In-depth study of the RWA protocol mechanism and ecosystem

Author: Taeheon Lee & Jungwoo Pyo, encryption KOL; translation: Golden Finance xiaozou

In this article, we will delve into key issues regarding real world asset (RWA) token risk management. We will analyze how different protocols deal with such associated risks and discuss any issues that may have been encountered so far. After that, we will explore how DeFi protocols can penetrate the RWA collateral lending market. Finally, we will evaluate a range of perspectives surrounding RWA in the Web3 space, while also considering what unique benefits and constraints these assets may bring to the Web3 industry.

1. Manage the default risk of RWA loans

In this section we discuss the significant default risk associated with using RWA collateral, and the strategies that can be employed to mitigate this risk. Before diving into the details, it is crucial to understand the risks of using token collateral in the traditional DeFi space and how existing DeFi protocols handle default risk. We will start with basic background, then shift our focus to how defaults on loans backed by RWA tokens differ, and examine how each RWA protocol addresses these challenges.

1.1 Default on loan positions in early DeFi protocols

In the previous DeFi model, when users deposit stablecoins into the protocol, they only need to care about whether the protocol mechanism can protect the value of the deposit. In other words, it is critical to assess whether the protocol is able to perform processes such as liquidation when the price of the borrower's collateralized tokens falls. For example, if you are a USDC depositor on AAVE, all you have to care about is whether the protocol will liquidate the lender's position protecting your USDC when the price of the ETH backed by the lender falls. The same goes for MakerDAO. All that is required to keep the value of DAI at $1 is to liquidate the borrower’s collateral position before the value of the collateral held by MakerDAO falls below the value of the DAI issued as a loan.

So from a depositor's point of view, they just need to check that the protocol is using the proper mechanisms in the main protocol (like AAVE or MakerDAO) and if there are any defaults. From a protocol perspective, when a default occurs, it checks what is wrong with the mechanism, and then only makes appropriate changes to the mechanism to handle the default.

1.1.1 Example

In March 2020, MakerDAO experienced a large number of defaults due to a sharp drop in token prices. The problem at the time was that MakerDAO’s liquidation mechanism was poorly designed, which prevented liquidators from participating in the liquidation process as required by the agreement. MakerDAO made improvements to the protocol during the recovery phase, including a major update to the collateral auction process for its liquidation mechanism.

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 firm called Gauntlet, DeFi protocols such as MakerDAO and AAVE have set loan-to-value (LTV) thresholds for liquidations and adjust these parameters when they believe the market is in a bear market to ensure Protect its collateral assets. For example, in December 2022, in response to a slowdown in the crypto market, the AAVE community increased the amount of collateral required for stablecoin loans.

1.1.2 Summary

In previous DeFi, if the protocol's token asset price was normal and its collateral was disposed of at that price, no default would occur. In other words, in the traditional DeFi model, if there is a breach of contract in an agreement, then this is a problem with the agreement design, which means that the agreement design is poor, or the possible risks of the agreement are not properly considered.

1.2 Default on Loan Positions of RWA Agreement

1.2.1 Borrower's Awareness of Default

Protocols dealing with RWAs view defaults a little differently: they recognize that defaults can occur for every RWA token collateralized, and they do not consider the protocol obligated to prevent this from happening.

In traditional DeFi, when the price of collateralized tokens falls below a certain level, they can be sold to the on-chain market. However, RWA tokens do not have a market where they can be immediately sold at a fixed price. Therefore, even if the price of RWA falls, it will be difficult for the protocol to properly sell collateral to protect the value of protocol assets. Furthermore, it is unclear whether token ownership on the blockchain reflects ownership of actual RWA, regardless of the degree of tokenization of RWA. These two factors make it practically impossible to quickly liquidate the collateral on the blockchain and redeem the borrower's loan position when the RWA token collateral needs to be liquidated.

