IOBC Capital: Why is RWA said to be the next engine of DeFi?

Author: 0xCousin, IOBC Capital

Tokenization of real-world assets may be the next engine for DeFi.

What are RWAs?

RWAs, or Real World Assets, refer to tangible assets. The most popular types of RWAs currently include: cash (USD), metals (gold, silver, etc.), real estate, bonds (mostly U.S. Treasury bonds), insurance, consumer goods, credit notes, royalties, and more.

The asset scale of RWAs far exceeds that of Crypto Native Assets. For example, the fixed income bond market is approximately $127 trillion, the total global real estate value is around $362 trillion, and the market value of gold is about $11 trillion, while the current market value of Crypto Native Assets is $1.1 trillion, only 1/10 of the market value of gold.

If a small portion of these RWAs is brought into the DeFi space, the total scale of DeFi will see a significant increase.

How to Bring RWAs into DeFi?

Typically, smart contracts are used to create tokens that represent RWAs, while providing off-chain guarantees, meaning that the issued tokens are always redeemable for the underlying assets.

RWAs have the following common applications in DeFi:

1. Stablecoins: For example, leading stablecoins like USDT, USDC, and BUSD are all RWAs. Issuers like Tether, Circle, and Paxos mint stablecoin tokens for blockchain and DeFi protocols by maintaining audited USD asset reserves;

2. Synthetic Assets: Synthetic assets also fall under RWAs. For instance, stocks and commodities can be traded on-chain in the form of derivatives linked to synthetic assets. Currently, Synthetix is the most developed in the synthetic asset space, locking in over $3 billion in assets during the peak of the 2021 bull market;

3. Lending Protocols: RWAs have already seen good development in lending protocols. Borrowers use RWAs as collateral, and DeFi platforms can provide collateralized lending services; there are also some credit lending services that do not require collateral, relying solely on brand reputation. The use of RWAs in DeFi lending protocols has played a very important positive role in the sustainable development and revenue scale of DeFi lending protocols.

Current Development Status and Cases in the RWA Sector

RWA Tokenization helps to expand the market scale of DeFi and assists traditional financial institutions in exploring new business models. Leading DeFi protocols are actively laying out RWA Tokenization, and some traditional financial institutions are also very interested in RWA Tokenization.

MakerDAO: RWA business scale exceeds $680 million, contributing over 58% of revenue.

Because the yields of traditional financial systems are currently higher than those of DeFi protocols, for example, the yield on U.S. Treasury bonds is about 3.5%, while the yield on leading DeFi collateralized lending protocols is around 2%, this provides DeFi protocols with an opportunity to obtain sustainable income.

To manage RWA business, MakerDAO established the RWA Foundation. Different foundations may be set up based on the type of collateral, and each SPV can choose the most suitable management jurisdiction/legal structure according to business needs. Its basic structure is as follows:

MakerDAO has made some adjustments in the business logic of collateralized lending for off-chain RWA assets. Mainly, the liquidation part is not executed through on-chain public auctions but is enforced off-chain by third parties. The smart contracts that implement the new functions mainly include:

• RwaLiquidationOracle: Acts as the liquidation beacon for off-chain enforcers;
• RwaFlipper: Acts as a virtual liquidation module in the case of cancellation;
• RwaUrn: Helps to borrow DAI and deliver it to a specified account;
• RwaOutputConduit and RwaInputConduit: Pay and repay DAI;
• RwaSpell: Deploys and activates new types of collateral;
• RwaToken: Represents RWA collateral in the system;
• TellSpell: Allows MakerDAO governance to initiate the liquidation process;
• CureSpell: Allows MakerDAO governance to cancel the liquidation process;
• CullSpell: Allows MakerDAO governance to cancel loans that are being liquidated.

