The Incredible Opportunity For Real World Asset Tokenization In DeFi

Decentralized finance protocols emerged as a powerful force that attracted thousands of new users into the crypto space in the "DeFi summer" of 2021. There was an explosion in the popularity of DeFi apps focused on crypto lending and borrowing, stablecoins, automated market makers, token swaps, synthetic assets, derivatives and more. 

The total value locked in DeFi, which can be thought of as its total capital under management, hit an incredible $248 billion by the end of that year, driven by rising asset prices and a flood of new users in the space. DeFi's TVL was boosted by an increase in liquidity mining protocols, which boosted yields by paying out rewards in the protocols' native cryptocurrencies. 

However, as we saw, the market showed itself to be unsustainable as "crypto winter" emerged at the beginning of 2022. Token prices declined sharply, and the rewards for DeFi users diminished. For instance, the lending rate of the stablecoin USDC peaked at 18% on Aave in December 2021, but has since fallen to just 0.75% today. 

The fall in DeFi has resulted in investors fleeing to the safety of traditional investments, such as US Treasury bonds that currently yield around 5%, thanks to the Federal Reserve's decision last year to abandon its policy of zero interest rates. As a result, TVL in DeFi has fallen dramatically, to just $46.5 billion today.

RWAs Attracting Fresh Capital

Some DeFi protocols have hit upon the concept of "real world assets", or RWAs that can serve as collateral or new investment opportunities and entice more capital. RWAs come with the promise of more consistent returns for investors. 

The concept of RWAs has been around for a few years but it's only recently that the idea has matured. Asset tokenization refers to bringing real world assets such as private equity, credit, bonds, commodities, real estate and art on-chain. Essentially, they can be represented on blockchains as tokens, enabling fractional ownership. 

RWAs are sometimes referred to as "tokenized securities" or "security tokens" and they offer some distinct advantages to investors. These include greater accessibility through fractional ownership, lower investment minimums, the ability to trade previously illiquid assets and more transparency, as transactions are recorded on an immutable, decentralized ledger. Blockchain protocols can even automate compliance. 

DeFi protocols benefit from RWAs because they can tap into a new class of investors who are unfamiliar or even averse to the idea of crypto. Before RWAs emerged, DeFi protocols could only accept cryptocurrencies such as Bitcoin and Ethereum as capital, limiting them to a very small number of investors. By accepting tokenized assets, DeFi protocols reduce the risk faced by investors and lenders. In other words, RWAs make it possible for a much larger class of investors to access DeFi opportunities.

The Leading Players

In order to remain attractive, DeFi is required to offer more attractive yields than traditional markets. A new breed of DeFi protocols, including Maple Finance, Creditcoin and Centrifuge are doing exactly that. They all use RWAs to pool funds from investors and lend them out, generating yield in return. 

Maple Finance has created a platform that enables institutional investors access to undercollateralized loans. It's based on the idea of lending pools that anyone can invest in. The lending pools are underwritten and managed by pool delegates, who are credit professionals tasked with sourcing institutional borrowers. The pool delegates also structure the terms of each lending pool. Investors can choose to deposit their funds into any lending pool they wish, essentially lending their crypto assets in return for the chance to earn yield. To date, Maple Finance claims to have lent a total of more than $1.8 billion through its lending pools. 

Creditcoin meanwhile is a credit network that's focused on facilitating loans to businesses in emerging markets, including those that are underserved by banks. Creditcoin works by matching investors and lenders with fundraisers or borrowers that have matching loan conditions. The basic premise is that Creditcoin is able to reduce the costs associated with verification and risk assessment by using blockchain to immutably record credit transaction events. Therefore, lenders can access the on-chain history of borrowers to assess the potential risks, making more informed decisions over who to lend to. 

It's a transparent ecosystem that enables DeFi to shed its traditional overcollateralization requirement for borrowers. Creditcoin empowers investment in RWAs by directly connecting investors to junior tranche debt opportunities. This secured, subordinated debt provides lenders with the capital required to extend credit to the estimated 1.4 billion unbanked or underbanked people in the world. Meanwhile, investors can earn yields of up to 20% APR. To date, Creditcoin has facilitated more than 3 million transactions worth a combined $70 million in value. 

While Creditcoin is more focused on credit, Centrifuge enables a much wider gamut of RWAs to be brought on-chain, including things like invoices and real estate. It operates a marketplace known as Tinlake that allows borrowers to convert their RWAs into non-fungible tokens or NFTs. These tokens can then be used as collateral to create asset pools, enabling investors to provide capital in a secure way. 

The potential impact of RWAs on DeFi is astonishing. For instance, one estimate valued the world's real estate market at $327 million in 2020, while non-financial corporate debt was said to exceed $87 trillion last year. These are just two examples of the enormous, multi-trillion dollar global markets that could explore RWA tokenization. 

Considerations

Investors should exercise caution when considering RWA-based DeFi opportunities. In particular, one should investigate the track record of any DeFi protocol to understand the risk involved. They should consider the underwriting process employed and its due diligence process, as well as risk management strategy. What are the collateralization requirements? Do they have any backstop mechanisms in place, or access to insurance in the event of repayment defaults? 

As with all investments, there are inherent risks. Maple Finance suffered a default on a $36 million loan in December 2022, when the borrower suffered losses due to the collapse of the FTX cryptocurrency exchange. Maple Finance responded by launching a new protocol, version 2.0, introducing a more rapid liquidation process for loans that default. 

In addition to directly lending capital, investors may also consider betting on the success of RWA-based DeFi protocols by acquiring their native crypto tokens. While the value of these tokens generally correlates with the general performance of the crypto market, they could make strong gains if the underlying platform succeeds.