1.2.2 Tranche Grading: A Default Response Mechanism

For this reason, the RWA protocol assumes that default can occur at any time, and the focus is not on liquidation to prevent protocol default, but how to distribute asset losses to lenders in the event of default. More specifically, some lenders may be willing to deposit because they want high interest returns even though there may be some capital loss, while others may prefer not to incur any losses even if the rate of return is low. The RWA protocol classifies lenders and deposits according to their risk appetite, even within the same vault.

This structure is called tranche (grading) in traditional finance, and most RWA agreements adopt a hierarchical structure when receiving deposits from lenders, usually divided into senior grading and primary grading. A senior tranche is a form of financing that protects against losses but earns limited returns, while a junior tranche is a pool of capital that earns higher returns but is the first to suffer losses.

Vaults that receive deposits from lenders in a hierarchical structure are also designed in the same way traditional finance uses. When borrowers pay back the principal and interest they borrowed, the repayments are distributed first to the senior tranche and then to lenders who deposit in the junior tranche. The entire remaining amount will be allocated to primary grading. In the event of a borrower's insolvency, the loss of the outstanding amount will first be borne by the junior tier. When the junior tier cannot recover all outstanding amounts alone, the loss is then borne by the senior tier.

1.2.3 Advanced Grading of GoldFinch Finance

Both TrueFi’s Structured Credit Vault and Centrifuge Tinlake’s Tin & DROP have advanced and junior tiers for each vault. However, GoldFinch Finance has a slightly different tiering structure: Lenders who deposit assets directly into specific vaults are called backers, and all deposits by backers are considered primary tiering. Conversely, lenders who deposit money into the GoldFinch protocol rather than specific vaults are known as liquidity providers, and their deposits are considered senior tiered. How many backers deposit funds in each vault determines how much of the funds in the advanced tier will be allocated to each vault. The result of this is that each treasury can borrow more liquidity than the funds provided by the supporters. In this sense, this model is called a leveraged model.

Let's speculate why GoldFinch uses a different advanced hierarchy than other RWA protocols. First, GoldFinch's target borrowers are all businesses in developing countries (even if they have their own unique characteristics), so bundle together all of GoldFinch's loan vaults, create a deposit product for their risk and It seems to be a natural way to provide users with diversified investments packaged into financial products in developing countries. On the other hand, other RWA protocols are so different in who they lend to, I don't think it makes sense to bundle all the loans in the protocol into a single deposit product.

1.3 Design Considerations for Hierarchical Structure

1.3.1 Funding primary tiers is important

As mentioned above, in the RWA token-collateralized loan protocol, if the borrower fails to repay the loan, then the protocol will face an insolvency loss, and the lenders of these vaults may not be able to recover their tokens. Given that lenders are primarily token holders who deposit stablecoins and expect to be rewarded with relatively little risk of asset loss, there needs to be a way to limit lending in the event of borrower bankruptcy The scale of human loss.

In the current RWA token-backed lending protocol, primary grading fills this role. Primary grading acts as a loss buffer, allowing ordinary investors to invest in the RWA protocol with relative ease. In other words, in loans backed by RWA tokens, which are not “risk-free”, primary grading is insurance for each loan position. The RWA protocol needs to focus on ensuring the size of primary tier deposits, monitoring whether each vault's primary tiers provide adequate returns for primary tier depositors.

1.3.2 Set the primary and advanced grading size ratio

If the size of the primary tranche is too small relative to the size of the loans originating in the vault, then the primary tranche will not be able to absorb sufficient losses; therefore, the size of the primary tranche should not be too small. Conversely, if the size of the junior tranche is too large, then you may not be able to earn enough interest income to invest in the junior tranche due to the structure of the junior tranche. This means that you need to set the ratio of the size of the primary grade to the advanced grade appropriately. This ratio can be set by considering the following factors:

• The probability of the borrower not repaying and the expected loss. The higher the probability that your coffers will default, the larger the primary tier size should be. To determine the likelihood that a borrower will not repay, you can use information such as: the borrower’s past loan and repayment history, the price stability and ease of disposal of the borrower’s pledged RWA, and general market conditions.
• Earnings competitiveness of primary tiers. The interest yield that can be expected for junior tiers should naturally be higher than that of senior tiers, and at least moderately higher than that available for stablecoins in other DeFi, so that token holders have an incentive to deposit their assets into senior tiers.

