In-depth study of the RWA protocol mechanism and ecosystem.
Study of RWA protocol mechanism and ecosystem.
Authors: Taeheon Lee & Jungwoo Pyo, Crypto KOL; Translation: LianGuaixiaozou
In this article, we will delve into the key issues of risk management for Real World Asset (RWA) tokenization. We will analyze how different protocols handle such risks and discuss all the potential challenges encountered so far. Then, we will explore how DeFi protocols are penetrating the RWA collateralized lending market. Finally, we will evaluate a range of perspectives surrounding RWAs in the Web3 space and consider the unique benefits and limitations these assets may bring to the Web3 industry.
1. Managing default risk of RWA loans
In this section, we will discuss significant default risks associated with the use of RWA collateral and strategies to mitigate such risks. Before diving into the details, it is crucial to understand the risks of token collateralization in traditional DeFi and how existing DeFi protocols handle default risks. We will start with the basic background and then shift the focus to the differences in defaulting on loans supported by RWA tokens and examine how various RWA protocols address these challenges.
1.1 Loan position default in early DeFi protocols
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In previous DeFi models, when users deposited stablecoins into protocols, they only needed to be concerned about whether the protocol mechanisms could protect the value of their deposits. In other words, it was essential to assess whether the protocol could execute liquidation processes when the price of the collateral tokens dropped for borrowers. For example, if you were a USDC depositor on AAVE, all you needed to care about was whether the protocol would liquidate the borrower’s position to protect your USDC when the collateralized ETH price dropped. The same applied to MakerDAO. To maintain the value of DAI at $1, all that needed to be done was to liquidate the borrower’s collateral position before the value of the collateral held by MakerDAO fell below the value of DAI issued as a loan.
Therefore, from the depositor’s perspective, they only needed to check if the protocol utilized appropriate mechanisms from major protocols like AAVE or MakerDAO and if there were any default cases. From the protocol’s perspective, when a default occurred, it would examine what went wrong with the mechanism and make appropriate modifications solely to address the default case.
In March 2020, MakerDAO experienced a large number of defaults due to a significant drop in token prices. The issue at the time was poor design of MakerDAO’s liquidation mechanism, which prevented liquidators from participating in the liquidation process as required by the protocol. MakerDAO made improvements to the protocol during the recovery phase, including significant updates to its collateral auction process for liquidations.
In addition to the liquidation mechanism, existing DeFi protocols also have risk parameters related to liquidation to prevent defaults. With the help of a token economic modeling company called Gauntlet, DeFi protocols such as MakerDAO and AAVE have set loan-to-value (LTV) thresholds for liquidations and adjusted these parameters when they believe the market is in a bearish state to ensure the protection of their collateral assets. For example, in December 2022, AAVE community increased the required collateral amount for stablecoin loans in response to the slowdown in the crypto market.
In previous DeFi models, there would be no default if the protocol’s token assets were priced correctly and collateral was disposed of at that price. In other words, in the traditional DeFi model, if a protocol defaults, it is a problem with the protocol design, indicating that the protocol design is poor or has not reasonably considered the risks that the protocol may face.
1.2 Default of Loan Positions in RWA Protocols
1.2.1 Borrower Default Awareness
RWA protocols have a slightly different perspective on defaults: they recognize that defaults can occur for each RWA token collateral and do not believe that the protocol is obligated to prevent such situations.
In traditional DeFi, when the price of collateral tokens falls below a certain level, they can be sold on the on-chain market. However, RWA tokens do not have a market where they can be sold immediately at a fixed price. Therefore, even if the price of RWA falls, it is difficult for the protocol to sell collateral to protect the value of protocol assets. In addition, it is currently unclear whether the token ownership on the blockchain reflects the actual ownership of RWA, regardless of the degree of tokenization of RWA. These two factors make it practically impossible to quickly liquidate collateral on the blockchain and redeem the borrower’s loan position when it is necessary to liquidate RWA token collateral.
1.2.2 Tranche Grading: A Default Response Mechanism
For this reason, RWA protocols assume that defaults can occur at any time and focus on how to allocate asset losses to lenders when defaults occur, rather than preventing protocol defaults through liquidation. Specifically, some lenders may be willing to deposit because they expect a high interest return, even if there may be some capital losses, while others may prefer not to bear any losses, even with a low return rate. RWA protocols classify lenders and deposits based on the lenders’ risk preferences, even for the same treasury.
