An Overview of the Mechanisms and Characteristics of Five Major RWA On-Chain Lending Projects

Author: armonio, AC Capital Research

Core Insights

1. The digital crypto ecosystem and traditional finance are mutually necessary. Although the combination is not entirely compatible due to incomplete infrastructure, their integration can still solve practical problems.

2. The mere introduction of blockchain technology cannot resolve the fragmentation of judicial power. Currently, RWA lending does not bring the trustless advantages into traditional finance; instead, it transmits the default risks of traditional finance into the blockchain. In the absence of a trustless environment, some projects attempt to tackle industry challenges through multi-party trust. This is a rare business innovation.

3. Participation qualifications carry over from the traditional world. Permissionless access is not a characteristic of RWA business. Licensing rights are important governance powers. Some projects attribute power to teams, while others rely on token governance. Whether governance is decentralized is a rare breakthrough in RWA lending.

4. Although RWA is not ideal, the market is large enough.

Background

One of the emerging trends in the blockchain and cryptocurrency world is the use of real-world assets to expand on-chain credit. This involves utilizing blockchain technology to create digital representations of real-world assets, such as real estate, commodities, or artworks, and using these digital assets as collateral to issue on-chain credit. By doing so, borrowers can access credit more easily and cheaply than traditional loans, while lenders can earn interest from the assets they hold by providing liquidity to the market. This approach has the potential to democratize access to credit and make it more inclusive, particularly for underserved or marginalized communities that struggle to obtain traditional financial services. Furthermore, by using real-world assets as collateral, on-chain credit markets can be more stable and less susceptible to the volatility and speculation that may plague other forms of cryptocurrency lending.

Overview of the Traditional Global Bond Market

The traditional bond market has a long and rich history that dates back to the 17th century when the Dutch East India Company issued bonds to finance its trading activities. Since then, financial markets have grown significantly, and bonds have gradually become an important financing tool for governments, corporations, and other institutions.

In modern times, the traditional bond market can be summarized as a decentralized global network of buyers and sellers, where transactions involve debt securities or bonds issued by borrowers seeking to raise funds. The market is highly diverse, with bonds issued by governments, corporations, municipalities, and other entities, and can be further categorized based on a range of factors such as bond maturity, credit rating, and currency denomination.

Market Situation Summary

According to the Bank for International Settlements, the traditional bond market is vast, with an estimated $123 trillion in outstanding bonds as of 2021. The market is also highly globalized, with bond issuance and trading primarily occurring in major financial centers such as New York, London, Tokyo, and Hong Kong, as well as in regional markets around the world.

Data from the Bank for International Settlements shows that in 2020, the United States and Japan together accounted for nearly half of global bond issuance, while Western Europe and China accounted for another quarter. This reflects the strong presence of developed countries in the market, which have well-established financial systems, deep capital pools, and stable political and economic environments that are attractive to borrowers.

In contrast, developing countries traditionally have a smaller share of the traditional bond market, partly due to their relatively underdeveloped financial infrastructure and political and economic instability. However, in recent years, there has been a trend of increased participation from emerging markets, with issuers from countries like Brazil, Mexico, and Indonesia becoming more active in the market.

• Despite this trend, there are still significant disparities in the distribution of the traditional bond market. For example, according to the International Monetary Fund, developing countries account for only about 20% of global bond issuance, despite representing roughly one-third of the world’s population and a significant share of global economic growth.

One factor contributing to these disparities is the so-called "interest rate gap," which refers to the difference in interest rates between developed and developing countries. Interest rates in developed countries are typically lower, reflecting their stronger financial systems and stable political and economic environments. This makes it more difficult for developing countries to compete in the traditional bond market, as they must offer higher interest rates to attract investors.

Vertical Structure of the Bond Market

The financial infrastructure of the traditional bond market includes a range of participants such as issuers, underwriters, dealers, and investors. The process of issuing bonds typically involves several steps, including selecting the type and structure of the bond, determining the interest rate or coupon, and finding buyers for the bonds. Issuers may work with underwriters, who help market and sell the bonds to investors, or they may issue bonds directly to the public through a public offering.

Once bonds are issued, they are typically traded on the secondary market, where investors can buy and sell bonds based on their market value, which is determined by a range of factors including the credit risk of the bond, its liquidity, and prevailing interest rates. The market price of bonds is also influenced by the yield curve, which reflects the relationship between bond yields and maturity dates, as well as other macroeconomic factors such as inflation and monetary policy.