RWA protocols should continually monitor the above factors to track whether primary grading can maintain its size. If the rate of return on junior tier deposits is low, it is recommended to use tokens in the protocol to reward junior tier depositors.

1.4 Case Study

1.4.1 Cases of breach of contract

In 2022, news of defaults on the RWA protocol vaults continued: First, TrueFi defaulted on a $3.4 million loan 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 loaned to crypto fund Auros Global. Additionally, a series of defaults in vaults managed by Celsius, Alameda, Orthogonal Trading, M11 and others resulted in a $54 million loan default by Maple Finance in December 2022. In addition to Maple Finance, TrueFi and Centrifuge also experienced $4.4 million and $2.5 million in defaults, respectively.

The defaults that occurred after October 2022 have one thing in common, that is, the borrowers are all cryptocurrency funds, and they often place the borrowed assets on exchanges such as FTX. They plan to use the loans in the RWA lending protocol to execute their strategies such as market making and arbitrage, earning profits to repay loans and interest. However, when FTX crashed, their loan was frozen on the exchange and they were unable to repay the loan in the RWA protocol. In addition to FTX, another case is Invictus Capital, which suffered huge losses after the collapse of the Terra stablecoin and was unable to repay the loan.

In the RWA protocol, once a vault defaults, the losses are shared by the lenders that funded the vault. When Babel Finance's $10 million loan from Maple Finance defaulted in July 2022, the outstanding default amount was credited to the vault, resulting in a loss of approximately 3.2%.

1.4.2 Protocol Mechanism Improvement

Maple Finance’s change of direction in its mechanism following last year’s default event provides insight into other default risk management approaches that the RWA protocol could consider in addition to the mechanisms described above.

Diversification of Borrowers - One of the reasons Maple Finance experienced such a large number of loan defaults last year (over $50 million) is that crypto funds are highly concentrated on the side of borrowers. Since borrowers are all participants in the crypto market, when an event like the FTX crash occurs, many vaults will be unable to repay at the same time. From the perspective of the protocol, such a large amount of outstanding loans at once places a heavy burden on the protocol, and needs to be recovered through the treasury created by the protocol. Maple Finance is also aware of this issue and has decided to diversify its borrowers starting in 2023.

Empowering treasury administrators – Previously, treasury administrators could not immediately declare a default if a borrower did not repay, but had to wait for a period of time before doing so. On the face of it, this might not seem like a problem, since defaults are triggered by mechanisms defined by the protocol. However, since there is no way to liquidate borrowers' collateral to force them to repay the loan, the RWA protocol requires lenders to freeze vault assets as soon as they determine that the vault has become insolvent, in order to protect lenders' assets as much as possible. With this in mind, Maple Finance amended its protocol to allow treasury administrators to immediately declare default if they believe a borrower is insolvent.

Adjusting treasury administrator incentives – A problem that has arisen during the 2022 default is that some treasury administrators are not sharing accurate information about the state of the vaults they manage and the repayment status of borrowers. Given the nature of the RWA protocol—which relies not only on protocol logic, but also on the trust relationship between lenders, borrowers, and administrators using the protocol—such actions by gold administrators could lead to greater default losses. In this regard, rules are also needed to force treasury administrators to deposit substantial assets into primary tiers when creating vaults.

2. DeFi protocol enters the RWA mortgage loan market

One of the most talked-about issues in the RWA ecosystem since the second half of 2022 has been the emergence of several projects among existing DeFi protocols that have announced their intention to incorporate RWA. MakerDAO and AAVE are the most prominent examples, while Frax Finance is also actively discussing mechanisms related to RWA. In this section, we will discuss the background environment in which MakerDAO and AAVE are trying to introduce RWA, and what form they have adopted.

