IOSG Ventures: How does RWA inject decentralized innovation vitality into DeFi?

Original author: Nelson, IOSG Ventures

Finding the Balance: Navigating the Fine Line between Financial Gain Maximization and Decentralization

Until recently, stablecoins were the only real-world asset (RWA) class 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, with a market capitalization of $86.9 billion, and USDC, with a market capitalization of $24 billion, together account for 7.5% of the entire crypto market’s $1.46 trillion market capitalization.

In the past two years, when traditional finance abandoned the zero interest rate policy and the yield on government bonds exceeded the native yield on DeFi, people understood that the story of RWA did not stop with stablecoins.

Let us examine the RWA market structure, starting from the most stable aspect, extending to returns and risks, and gradually exploring its future development and trajectory.

Types of RWA

Industry developments and challenges

Stablecoins: The backbone of RWA

Stablecoins have become unsung heroes in the ever-changing cryptocurrency landscape. These digital currencies are designed to maintain stability by pegging their value to traditional assets such as the U.S. dollar, and they have played a key role in injecting real-world capital into crypto markets. Here are a few observations on the stablecoin space.

The Lucrative Stablecoin Ecosystem: Cryptocurrency’s Cash Cow

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

For example, consider Tether (USDT) - in the first quarter of this year, its profits exceeded those of financial giant Blackstone Group, with Tether recording an impressive profit of $1.48 billion compared to Blackstones $1.16 billion. What’s more noteworthy is that Tether manages 120 times less funds than Blackstone Group. Tether manages US$70 billion, while Blackstone Group manages US$8.5 trillion. Tether generates most of its revenue from reinvesting its fiat collateral, and recently, their balance sheet has been tilted towards Treasuries. Thanks 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 base rate of return and therefore achieve staggering profits.

However, this also raises the first question for existing stablecoin providers. Centralized stablecoins like Tether and Circle have been criticized for privatizing profits at the expense of socialization, raising issues of fairness. In March of this year, the market suddenly realized that holding stablecoins was not risk-free, and holders would face losses if they encountered any problems related to collateral management, but they were not compensated for the risks they took.

There are also widespread issues of lack of transparency and exposure to undisclosed risks, as seen during the bankruptcies of Silicon Valley banks. At the time of the bankruptcy, the market was unaware that Circle had any exposure to Silicon Valley Bank. On the other hand, while Tether has not been affected by the recent bankruptcies of traditional banks, Tethers balance sheet is still exposed to illiquid venture capital styles as well as lending operations. These are obviously not risks that USDT holders are willing to take.

Both Circle and Tether were designed based on the assumption that their collateral would not lose value and would be 100% liquid, when in reality neither assumption holds true. This makes both Circle and Tether vulnerable to bank runs in a black swan event. By sheer luck, Circle avoided this after Silicon Valley Bank went bankrupt.

Crypto-native stablecoins attempt to control the above risks, however, every design ultimately encounters the stablecoin trilemma, requiring a choice of two of the following three:

• Exchange rate peg (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 didn’t receive much attention beyond the previously mentioned stablecoins, which are more of a safe haven than financing in the crypto market tool. An important catalyst for the recent rise has been high interest rate policy.

The growing gap between returns native to DeFi and returns from traditional finance has fueled interest in solutions that can help bridge this gap. Once again, stablecoins are the protagonist, but this time it’s DeFi’s native stablecoin protocol - Maker DAO.

Specifically, MakerDAO is the third-largest DeFi protocol by total value locked (TVL) and has made a strategic shift in asset management to significantly increase exposure to real-world assets (RWAs). Essentially, the dissatisfaction of Makers governance is that when there are productive and risk-free alternatives, its balance sheet will hold unproductive and risky USDC, which directly exposes Maker to treasury bonds, which will A large amount of off-chain infrastructure and legal means need to be established. Fortunately, Maker, one of the more resourceful DAOs, finally managed to build this bridge. So far its been a success. 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 sea change in the DeFi space, jeopardizing smaller competitors that have been unable to keep up with yields, such as Liquidity’s LUSD and AAVE’s[GHO]This has caused significant pressure and driven overall rates higher 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 Makers RWA strategy may trigger growth in DAI demand and adoption in DeFi protocols.

However, while the RWA strategy helped Maker achieve scalability and optimize its finances, it clearly distanced it from its status as a trustless DeFi protocol.

Adoption Challenges of Tokenized T-Bills in DeFi

Among DeFi projects, no project’s RWA balance sheet rivals Maker’s $3 billion. One of the key challenges to wider adoption of RWA is the limited transferability of tokenized Treasuries within the DeFi ecosystem. Existing infrastructure often blocks their movement between different DeFi protocols and externally owned accounts (EOAs). As a result, tokenized RWA Treasuries face limitations in their usefulness as collateral within the DeFi space.