The traditional bond market has historically played a key role in supporting economic growth and development, providing a reliable source of financing for a wide range of projects and initiatives. However, the market also faces a number of challenges and constraints, such as the risk of borrower defaults, the complexity of some bond structures, and the potential for market volatility. As a result, there is growing interest in alternative financing models, such as blockchain-based lending platforms that use real-world assets as collateral.

Challenges of Traditional Lending

Traditional financial lending faces numerous challenges that have led to a growing demand for blockchain-based lending solutions. Some of the main challenges include:

1. High transaction costs: Traditional financial lending often involves a large number of intermediaries, each taking a cut from the transaction. This can lead to high transaction costs, making it more difficult for borrowers to access credit and for lenders to generate sufficient returns.

2. Lack of transparency: Traditional financial lending may also lack transparency, with borrowers often unaware of the terms and conditions of their loans or the fees and charges associated with borrowing. This can lead to a lack of trust between borrowers and lenders, making it harder to establish long-term relationships.

3. Slow and inefficient processes: Traditional financial lending can also be slow and inefficient, with borrowers often required to provide extensive documentation and navigate lengthy approval processes. This can be particularly challenging for small businesses and individuals who may not have the resources to navigate these processes.

4. Limited access to credit: Finally, traditional financial lending may be affected by limited access to credit, particularly in developing countries or for individuals and businesses with limited credit histories. This can make it difficult for these individuals and businesses to obtain the funding they need to grow and thrive.

These challenges have led to a growing demand for blockchain-based lending solutions that offer a range of benefits, including increased transparency, lower transaction costs, and faster, more efficient processes. As blockchain technology continues to mature and evolve, we are likely to see ongoing innovation in this space as developers and entrepreneurs seek to leverage the unique advantages of blockchain technology to create new and innovative lending products and services.

Blockchain Lending with Real-World Assets as Collateral

DeFi represents a significant shift in the traditional financial system, offering greater accessibility, transparency, and efficiency. As technology continues to evolve and mature, we can expect to see ongoing innovation in this space, with new products and services designed to meet the needs of global users.

A. Definition and Characteristics of Real-World Asset Blockchain Lending

Blockchain lending with real-world assets (RWA) involves using blockchain technology to create digital representations of real-world assets, such as real estate, commodities, or artworks, and using these assets as collateral to issue loans or other forms of credit. This type of lending is often referred to as "asset-backed lending" and has several key characteristics.

First, stability. The use of RWAs provides a more stable and reliable basis for the valuation of blockchain-based financial products and services, helping to reduce risk and enhance the stability of the blockchain ecosystem. This is because RWAs are backed by tangible assets that have intrinsic value and are associated with real-world cash flows, making them less susceptible to volatility and speculation compared to purely cryptocurrency-based lending.

Second, democratization. Blockchain lending with RWAs can democratize access to credit and make it more inclusive, particularly for underserved or marginalized communities that may struggle to obtain traditional financial services. This is because RWAs can be used as collateral to issue loans and other forms of credit that are easier and cheaper to access than traditional loans.

Third, transparency. The use of blockchain technology can enhance the transparency and accessibility of the lending process, as all transactions are recorded on a public ledger that is accessible to all participants. This helps to reduce the risk of fraud and increases trust between lenders and borrowers.

Overall, blockchain lending with real-world assets has the potential to make credit more accessible, stable, and transparent. New mechanisms will reduce risks for all participants, fundamentally transforming the lending industry.

B. Advantages of Blockchain Lending over Traditional Lending

Blockchain lending with real-world assets represents a significant departure from traditional lending models in several key ways.

First, one of the most notable differences is international accessibility and the integrity of the global market. Unlike traditional lending, which is often subject to geographic and regulatory constraints, blockchain lending is available to borrowers and lenders anywhere in the world. This is because blockchain lending operates on a decentralized network that is not bound by any specific geographic location or jurisdiction. As a result, blockchain lending with real-world assets can provide borrowers and lenders with greater flexibility and opportunities to access capital that they may not be able to obtain through traditional lending channels.

In addition to the aforementioned international accessibility, blockchain lending with real-world assets also offers greater accessibility to crypto financial instruments. One example of this is the ability for RWA loan projects to issue tokens that can be refinanced by other DeFi projects. This creates a more interconnected lending ecosystem, allowing borrowers to access funding from a wider range of sources. Furthermore, on-chain activity can serve as evidence for decentralized identity (DID) and reputation systems based on DeFi. This means that borrowers' behaviors and payment histories can be tracked and used to build trust and reputation within the DeFi ecosystem. Finally, blockchain lending can also provide borrowers with greater flexibility, as they can choose different borrowing assets with varying risk exposures based on their individual risk tolerance and investment goals.