2.1 MakerDAO

2.1.1 Purpose of introducing RWA

Steady Growth of the Protocol - One of the main agendas of the MakerDAO community has always been to create a way to steadily increase DAI issuance. One of the problems MakerDAO has faced since operating the stablecoin in 2018 is that it cannot continue to grow DAI with ERC20 token collateral alone. MakerDAO recognizes that accepting only token collateral would make the issuance of DAI too dependent on long-term demand for the cryptocurrency. By incorporating RWA collateral, MakerDAO hopes that DAI will provide utility as a lending tool for entities that want to borrow on RWA or credit. Under this strategy, MakerDAO will no longer be solely dependent on cryptocurrency market conditions, but will also be able to create demand for DAI based on the real economy. Therefore, the issuance of DAI will be able to grow more steadily.

Monetization - MakerDAO also initially created demand for DAI through the DAI deposit fee (i.e. DSR) provided by the protocol, based on which the interest paid by borrowers became the protocol's main source of income. However, the MakerDAO community quickly realized that the return of tokens was not high and sustainable, so they began to focus on the return of RWA, which is quite high and sustainable, and they began to borrow directly from those who wanted to mortgage RWA. The entity issues DAI and makes RWA earnings 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 an RWA-secured loan to a specific borrower, it relies on the support of community members to make a decision. In making these decisions, the MakerDAO community decided to use the following evaluation criteria:

• Scalability: First of all, MakerDAO requires that RWA must have a high enough circulation and a large enough market size to increase the issuance of DAI.
• Stability: Since RWA is used as collateral for issuing DAI, it is very important for the collateral to maintain a stable value. To do this, the MakerDAO community determines whether the price of RWAs is stable enough, and whether there is enough liquidity in the market to handle them. In addition, the protocol will also assess whether there are any risks that may endanger the stability of MakerDAO.
• Demand: Even if MakerDAO accepts RWA as collateral and issues DAI, it does not make much sense to receive RWA as collateral for MakerDAO if it is better to borrow money from traditional financial institutions in terms of interest and other financial costs. In this regard, the MakerDAO community will evaluate the utility of borrowing on MakerDAO from the perspective of RWA owners, i.e., whether MakerDAO and RWA owners can mutually benefit.
• Regulatory risk: In addition to addressing RWA, the MakerDAO team considers whether additional regulatory or legal entities need to be involved in the process of incorporating assets into the protocol, and whether there are additional technical, economic, or regulatory risks.

2.1.3 Implementation steps

Additionally, 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 it and have legal mechanisms in place that allow them to deal with RWA when they need to be liquidated.
• In the traditional financial world, is it possible to prevent DAI borrowers from re-mortgaging the same asset? Because legal rights to tokenized RWA are separate from rights in the real economy, borrowers may use their RWA to borrow from MakerDAO and then borrow again in traditional financial institutions. If this happens, borrowers are less likely to repay the loans they take out of the RWA agreement. Given this aspect, MakerDAO seeks to prevent borrowers from using their RWA as collateral to obtain another loan.
• Can you reliably retrieve price information, etc.? How will Oracle be designed? Even with 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 a borrower's repayment potential. In this regard, MakerDAO is concerned with how to reliably capture the value of these RWA assets.

2.1.4 Adoption status

In July 2022, MakerDAO created the real-world financial core department, aiming to increase MakerDAO's influence on real-world finance. Through this arm, the protocol team has been extending RWA-backed loans to players in the real-world financial space and continues to create vaults for them. These vaults operate by issuing DAI directly 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 currently exceeds $600 million, and the rate of DAI issuance has been growing rapidly, especially since the end of 2022. Vaults like RWA009-A are especially important because they fund directly from MakerDAO, rather than lending out from a government-regulated bank. In terms of protocol revenue, it also helps boost the protocol’s net income, with DAI issued as RWA collateral worth approximately $650 million as of January 2023, accounting for roughly 75% of the protocol’s total fee revenue.