For DAOs, the ability to directly gain RWA exposure is hampered by legal complexities and inherent risks posed by a lack of off-chain representation. However, innovative solutions like Centrifuge Prime are solving this problem. Centrifuge Prime establishes the legal structure that enables DAOs and individuals to securely access tokenized Treasury securities, mitigating the risks and legal barriers traditionally faced in these transactions. This development represents an important step forward in expanding DAOs’ investment capabilities in secure and regulated assets.

Credit Markets: Higher annualized returns come with higher risks

Credit markets attempt to serve those seeking higher risk opportunities and diversified solutions 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 originators, must undergo traditional due diligence and/or use some RWA collateral to support their borrowing activity. For example, Goldfinch’s “trust through consensus” approach allows borrowers to demonstrate creditworthiness through collective third-party assessments. 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 a significant risk that these solutions end up attracting high-risk borrowers that traditional financial institutions refuse to serve, 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 brought certain growth pressure to credit markets such as Maple and Centrifuges invoice finance business, because investors currently prefer to participate directly in the bond market. This is why Centrifuge and Maple have added additional treasury bond investment pools in addition to their main businesses to diversify the growth pressure on the platforms.

Overall, this direction has yet to prove its product-market fit among the cryptocurrency audience, and we see existing projects placing more emphasis on low-risk alternatives such as investment-grade bonds, senior structured credit, commodity tokens ation, and even real estate.

Explore the demand side of RWA

Encrypt native users

Over the past nearly 15 years, crypto-native users have accumulated a large amount of on-chain wealth and have developed the habit of keeping most of their wealth on-chain. For those accustomed to the crypto rail, going back to cumbersome traditional financial (tradFi) infrastructure becomes quite inconvenient. However, many people are looking to diversify their wealth into assets not related to cryptocurrencies. The tokenization of real world assets (RWA) allows them to enjoy these diversified benefits while maintaining the fun of the on-chain experience.

Additionally, the growth of the on-chain economy has resulted in multiple DAOs managing 8-9 figure fiscal budgets, most of which are focused on volatile crypto-assets. As part of prudent fiscal management, we expect to see more DAOs deploying a portion of their balance sheets into RWA.

Can the RWA category attract traditional finance audiences to the crypto track?

For us, yes.

Some tokenized RWAs can be traded around the clock, such as [Backed](https://backed.fi/). Tokens can be freely traded on decentralized exchanges (DEX) at any time. As a result, markets gain another venue where they can respond to new information in real time, even though traditional financial exchanges may be outside of business hours.

As cryptocurrencies become a more mainstream asset class, the overlap between crypto and stock investors will only increase. Holders of traditional finance may be interested in leveraging the composability and innovation of DeFi. For example, imagine a product like Liquidity that allows users to issue zero-interest loans against their retirement investments in SP 500 ETFs. Such a product would certainly There will be a certain audience.

Summarize

Many people are thinking about how the above-mentioned agreement will change when the high interest rate environment changes. We believe that generating revenue for the above-mentioned agreements in a high interest rate environment is actually a short-term expedient, but the ultimate focus is still on the main business of each agreement. For example, MakerDAOs long-term focus is still on how to expand the influence of their DAI (circulation volume and application scenarios); although Centrifuge also has T-bills business that brings them some income, the main focus in the future is still on invoice finance related matters ( Programmable decentralized invoice finance infrastructure); Maple Finance In the same way, long-term value still depends on credit lending and borrowing (after experiencing some wrong decisions in the past, Maple Finance is actively looking for ways to better balance risks and capital efficiency credit solution path), so everyone will eventually have to return to their original business or expand on it.

Additionally, since the rise of cryptocurrencies, real-world assets (RWA) have gained significant traction within the crypto space, especially with the success of stablecoins like USDT and USDC, which have become a lucrative part of the crypto market. field. The RWA landscape within crypto is undergoing a transformative journey, presenting a nuanced picture of challenges and opportunities. At the forefront of this evolution are stablecoins, which as major RWAs have seamlessly integrated into the crypto market. Their widespread adoption signals a proven product-market fit, providing a stable bridge between traditional financial systems and the vibrant world of decentralized finance (DeFi).

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

Tokenized treasury bonds, as a bridge between traditional finance and decentralized finance (DeFi), have also attracted interest under the current favorable circumstances, which have also brought credit loan protocols into peoples sights. The tokenization of various assets like 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 for easier access. This evolution has opened up unique opportunities for native DeFi users who have accumulated significant on-chain wealth over the past decade.

The integration of traditional financial (tradFi) products with blockchain technology heralds innovation, unlocking novel financial tools and strategies. As the overlap between traditional and crypto investors continues to grow, the synergies between the two worlds are poised to redefine the financial landscape. The potential for 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 RWAization, while opening up new avenues, also introduces a trade-off. The integration of effective RWA will inevitably compromise the trustless nature that the crypto space has always been. Finding the right balance between innovation and decentralization will be a key challenge we face in this evolving field.