When MakerDAO deems it necessary, it calls tell() on RwaLiquidationOracle. This will start a countdown, and after the remedy period ends, the oracle will begin reporting that the position is being liquidated. If the reason for triggering the liquidation is remedied, MakerDAO governance can restore normal status by calling Cure(); if MakerDAO governance has triggered liquidation and the remedy period has expired without being called, the off-chain enforcer (such as a trustee) can report that the position is in liquidation by calling good().

If there is still debt remaining on the position at the end of the liquidation process, and MakerDAO believes the debt will not be repaid, it can trigger the cancellation by calling cull(). Cancellation is done by setting the collateral value of the system to zero, which will lead to on-chain liquidation of the position through bite(), etc. Unlike the liquidation modules for existing collateral types, the dedicated liquidation module RwaFlipper does not attempt to sell the underlying collateral but simply marks losses on the system's balance sheet by allowing the creation of system debt.

MakerDAO has made significant progress in adopting RWAs. Currently, MakerDAO has a decentralized stablecoin DAI supported by RWAs worth over $680 million.

In terms of RWAs, MakerDAO has broken down its $680 million in RWAs into three specific cases:

1. Most of MakerDAO's RWA collateral (about $500 million) comes in the form of U.S. Treasury bonds managed by Monetalis (MIP65). These assets provide a source of income from idle USDC collateral for the MakerDAO protocol;

2. MakerDAO also launched a vault supported by a $100 million loan from a commercial bank in Philadelphia called Huntingdon Valley Bank (HVB). HVB uses MakerDAO to support the growth of its existing business and investments in real estate and other related verticals, becoming the first case of commercial loans between U.S. regulated financial institutions and decentralized digital currencies;

3. In a separate vault, Société Générale borrowed $7 million from MakerDAO, with its position supported by AAA-rated bonds worth €40 million as OFH tokens.

By introducing RWAs as collateral, MakerDAO has significantly increased its protocol revenue. As of now, over 58% of MakerDAO's revenue comes from RWA business.

Centrifuge: Bringing RWAs into the Crypto ecosystem in the form of NFTs, with a TVL exceeding $170 million.

Centrifuge brings real-world assets into the Crypto ecosystem in the form of NFTs. The dApp of the Centrifuge protocol is called Tinlake, and the product logic of Tinlake is mainly as follows:

1. Asset originators use Tinlake to bridge real-world assets. These assets are converted into NFTs, which include relevant legal documents;

2. Asset originators can use tokenized real-world asset NFTs as underlying collateral to create asset pools;

3. When creating a pool, two tokens are created—DROP Token and TIN Token;

4. Investors can decide which pool to fund based on their individual risk preferences, purchasing DROP or TIN Tokens;

5. DROP Token holders have guaranteed returns, determined by a fee function, with each pool having a fixed interest rate and compounding every second;

6. On the other hand, TIN Token holders do not have guaranteed returns. They receive a variable yield based on the pool's investment returns, which may exceed the returns of holding DROP Tokens;

7. TIN Token holders bear higher risks, as they will absorb the first loss if the borrower defaults.

In addition to MakerDAO and Centrifuge, there are also some DeFi protocols and traditional financial institutions exploring RWAs:

Opportunities and Risks of RWAs

The trust assumption of RWAs: Since the tokenization of RWAs is ultimately off-chain and cannot be enforced through smart contracts for liquidation, it still relies on the endorsement of traditional financial institutions. The trust attributes of these RWAs may never reach the same level as Crypto Native Assets. At the same time, due to the existence of the RWA trust assumption, fully permissionless DeFi protocols also find it difficult to support RWAs. Therefore, current RWA Tokenization projects generally still have centralized entities playing a role and influence in the handling of RWA assets.

Potential opportunities for RWAs: STOs (Security Token Offerings) have traditionally been seen as a limited implementation of RWAs. Since many STOs are often niche securities available only on permissioned platforms, their adoption has not reached the same level as RWAs on public chains. Current STOs are among the few asset tokenization solutions recognized by regulators in the blockchain industry, and the development path of STOs in embracing regulation may also be a direction for RWAs to explore.