This structure is known as tranche grading in traditional finance. Most RWA protocols adopt a grading structure when receiving lenders’ deposits, usually divided into senior tranches and junior tranches. Senior tranches are a form of financing that can prevent losses but have limited returns, while junior tranches are a capital pool that can achieve higher returns but are the first to suffer losses.
The design of the treasury that receives lenders’ deposits in a grading structure is also the same as the grading used in traditional finance. When borrowers repay the principal and interest they borrowed, repayment is first allocated to the senior tranches and then to lenders who deposited in the junior tranches. The remaining amount is allocated to the junior tranches. In the event of borrower bankruptcy, the unpaid amount losses are borne first by the junior tranches. When the junior tranches cannot recover all the unpaid amounts individually, the losses are then borne by the senior tranches.
1.2.3 GoldFinch Finance Senior Tranches
Both TrueFi’s structured credit pools and Centrifuge Tinlake’s Tin & DROP pools have senior and junior tranches. However, GoldFinch Finance’s tranche structure is slightly different: lenders who deposit assets directly into specific pools are called backers, and all their deposits are considered junior tranches. On the other hand, lenders who deposit money into the GoldFinch protocol instead of specific pools are called liquidity providers, and their deposits are considered senior tranches. The amount of funds deposited by backers into each pool determines how much of the senior tranches’ funds will be allocated to each pool. As a result, each pool is able to borrow more liquidity than what is provided by the backers, making this model a leverage model.
Let’s speculate why GoldFinch uses a different senior tranche structure compared to other RWA protocols. First, GoldFinch’s target borrowers are businesses in developing countries (even though they have their own characteristics), so it seems natural to bundle all of GoldFinch’s loan pools together to create a deposit product for their risks and returns, and package the senior tranches as diversified investments in developing country financial products for users. On the other hand, it wouldn’t make sense to bundle all loans in the protocol into a single deposit product for other RWA protocols due to the differences in loan targets.
1.3 Design Considerations for Tranche Structure
1.3.1 Importance of Providing Funds for Junior Tranches
As mentioned above, in RWA token-backed lending protocols, if borrowers fail to repay their loans, the protocol will face unrecoverable losses, and the lenders of these pools may not be able to recover their tokens. Considering that lenders are primarily token holders who deposit stablecoins and expect returns with relatively small asset loss risks, there needs to be a way to limit the scale of losses for lenders in the event of borrower default.
In current RWA token-backed lending protocols, junior tranches serve this role. Junior tranches act as a buffer for losses, allowing ordinary investors to invest in RWA protocols relatively easily. In other words, RWA token-backed loans are not “risk-free,” and junior tranches act as insurance for each loan position. RWA protocols need to focus on ensuring the scale of junior tranche deposits and monitoring whether each pool’s junior tranches provide sufficient returns for junior tranche depositors.
1.3.2 Setting the Ratio of Junior and Senior Tranches
If the scale of junior tranches is too small relative to the size of loans originating from pools, then the junior tranches will not be able to absorb enough losses; therefore, the scale of junior tranches should not be too small. On the other hand, if the scale of junior tranches is too large, then due to the structure of junior tranches, you may not be able to generate enough interest income to invest in junior tranches. This means that you need to set the ratio of junior and senior tranches appropriately. This ratio can be determined by considering the following factors:
The probability and expected loss of borrower default. The higher the probability of defaulting on your vault, the larger the size of the junior tranche should be. To determine the likelihood of borrower default, you can use the following information: the borrower’s past loan and repayment history, the stability of the price of the borrower’s pledged RWA and the ease of disposal, and the overall market conditions.
The competitiveness of junior tranche returns. The expected interest rate of the junior tranche should naturally be higher than that of the senior tranche, and at least moderately higher than the interest rate that stablecoins in other DeFi platforms can earn, so that token holders are motivated to deposit their assets into the senior tranche.
The above factors should be continuously monitored in the RWA protocol to track whether the junior tranche can maintain its size. If the return on junior tranche deposits is low, it is recommended to use tokens in the protocol to reward the junior tranche depositors.