Against this backdrop, MakerDAO continually reviews and evaluates vaults that lend DAI as RWA collateral, such as short-term bonds, institutional credit, and energy production facilities.

The MakerDAO community stated that each RWA must go through governance to decide whether to dispose of assets, which is inefficient and slow. Therefore, MakerDAO is looking to work with RWA collateralization protocols like RWA tokenization and Centrifuge (+Tinlake) to allow the RWA protocol to take care of the necessary steps for RWA asset processing. MakerDAO is also discussing cooperation with Maple Finance. In this cooperation, Maple Finance will be used as infrastructure again to facilitate RWA-based mortgage loans, and MakerDAO may issue DAI to Maple Finance, and adjust parameters such as the DAI issuance limit and default interest rate of each vault according to the risk of each vault . In working with the RWA protocol, MakerDAO expects other protocols to play the following roles: (1) attract and manage borrowers, (2) take care of legal proceedings or organize legal structures, and (3) handle defaults.

2.2 GHOST

2.2.1 Background

The rise of GHO - In July 2022, the Aave Governance Forum proposed a plan to issue a stable currency called GHO based on the Aave protocol in an agenda item called "Introduction to GHO". Like other stablecoins, GHO will be backed by multiple asset classes. It’s worth noting, though, that it’s not specific to cryptocurrencies, but rather a group of assets that are less correlated, such as RWA and credit scores.

In the GHO mechanism, an entity called a Facilitator is authorized to issue GHO tokens instead of a single entity managing all collateral. The Facilitator proposes the method of issuing GHO to the community. If the proposal is passed, GHO can be issued within a certain range according to the method proposed by the Facilitator. Interestingly, Facilitators do not have to insist on issuing crypto-backed stablecoins; in fact, GHOs can be issued/burned in any manner defined by each Facilitator, including collateralized, algorithmic, credit-based or delta-neutral for multiple asset classes Positions, the more diversified the Facilitator is, the more stable the price of GHO will be.

The importance of RWA in the DeFi field - In November and December 2022, the Aave community began to discuss the importance of RWA. In "Helping Aave Think About RWA," Punia from Warbler Labs notes that RWA can help the Aave protocol in two ways: by providing stability through the diversification of stablecoin collateral beyond cryptocurrencies, and by leveraging more stablecoin collateral than cryptocurrencies. A larger asset pool paves the way for GHO to expand into a global stablecoin.

In the article "Why RWA is important to 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 has obvious limitations, and RWA is the way to achieve Required for larger growth (approximately 100-fold). DeFi needs to take some market share from TradFi to finally enter the mainstream.

• DeFi and TradFi are similar to an inversion of the ratio between e-commerce and brick-and-mortar transactions, because with the Internet, people prefer e-commerce to brick-and-mortar transactions. The same goes for DeFi and TradFi: as blockchain technology develops and becomes more active, people will prefer DeFi to TradFi.
• There are always user needs in the financial field, and people always want more flexible ways in financial applications and funds, which is a common phenomenon. DeFi could serve them better in all of these ways.
• The visibility and interoperability of DeFi make it safer and less volatile than centralized protocols, thus better serving the entire economic system.

The success of MakerDAO - The success of MakerDAO has further strengthened the use case of RWA based on the Aave protocol. Obtaining a stable income stream from the DeFi protocol is crucial to its sustainability. According to the article "Overview of Aave's RWA Strategy", as of November 2022, MakerDAO has obtained more than 50% of the protocol revenue from RWA.

The chart above shows how MakerDAO’s revenue has changed by asset, with RWA accounting for more than 50% of revenue as of March 2023. With RWA becoming a larger share of total revenue over time, it's clear that RWA is a lot more important than we thought.

2.2.2 Effect and Expected Results

According to the article "Overview of Aave's RWA Strategy", the risks of Aave only using on-chain assets as collateral for GHO are as follows:

*During a market downturn, if the underlying assets lack market liquidity, there is a risk of the agreement accumulating liabilities, i.e., there is a risk of agreement default if only crypto assets are considered as collateral.

