralized stablecoin entities, while investing the entrusted fiat and earning substantial profits, face scrutiny as they transfer the underlying investment risks to users, without users receiving any returns from the underlying assets. This dynamic reveals a delicate balance between entity profitability and fair treatment of its user community.

Tokenized government bonds, as a bridge between traditional finance and decentralized finance (DeFi), have also garnered interest in favorable circumstances, bringing credit lending protocols into the spotlight. Tokenization of various assets like stocks, real estate, and commodities is expanding, offering more investment opportunities. Despite limitations in integrating RWAs, DeFi protocols have made significant strides in building bridges for easier access. This evolution opens up unique opportunities for DeFi native users who have accumulated substantial on-chain wealth over the past decade.

The fusion of traditional finance (tradFi) products with blockchain technology portends innovation, unlocking novel financial tools and strategies. As the overlap between traditional and crypto investors continues to grow, the synergistic effect between these two worlds is poised to redefine the financial landscape. The potential for collaboration offers prospects of developing untapped markets and creating novel, inclusive financial ecosystems.

In summary, the future of RWAs lies in asset and capital expansion, as well as addressing current challenges. This progress is necessary for diversification, convenience, access in geographically restricted areas, and regulatory support. However, it must be acknowledged that the process of RWA-ization, while opening up new avenues, also introduces a trade-off. The effective integration of RWAs inevitably compromises the trustless nature that the crypto space has long embraced. Finding the right balance between innovation and decentralization will be the key challenge we face in this ever-evolving field.

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