1.4 Case Analysis
1.4.1 Default Cases
In 2022, there was a series of news about defaults on the RWA protocol vault: first, the $3.4 million loan default by TrueFi to Blockwater Capital. Invictus Capital, a cryptocurrency fund that borrowed money from TrueFi, also failed to repay a $1 million loan on time. Maple Finance also failed to recover 2,400 wETH lent to the cryptocurrency fund Auros Global. In addition, a series of vault defaults managed by Celsius, Alameda, Orthogonal Trading, M11, and other companies led to a $54 million loan default in December 2022 for Maple Finance. Apart from Maple Finance, TrueFi and Centrifuge also experienced defaults of $4.4 million and $2.5 million respectively.
Defaults that occurred after October 2022 have one thing in common: the borrowers are all cryptocurrency funds that often keep the borrowed assets on exchanges like FTX. They plan to use the loans in the RWA lending protocol to execute their strategies, such as market-making and arbitrage, to earn profits to repay the loans and interest. However, when FTX collapsed, their loans were frozen on the exchange, and they couldn’t repay the loans in the RWA protocol. Besides FTX, there is another case involving Invictus Capital, which suffered significant losses and couldn’t repay the loan after the collapse of the Terra stablecoin.
In the RWA protocol, in the event of a vault default, the losses will be shared by the lenders who provided funds to the vault. When Babel Finance’s $10 million loan from Maple Finance defaulted in July 2022, the outstanding default amount was recorded as a loss for the vault, resulting in a 3.2% loss.
1.4.2 Protocol Mechanism Improvement
Maple Finance changed its mechanism direction after last year’s default events, providing insights into other default risk management methods that can be considered for the RWA protocol in addition to the above mechanisms.
Borrower diversification – One of the reasons why Maple Finance experienced such a large-scale loan default (over $50 million) last year was the high concentration of cryptocurrency funds on the borrower side. Since the borrowers are participants affected by the cryptocurrency market, when events like the collapse of FTX occur, many vaults will simultaneously face the inability to repay. From the perspective of the protocol, such a large amount of unpaid loans at once brings a heavy burden to the protocol, which needs to be recovered by the vaults created by the protocol. Maple Finance also recognized this issue and decided to achieve borrower diversification starting from 2023.
Empowerment of Vault Administrators – Previously, vault administrators were not able to declare defaults immediately in the event that borrowers failed to repay. They had to wait for a certain period of time. On the surface, this may not seem like a problem since defaults are triggered by the mechanism defined in the agreement. However, as there was no way to liquidate the collateral of the borrowers to force them to repay the loans, the RWA protocol required the lenders to freeze the vault assets as soon as they determined that the vault had lost its ability to repay, in order to protect the lenders’ assets as much as possible. In light of this, Maple Finance modified the agreement to allow vault administrators to declare defaults immediately if they believe that the borrowers have lost the ability to repay.
Adjustment of Vault Administrator Incentive Mechanism – One issue that emerged during defaults in 2022 was that some vault administrators did not share accurate information about the status of the vaults they managed and the repayment status of the borrowers. Given the nature of the RWA protocol, which relies not only on the agreement logic but also on the trust relationships among the lenders, borrowers, and administrators using the protocol, this behavior of the administrators could lead to greater default losses. In this regard, rules are needed to compel vault administrators to deposit a large amount of assets into the primary tranches when creating vaults.
2. DeFi Protocols Entering the RWA Collateralized Loan Market
Since the second half of 2022, one of the most discussed issues in the RWA ecosystem is the emergence of several projects in existing DeFi protocols that have announced their intention to include RWA. MakerDAO and AAVE are the most prominent examples, and Frax Finance is also actively discussing mechanisms related to RWA. In this section, we will discuss the background environment in which MakerDAO and AAVE attempted to introduce RWA and the forms they took.
2.1.1 Purpose of Introducing RWA
Protocol’s Stable Growth – One of the main agendas of the MakerDAO community has always been to create a stable way to increase the issuance of DAI. One of the major issues MakerDAO has faced since operating stablecoins in 2018 is that it cannot continue to increase DAI solely based on ERC20 token collateral. MakerDAO recognizes that relying solely on token collateral would make the issuance of DAI too dependent on long-term demand for cryptocurrencies. By including RWA collateral, MakerDAO hopes that DAI will provide utility as a borrowing tool for entities interested in RWA or credit loans. Under this strategy, MakerDAO will no longer rely solely on market conditions for cryptocurrencies, but will also be able to create DAI demand based on the real economy. As a result, the issuance of DAI will be able to grow more steadily.