Finally, blockchain lending with real-world assets features consensus and democratization. The decentralized nature of blockchain lending means that all participants in the network have a voice in the decision-making process. This stands in stark contrast to traditional lending, which is typically controlled by a small number of institutions or individuals who decide who can borrow and at what interest rates. In the realm of blockchain lending, decisions about who can borrow and at what rates are made through a consensus-driven process, ensuring that all participants have a say in the lending process. This democratic approach to lending helps to enhance transparency and fairness while also reducing the risk of bias and discrimination that may exist in traditional lending models.

In summary, blockchain lending with real-world assets offers several key advantages over traditional lending, including greater international accessibility, accessibility to crypto financial instruments, and a more democratic decision-making process. These factors contribute to making lending more inclusive, transparent, and accessible to a broader range of borrowers and lenders, while also promoting stability in the lending ecosystem and reducing risks.

C. Limitations of Blockchain Lending with Real-World Assets

While blockchain lending with real-world assets has many advantages over traditional lending, there are also some limitations that must be considered.

First, while blockchain technology provides a trustless and transparent platform, blockchain lending with real-world assets introduces credit risk. Even if the assets are backed by real-world assets, borrowers can choose to default, exposing real-world settlement and jurisdictional issues. In such cases, the consensus on the blockchain has already failed, and the trustless aura cannot be cast upon the real-world collateral. Additionally, there may be challenges related to asset valuation, which can make it difficult to assess the appropriate level of collateral required for loans.

Second, global compliance issues may arise when lending across borders. Different countries have varying regulatory frameworks and compliance requirements, which can pose legal and operational challenges for blockchain lending platforms operating across multiple jurisdictions. Compliance with anti-money laundering (AML) and know your customer (KYC) regulations can be particularly challenging for blockchain lending platforms, which may need to work closely with regulators in different countries to ensure compliance.

Third, blockchain lending still faces technical risks. Blockchain technology is still evolving, and there may be technical challenges related to security, scalability, and interoperability that could affect the stability and reliability of blockchain lending platforms. There may also be challenges related to the programming and execution of smart contracts, which could impact the performance and accuracy of lending agreements.

Overall, while blockchain lending with real-world assets has many advantages over traditional lending, it is important to consider the potential limitations and risks associated with this new form of lending. By carefully assessing risks and implementing appropriate risk management strategies, blockchain lending platforms can ensure the continued growth and development of this innovative emerging industry.

Case Studies of Blockchain Lending Projects

After the FTX crisis, the boom of DeFi and DeFi related to RWA has faded. Major participants in RWA during the last bull market have scaled down, with survival becoming the primary goal. However, their strategies are still worth noting. At least, during the bull market, they created explosive business scales.

"Waterfall" Financial Structure

To mitigate the credit risk of real-world asset contamination, most RWA lending has introduced a waterfall structure. It now seems to have become mainstream in the RWA lending industry.

The waterfall structure in CLOs (Collateralized Loan Obligations) refers to the priority of payments to the parties involved in the CLO. This structure is called a "waterfall" because payments flow down in a predetermined order, just like water flowing down a waterfall.

The waterfall structure is typically divided into several "tranches," which are different layers of debt issued by the CLO. Payments are arranged in order of priority, with the highest-ranking payments receiving payment first, followed by the next highest, and so on. The payment waterfall starts at the top of the structure and flows down through each tranche until all payments are completed.

This structure was originally invented in the 1980s but became popular after the 2000s. The main reasons for its prevalence are threefold: 1. The development of financial technology has enabled institutions to measure risks more accurately; 2. Electronic trading systems have reduced transaction costs; 3. In a low-interest-rate environment, as long as you have additional risk information, this structure can provide extra returns.

There is an outlier in RWA, led by Ondo Finance, which provides lending financing backed by high-quality assets such as U.S. Treasury bonds. Due to the extremely low default risk (including interbank bonds from the U.S.), there is no need to adopt a "waterfall" structure to address default risks.

A. Centrifuge Product:

Centrifuge has the largest RWA collateral lending market. As it claims: "Centrifuge is the infrastructure for decentralized financing of real-world assets on-chain, creating a fully transparent market that enables borrowers and lenders to transact without unnecessary intermediaries."

TVL: 192.1M

FDV: 112.2M

Investors: Mechanism:

Features:

On-chain - Off-chain Structure

As a pioneer in the RWA lending industry, Centrifuge adopts an on-chain and off-chain structure to reduce credit risk. In the off-chain structure, it establishes an SPV structure, making it easier to liquidate collateral in the event of a default. It uses centralized KYC and AML services to comply with regulations in different countries. Financial Agreements In addition to on-chain signatures and transaction records, investors can also sign subscription agreements with issuers.