Monetization – Initially, MakerDAO created demand for DAI through the DAI Savings Rate (DSR) provided by the protocol, and the interest paid by borrowers became the main source of income for the protocol. However, the MakerDAO community soon realized that token yields were not high and not sustainable, so they began to focus on the revenue from RWAs, which is relatively high and sustainable. They started issuing DAI directly to entities that wanted to borrow against RWA and made RWA revenue the main source of income for the protocol.
2.1.2 Adoption of Standards
Whenever MakerDAO creates a vault for a specific RWA or provides a loan secured by RWA to a specific borrower, it relies on the support of community members to make decisions. When making these decisions, the MakerDAO community uses the following evaluation criteria:
Scalability: First, MakerDAO requires that the RWA must have a sufficiently high circulation and a large enough market scale to increase the issuance of DAI.
Stability: Since RWA is used as collateral for issuing DAI, it is crucial that the collateral maintains its value stability. Therefore, the MakerDAO community needs to determine whether the price of RWA is sufficiently stable and whether there is enough liquidity in the market to handle them. In addition, the protocol also evaluates whether there are any risks that may jeopardize the stability of MakerDAO.
Demand: Even if MakerDAO accepts RWA as collateral and issues DAI, it doesn’t make much sense if borrowing from traditional financial institutions is better in terms of interest and other financial costs. In this regard, the MakerDAO community will assess the utility of borrowing on MakerDAO from the perspective of RWA owners, that is, whether MakerDAO and RWA owners can mutually benefit.
Regulatory Risks: In addition to dealing with RWAs, the MakerDAO team also considers whether more regulatory or legal entities need to be involved in the process of including assets in the protocol, and whether there are additional technical, economic, or regulatory risks.
2.1.3 Implementation Steps
In addition, MakerDAO summarizes the specific steps required to adopt RWA.
How to convert RWA assets into tradable assets on MakerDAO? In order to use RWA as collateral for the protocol, users need to be able to tokenize them and have appropriate legal mechanisms to allow them to handle RWA when liquidation is needed.
In the traditional financial world, is it possible to prevent DAI borrowers from re-collateralizing the same asset? Since the legal rights of tokenized RWA are separate from the rights in the real economy, borrowers may borrow from MakerDAO using their RWA and then borrow again from traditional financial institutions. If this happens, borrowers are less likely to repay the loan they obtained from the RWA protocol. In this regard, MakerDAO is trying to prevent borrowers from using their RWA as collateral to obtain another loan.
Is it possible to reliably retrieve price information, etc.? How will the Oracle be designed? Even though there are differences in how collateral is handled in the liquidation process, since RWA acts as collateral, the value of RWA still has a significant impact on the repayment potential of borrowers. In this regard, MakerDAO is concerned about how to reliably obtain the value of these RWA assets.
2.1.4 Adoption Status
In July 2022, MakerDAO established the Real-World Finance Core Unit with the aim of increasing MakerDAO’s influence in the real-world finance. Through this unit, the protocol team has been providing loans supported by RWA to participants in the real-world finance and continues to create vaults for them. The operation of these vaults is to directly issue DAI to borrowers in need of loans. The main vaults are as follows (as of March 2023).
The amount of DAI issued as RWA collateral on MakerDAO has now exceeded $600 million, and the issuance speed of DAI has been growing rapidly, especially since the end of 2022. Vaults like RWA009-A are particularly important because they provide funding directly from MakerDAO instead of being borrowed from government-regulated banks. In terms of protocol revenue, it also helps increase the net revenue of the protocol. As of January 2023, the value of DAI issued as RWA collateral is approximately $650 million, accounting for about 75% of the total protocol fee revenue.
In this context, MakerDAO is constantly reviewing and evaluating vaults that lend DAI as RWA collateral, such as short-term bonds, institutional credits, and energy production facilities.
The MakerDAO community states that each RWA must be processed through governance to determine whether to handle the assets, which is inefficient and slow. Therefore, MakerDAO is seeking to collaborate with RWA tokenization and RWA collateral loan protocols such as Centrifuge (+ Tinlake) to allow the RWA protocols to take the necessary steps in handling RWA assets. MakerDAO is also in talks with Maple Finance for collaboration. In this collaboration, Maple Finance will once again be used as infrastructure to facilitate RWA-based collateral loans. MakerDAO may issue DAI to Maple Finance and adjust the DAI issuance limits and default interest rates of each vault based on the risk of each vault. In the collaboration with RWA protocols, MakerDAO expects other protocols to play the following roles: (1) attract and manage borrowers, (2) handle legal procedures or organize legal structures, and (3) handle defaults.
The rise of GHO – In July 2022, the Aave governance forum proposed a plan for issuing a stablecoin called GHO based on the Aave protocol in a proposal called “Introducing GHO.” Like other stablecoins, GHO will be backed by multiple asset classes. However, it is worth noting that it is not specific to cryptocurrencies but a set of loosely correlated assets such as RWA and credit scores.
In the GHO mechanism, an entity called the Facilitator is authorized to issue GHO tokens instead of a single entity managing all collateral. The Facilitator proposes the issuance method of GHO to the community, and if the proposal is approved, GHO can be issued within a certain range according to the method proposed by the Facilitator. Interestingly, the Facilitator is not required to adhere to issuing stablecoins collateralized by cryptocurrencies; in fact, GHO can be issued/destroyed in any way defined by each Facilitator, including collateralization with multiple asset classes, algorithms, based on credit or delta-neutral positions. The more diverse the Facilitators, the more stable the price of GHO.
The importance of RWA in the DeFi space – In November and December 2022, the Aave community began discussing the importance of RWA. In an article titled “Helping Aave Think About RWA,” Punia from Warbler Labs pointed out that RWA can help the Aave protocol in two ways: by providing stability through diversification of collateral beyond cryptocurrencies and by leveraging a larger asset pool than cryptocurrencies to expand GHO into a global stablecoin.
In the article “Why RWA is important for DeFi”, the author believes that although DeFi can achieve a certain degree of growth (about 10 times) by focusing on native cryptocurrencies, the size of the cryptocurrency market is clearly limited, and RWA is necessary to achieve larger growth (about 100 times). DeFi needs to capture a portion of the market share from TradFi in order to eventually enter the mainstream.
DeFi and TradFi are similar to the reversal of the proportion between e-commerce and physical store transactions, as with the development of blockchain technology and its increasing activity, people will prefer DeFi over TradFi.
There has always been a demand for users in the financial field, and people always hope to have more flexible ways in financial applications and funds. DeFi can better serve them in all these aspects.
The visibility and interoperability of DeFi make it more secure and less volatile than centralized protocols, thereby better serving the entire economic system.
The success of MakerDAO – The success of MakerDAO further strengthens the use case of RWA based on the Aave protocol. Stable income from DeFi protocols is crucial for its sustainability. According to the article “Overview of Aave’s RWA Strategy,” as of November 2022, MakerDAO has obtained over 50% of protocol revenue from RWA.
The graph above shows the income distribution of MakerDAO by asset. As of March 2023, RWA accounts for more than 50% of the income. Over time, the share of RWA in total income is increasing, indicating that RWA is much more important than we imagined.
2.2.2 Effects and Expected Results
According to the article “Overview of Aave’s RWA Strategy,” the risks of using on-chain assets as collateral for GHO in Aave are as follows:
During market downturns, if the relevant assets lack market liquidity, the protocol is at risk of accumulating debt, that is, if only cryptographic assets are considered collateral, there is a risk of protocol default.
The lack of liquidity in the protocol ultimately makes it vulnerable to economic attacks or liquidations.
Cryptocurrency assets are highly sensitive to market conditions. During market downturns, the cash flow of lending protocols may deteriorate due to reduced leverage demand.
Ultimately, when RWA assets are provided as collateral for GHO, the Aave community hopes to see the following effects, which are broadly consistent with the expected effects when the MakerDAO community decided to accept RWA:
Since RWA is more stable and less volatile than cryptographic assets, its risk is more dependent on macroeconomic flows and more resilient to volatility in the cryptocurrency market itself.
RWA borrowers’ funding is typically used for productive businesses rather than speculative trading. This is much larger in scale than cryptocurrency speculation, whether in a bull or bear market.