Diverse RWA Collateral

Collateral is diversified, including consumer loans from emerging markets and structured credit. Each project will have an independent SPV wallet to control its fundraising. Interest rates range from 3%+ to 10%+.

High Default Rate

In terms of scale, its default rate for completed loans is 5.6%. A high default rate does not indicate failure; rather, it tends to adopt higher-risk financial strategies. Since it does not intentionally select investment projects, it does not bear any responsibility when projects fail.

B. Maple Product:

Maple is transforming capital markets by combining industry-standard compliance and due diligence with the transparency and frictionless lending brought by smart contracts and blockchain technology. Maple serves as an entry point for financial institutions, liquidity pool representatives, and companies seeking on-chain capital to achieve growth.

TVL: 28.4M

FDV: 78.7M

Backers:

Mechanism:

Maple converts traditional CLOs (Collateralized Loan Obligations) into cryptocurrency form. Each project has a representative who is also the provider of first-loss capital. The representative is responsible for executing impairment in the event of a default. Representatives must be verified by the Maple team.

Features:

Black Box and Centralization:

The power to determine who can become a representative is controlled by the Maple team. Currently, 62% of active loans are given to Maven 11. There is a recovery plan in case of default, along with legal agreements with borrowers.

Moderate Default Rate

Its default rate is 2.935%, but considering the risk exposure ratio to M11, I believe it carries too much risk.

C. GoldFinch

GoldFinch is a decentralized protocol for crypto lending without requiring cryptocurrency collateral. The GoldFinch protocol has four core participants: borrowers, supporters, liquidity providers, and auditors. Unlike other protocols, GoldFinch aims to establish a unified risk asset (RWA) related to actual assets. All assets in the senior asset pool face the same risks.

FDV: 101.6M

TVL: 66M

Supporting Institutions: Mechanism:

Features:

1. Decentralization:

The project features a decentralized decision-making process, where supporters collectively decide whether a project can successfully raise funds and the scale of funding.

2. Innovative Credit Model:

The project employs a leverage model and dynamic supporter incentive mechanism. The leverage model determines the amount of capital allocated from the senior asset pool to each borrower pool based on the trust level of each borrower pool. When more supporters invest in a borrower pool, that pool appears more reliable and can access more leveraged capital.

3. Diverse Borrowers:

The project diversifies capital across different types of borrowers and lending situations, covering everything from fintech in emerging countries to consumer debt support loans in developed countries. The decentralized nature of borrowers means that default risk is also dispersed.

4. Unified Risk and Liquidity:

The project has a unified senior asset pool, with responsibilities and interest rates remaining consistent across the board.

5. Low Default Risk:

So far, the default risk is zero, indicating that the project has a low default risk.

D. Credix

Product

Credix is a next-generation credit ecosystem that enables institutional borrowers to access liquidity and creates attractive risk-adjusted investment opportunities for institutional investors, credit funds, and accredited investors.

Supporting Institutions: Mechanism:

Features:

Centralization:

The project has a centralized underwriting process, with one person responsible for screening, due diligence, and investment structuring. This is similar to the situation in traditional finance where one entity controls the investment process.

Market Specific:

When creating new lending projects, a unique LP token is generated to distinguish investments in different liquidity pools across different markets. However, this may lead to weaker liquidity, as liquidity demand and supply are fragmented.

Non-transferable:

The tokens used in this project are non-transferable and can only be traded in accounts that comply with regulatory requirements. While this design helps with compliance issues, it may make it difficult for individual investors to participate in the market. As a result, many investors may be excluded from participation due to the platform's strict requirements.

Three Layers of Default Protection:

Credix employs multiple methods to ensure that funds in senior collateral can be restored. In addition to over-collateralized assets and funds in subordinate collateral, it can also utilize the payment gap between fintech company revenues and the interest they pay to Credix for restoration.

E. TrueFi:

Product:

TrueFi is an unsecured lending protocol based on on-chain credit scoring, controlled by TRU holders. It is part of the TrustToken ecosystem. There is no explicit solution in the event of overdue or default. The quality of each loan project heavily relies on the decisions of the portfolio manager. It is also a centralized structure.

Supporting Institutions:

Mechanism:

Portfolio managers provide details for each transaction, and borrowers choose whether to accept. Transactions can also be divided into three risk tiers. Different tiers have different default liabilities and interest rates.