2.2.3 Aave’s RWA Adoption Strategy
Compared to traditional cryptocurrencies, RWA is a completely different asset class. There have been many discussions in the Aave community on how RWA should be implemented. In the article “Overview of Aave’s RWA Strategy,” the author elaborates on the different elements of DeFi to illustrate which elements are advocated.
Asset Types: The author advocates for the introduction of low-risk, low-yield RWA first to understand how it functions in the crypto market, establish long-term trust in RWA Facilitators, and gradually introduce higher-risk, higher-yield assets. The asset types should not be directly related to the crypto market, excluding loans to market makers, miners, DAOs, etc.
Debt Ceiling: In the real world, adopting GHO as the legal tender takes time, so we must assume that all borrowers will initially exchange GHO for existing legal tenders (USDC, USDT, USD, etc.). That’s why the specified debt ceiling should be proportional to the liquidity available for selling or redeeming existing stablecoins because ultimately, it is important for GHO to maintain its value pegged to the US dollar. In summary, the debt ceiling should be such that if a large amount of GHO is sold to the market, the debt ceiling will not be devalued.
Interest Rates: The author believes that Aave’s current interest rate model should not be applicable to RWA, and the interest rates should be based on underwriting and similar TradFi transactions. This is because Aave’s Facilitators can set different interest rates for RWA compared to other asset classes.
2.2.4 Adoption Case
On December 28, 2021, Aave partnered with Centrifuge to launch the RWA market for tokenizing RWAs. The RWA market provides Centrifuge Tinlake’s TIN & DROP model in Aave’s services, allowing depositors to earn income by collateralizing stablecoin-related RWAs, and Centrifuge issuers to use Aave lending as a source of liquidity for the crypto market.
Since the RWA market is a closed market, only users who have been verified through the KYC process as depositors can participate as investors. Issuers (Centrifuge issuers) can create pools for their assets, with LP tokens corresponding to Centrifuge Tinlake’s DROP. Depositors (investors) can deposit USDC and purchase DROP from the pool.
The RWA market grew rapidly after its launch, surpassing $20 million in April 2022. However, during a market downturn, the market size contracted, and as of March 2023, the total market size is approximately $7.5 million. Fortunately, there were no fund defaults, and the protocol itself operated steadily as expected.
Through the operation of the RWA market, Aave has learned that several key challenges need to be addressed to truly introduce RWA into DeFi.
It needs to collaborate with experts in various fields related to risk assessment (RA) or underwriting.
Borrowers should carefully consider their strategies, taking into account the lifespan and liquidity of RWA collateral, as it is fundamentally a different type of asset compared to highly liquid assets like cryptocurrencies.
RWA funding relies on Aave’s stablecoin liquidity, which is often influenced by factors outside of Aave.
RWA Facilitator. Examples from the RWA market show us the potential of introducing RWA into DeFi. We have seen discussions about using RWA Facilitator as one of the driving factors for GHO issuance progressing. As of December 2022, Centrifuge will continue to strive to become a comprehensive service provider as a GHO RWA Facilitator.
In previous articles, we identified some key challenges that need to be addressed to make RWA scalable. In the Aave protocol, we expect the RWA Facilitator to have the following characteristics:
Compatibility with DeFi: This means ensuring that RWA collateral is well integrated into the on-chain ecosystem.
Trustworthy infrastructure: Intermediary services involving RWA collateral require a high level of transparency within a sound legal framework. To successfully bring RWA into the on-chain ecosystem, a trusted professional brokerage framework is needed.
Centrifuge is currently developing an index token based on assets held in the Centrifuge pool. Index token buyers will purchase a portfolio of Centrifuge assets, which is the result of collective wisdom from the credit community in the ecosystem for risk diversification. The RWA pool can also be a constituent of the index, which could be the best case for RWA as an Aave GHO Facilitator.
3. Current Status and Future of the RWA Mortgage Market
So far, we have described the mechanisms adopted by protocols to handle RWA tokens and why they are designed that way. In this section, we will quickly take a look at the current state of protocols that handle RWA tokens. We will first examine the overall trend of loan amounts and then look at the performance of each protocol.