Features:

TrueFi has chosen a gradual decentralization process. Currently, the solution is highly centralized. The platform level does not consider default recovery plans. So far, its default rate is 0.258%, which is relatively low. However, this is not a result of TrueFi's systemic credit solutions. Loans do not require real-world assets (RWA) as collateral; they purely rely on the borrower's credit or reputation.

Comparative Analysis:

1. KYC and Compliance:

Since the business involves real-world assets, cash flows, and settlements in the event of defaults, local government support, KYC, and compliance issues are crucial. All these projects place great importance on these matters and have introduced third parties related to this business. As mentioned earlier, the largest part of the financial cost of loans is compliance costs, and these projects do not have more advantages in this regard compared to traditional finance. To meet compliance requirements, even the tokenized certificates are designed to be non-transferable.

2. Credit:

On-chain credit is a good thing for open finance. However, these projects have not attempted to incorporate on-chain credit into project credit assessments. On one hand, DeFi has a short history, and on-chain activity is limited. On the other hand, the cost of creating an anonymous account is nearly zero. On-chain data cannot represent individual creditworthiness. Only GoldFinch has attempted to ensure that each entity can only have one unique account on the platform.

3. Default Recovery Solutions:

Maple Finance, GoldFinch, and Centrifuge provide solutions in the event of credit defaults. For off-chain collateral, these projects prefer to use SPVs to control disposal rights. Credix informs users that they have a team to manage collateral. TrueFi does not provide explicit statements regarding default situations. Interestingly, when FTX collapsed, Justin SUN transferred $6 million from Alameda Research.

4. Transparency:

All on-chain activities are transparent. However, off-chain cash flows and off-chain information related to debt credit need to be disclosed regularly. Centrifuge claims to have a peer-to-peer network for sharing information. However, since the crypto industry is brand new, there is still a need to discuss whether information disclosure should comply with securities laws.

5. Liquidity:

Centrifuge provides withdrawal guarantees for others. GoldFinch has unique credit risk assessments and liquidity in a unified senior asset pool. As the business scales, its liquidity will also increase. Credix has poor liquidity, especially when its loan pool is depleted. Maple Finance does not specify how to establish liquidity.

Conclusion and Recommendations

This is not a good business, but a huge business.

Real-world finance is far larger than DeFi, and the decentralized world is still in its infancy compared to traditional industries. Even a small portion of traditional finance shifting to blockchain would be a tremendous success for DeFi and its infrastructure.

The crypto world needs real-world assets (RWA) to enhance its credit value.

There are fewer stable businesses in the emerging decentralized world. Therefore, the discount rate for collateral is much higher than for real-world assets. We can see that if USDC and USDT support a certain blockchain, that blockchain will have better liquidity and be easier to build DeFi on. The same applies to other business areas. The crypto world needs stable real-world assets to improve its credit. The largest classification of on-chain assets is actually stablecoins. If we retrieve the number of authorizations for centralized stablecoins across different ecosystems, we will find that: the higher the authorization, the higher the valuation of the chain. This is why RWA is so important for the crypto industry.

The imbalance in the development of the global financial system provides a survival space for RWA lending.

In the traditional world, especially in some developing countries, financial infrastructure is limited. Many business opportunities are missed due to the lack of a credit system. The real world needs blockchain to help establish a credit system. There are significant disparities in financial levels between countries and regions. For example, in Kenya, the financial network is not widespread, and many cities lack a financial system. The accessibility of crypto finance is far superior to that of traditional finance.

Lack of Infrastructure

Even though we know there are many advantages to using blockchain, the handling process for each lending case involving the real world and different jurisdictions will affect lending risks. In the real world, the settlement of RWA and other financial and compliance services is very time-consuming and costly. In my view, GoldFinch is the most innovative and decentralized RWA lending project. However, even GoldFinch has not introduced credit scoring for endorsers to assess lending risks. All solutions to default risks rely on individual regulations in various jurisdictions of the traditional world. As long as these regulations are not blockchainized, most financial costs cannot be waived.

KYC and Compliance are just passive requirements for clients

When we read the documentation of these projects, very few lines show the connection between KYC and security. All compliance efforts seem to be merely to comply with the law, not for the safety of clients' funds. All these reasons lead to a huge RWA collateral lending market, but crypto projects find it difficult to scale their businesses in the short term.

References: Financial Infrastructure and Access to Finance: A Global PerspectiveFinancial Infrastructure, Group Lending and Funding Costs in Developing Countrieshttps://uploads-ssl.webflow.com/62d551692d521b4de38892f5/631146fe9e4d2b0ecc6a3b97goldfinchwhitepaper.pdfhttps://rockawayx.com/comms/centrifuge-analysi