3.1 TVL and Overall Loan Amount Trend
3.1.1 Growth and Contraction of Cryptocurrency Fund Loans
The chart below shows the active loan volume based on RWA token lending protocols. Prior to 2022, TrueFi accounted for the majority of RWA mortgage loans, partly because TrueFi was the first RWA mortgage lending protocol. Since then, Maple Finance has grown rapidly, and by the second half of 2022, Maple Finance and TrueFi each held a significant share of the RWA mortgage market.
During this period, the borrowers of Maple Finance and TrueFi were mainly cryptocurrency funds engaged in cryptocurrency market making and trading, such as MGNR, Auros Capital, Folkvang Trading, and Alameda Research. Until the second half of 2022, Maple Finance and TrueFi seemed to experience rapid growth as trading firms needed more funds during the cryptocurrency bull market.
However, as we entered the second half of 2022, events such as the collapse of the Terra protocol and the run on FTX Bank had a significant impact on major cryptocurrency funds, resulting in a corresponding decrease in the loan volume for these funds. Therefore, starting from 2023, the weight of Maple Finance and TrueFi in the chart virtually disappeared.
3.1.2 Stable Growth of Non-Encrypted Fund Loans
Although Centrifuge and GoldFinch have not experienced explosive growth like Maple Finance, they have maintained steady growth since 2022 and seem to have maintained the overall loan amount during major events in the second half of last year without significant damage. Centrifuge offers loans for various asset classes, including real estate-backed loans and freight invoice-backed loans. GoldFinch provides loans to fintech companies and real estate companies in developing countries. The chart below shows the various areas in which Centrifuge provides loans, actually lending to various sectors including real estate, developing countries, and institutions.
Centrifuge and GoldFinch did not suffer significant damage last year because their loans were not concentrated in encrypted companies, but rather in non-encrypted companies. Given this, the demand for loans from them remains strong, and the demand is steadily growing regardless of the condition of the cryptocurrency market.
3.1.3 Adding RWA Collateral to DeFi Lending Protocols
In addition, as mentioned above, stablecoins and lending protocols such as MakerDAO, AAVE, and FRAX are actively venturing into the field of RWA collateral loans and slowly increasing the proportion of RWA assets within their respective protocols. Since June of last year, FRAX has been discussing through its governance forum the allocation of FRAX to the RWA collateral loan pool and voting on collaborations with companies such as TrueFi and PropFi. Although we are still unfamiliar with the RWA collateral loan mechanism in DeFi, witnessing the rapid growth of this field in 2023 will be very interesting.
3.2 Benefits of Using RWA
3.2.1 Attracting Real-World Economy Players to Join the DeFi Ecosystem
Most users of DeFi and NFT products are still concentrated among a few who hold and trade cryptocurrencies in the long term. Therefore, in order to develop the Web3 ecosystem, we need to bring more users into the Web3 ecosystem. Various initiatives are underway, such as Web2 X Web3 collaborations and loans supported by RWA tokens, which could be one of them.
If RWA collateral loans can provide value to investment firms and institutions that traditional finance cannot provide, and bring their liquidity into the DeFi ecosystem, it may once again drive the overall growth of the Web3 ecosystem. By gradually bringing more institutions into the Web3 space through RWA protocols, blockchain can be positioned as the infrastructure for emerging financial technologies. Introducing RWA tokens into the DeFi ecosystem is an important step in expanding the user base.
3.2.2 Besides Tokens, DeFi Can Have Other Monetization Methods
As mentioned earlier, RWA collateral allows blockchain projects to generate revenue from sources other than cryptocurrencies. The problem with traditional cryptocurrency-based incentive measures is that they rely too much on market conditions and cannot provide meaningful or sustainable returns.
However, by using interest income from RWA as a new revenue stream, DeFi protocols can have income streams other than newly issued tokens. From the perspective of DeFi, this may be attractive, especially if the risks associated with RWA are well understood and managed. In fact, if you browse the rwa.xyz website, you will see that the average interest yield of RWAs handled by DeFi protocols is 10%. Most of MakerDAO’s income comes from its RWA treasury, so if RWAs are used correctly, the protocol can expand its revenue streams.
3.2.3 Security requirements unaffected by the DeFi cryptocurrency market
In any field, whether it is DeFi or NFT, one of the biggest issues for blockchain projects is that they are highly influenced by the cryptocurrency market, with Bitcoin being the representative. For DeFi lending protocols, this issue is even more serious because people who store fiat tokens (ETH, UNI, etc.) on DeFi lending protocols and attempt to lend are usually trying to take advantage of long positions. Conversely, people who store stablecoins on DeFi lending protocols and wish to borrow fiat tokens represent short positions.
Therefore, if you take a look at DeFi protocols like MakerDAO or AAVE, you will see that the scale of the protocols will increase or decrease dramatically depending on the market conditions. However, if there are entities in the user base of the protocol that hold RWAs, the demand for these protocols will be relatively unaffected by the crypto market and allow for operations with a certain degree of predictability in the scale of the protocol.
3.3 Disadvantages or limitations of using RWA
3.3.1 Trust issues
In addition to the advantages in cost and transaction speed, the ability to achieve expected results without trusting a centralized party has always been one of the most important values of DeFi. However, most DeFi activities that use RWA tokens as collateral are based on trust. When lenders deposit money into the treasury, they must trust the third party, and they must also trust that the borrowers will honestly repay the loan.
Look at what happened to RWA protocols in the past year, with treasury defaults and borrowers unable to redeem their principal due to misconduct by third parties in the treasury. We have experienced such situations, and we will continue to face these trust issues until there is a more solid legal and institutional foundation around RWA tokens. Even then, compared to fully native DeFi, the protocols we use may still have a certain degree of trust issues.
3.3.2 Only a portion of users are eligible for loans
In RWA lending protocols, we mentioned that there is a certain degree of trust required between lenders, borrowers, and third parties, and the loans supported by RWA tokens are indeed used for low-collateral loans. However, due to the need for trust between the parties involved, the user base that is able to borrow through RWA lending protocols is still concentrated in certain institutions. If you look at products like Centrifuge, GoldFinch, Maple Finance, you will find that the entities borrowing or acting as administrators through these protocols are mostly reputable and knowledgeable institutions. There is no market that allows ordinary people to easily mortgage RWAs for loans.
3.3.3 Can it really reduce costs?
Smart contracts can indeed reduce many arbitration costs in financial transactions. However, as for the RWA protocol, the tokenization process of RWA, the identification of borrowers, and the risks associated with RWA will incur additional costs because it requires experts with RWA knowledge and entities to handle legal and management tasks. In fact, some protocols require dedicated tools for each treasury. In this regard, there are still various costs associated with RWA. These limitations will continue to exist until the infrastructure for each RWA is in place and risk assessment standards for various assets are established.
3.4 Personal opinions on the RWA protocol
RWA has great value as it can address some limitations of the blockchain ecosystem and partial inefficiencies in traditional finance. Once we obtain some administrative guidelines on RWA in 2023, RWA will receive more attention from the blockchain market, which is why RWA tokens have attracted a lot of attention and the market will grow in the future.
3.4.1 Need to identify identities different from traditional finance or Web3 products
However, for protocols that deal with RWA, the underlying concept is quite different from many DeFi or blockchain projects. This is because everything is not processed through smart contracts like existing Web3 products, and to some extent, you have to trust someone and accept the accompanying problems. This is very different from existing Web3 products that people in the Web3 field have seen. Protocols that deal with RWA are in between the existing financial system and Web3 products.
In this regard, when protocols deal with RWA, they need to not only understand clearly the value they can bring to the existing financial sector and the blockchain ecosystem through their services, but also understand why they want to try to deal with RWA and the various problems and limitations that may arise in the process, both for the existing financial sector and the blockchain ecosystem. Protocols should be aware of the problems that may arise during operation due to transparency and centralization of information and improve on these issues to make the RWA market development a more mature industry.
3.4.2 Importance of risk management
As I have mentioned throughout this article, protocols that deal with RWA still revolve around lending agreements, where the lending that takes place is based on a form of credit. Since the loans themselves are often for leverage purposes, the lending system itself can become unstable during the process of over-expansion and investment. This risk is more destructive to the protocol, especially because this type of lending is not regulated and monitored like traditional finance, but can be decided by third parties in various treasuries.
Most RWA protocols are not fully prepared to deal with these risks, so these protocols are currently forced to rely on opaque information disclosure (compared to traditional Web3 products), the behavior of certain entities, and the unregulated nature of their mechanisms. In this context, each protocol must always pay attention to the management of these risks.