• The lack of liquidity of the protocol ultimately makes it vulnerable to economic attacks or liquidations. *Crypto assets are highly sensitive to market conditions, and during market downturns, lending protocols' cash flow may deteriorate due to reduced need for leverage.

Ultimately, the Aave community expects to see the following effects when RWA assets are offered as collateral for GHO, roughly in line with what the MakerDAO community expected when they decided to accept RWA.

• Since RWA is more stable and less volatile than encrypted assets, its risk is more dependent on macroeconomic flows and more volatile to the encrypted market itself. *Fundraising by RWA borrowers is typically for productive business, not speculative transactions. This is much larger than the scale of cryptocurrency speculation, whether it is a bull market or a bear market.

2.2.3 Aave’s RWA Adoption Strategy

RWA is a completely different asset class compared to traditional cryptocurrencies. There is a lot of discussion in the Aave community about 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 ones are being advocated.

• Asset type: The author advocates first introducing RWA with lower risk and lower return to understand how it works in the encrypted market, so as to build long-term trust in RWA Facilitator, and then gradually introduce assets with higher risk and higher return . The asset class should not be directly related to the crypto market, e.g. excluding lending to market makers, miners, DAOs, etc.
• Debt Ceiling: Adoption of GHO as a fiat token takes time in the real world, so we have to assume that all borrowers will initially convert GHO to existing fiat tokens (USDC, USDT, USD…). This is why the designated debt ceiling should be proportional to the liquidity available to sell or redeem existing stablecoins, because ultimately, it is important for the GHO to maintain a soft peg to the US dollar to maintain its value. 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 depreciate.
• Rates: In the author's opinion, Aave's current rate model should not be applied to RWA and rates should be based on underwriting and TradFi-like transactions. This is because Aave's Facilitator can set a different rate for RWA than other asset classes.

2.2.4 Adoption status

On December 28, 2021, Aave partnered with Centrifuge to launch the RWA marketplace for the tokenization of RWA. The RWA market provides Centrifuge Tinlake's TIN & DROP model in the Aave service, allowing depositors to obtain income through stable encryption-related RWA collateral, and Centrifuge issuers use the encryption market as a source of liquidity through Aave lending.

Since the RWA market is a closed market, only users who have been verified as depositors through the KYC process can participate as investors. Issuers (Centrifuge issuers) can create pools for their assets, and LP tokens correspond to Centrifuge Tinlake's DROP. Depositors (investors) can deposit USDC for deposit pledge and purchase DROP from this pool.

The RWA market grew rapidly once it was launched, breaking through $20 million in April 2022, but then shrank during the market downturn, with a total market size of about $7.5 million as of March 2023. Fortunately, no funding defaults occurred, and the protocol itself functioned in an orderly manner as expected.

Through the operation of the RWA market, Aave learned that several key challenges need to be resolved in order to truly introduce RWA into DeFi.

• It requires experts in various fields related to risk assessment (RA) or underwriting.
• Lenders should think carefully about their strategy, considering the lifespan and liquidity of RWA collateral, as it is inherently a different asset than highly liquid types such as cryptocurrencies.
• RWA funding relies on Aave's stablecoin liquidity, which is often affected by factors outside of Aave.

RWA Facilitator. The example of the RWA market shows us the potential of bringing RWA into DeFi. We have seen that discussions are progressing regarding the RWA Facilitator as one of the enablers for the GHO release. As of December 2022, Centrifuge will continue to attempt to become a full-service GHO RWA Facilitator.

We identified some key challenges that need to be addressed in a previous post to make RWA scalable. In the Aave protocol, we expect the RWA Facilitator to have the following characteristics:

• Compatibility with DeFi: This refers to ensuring that RWA collateral is well integrated into the on-chain ecosystem.
• Credible infrastructure: intermediary services involving RWA collateral require a high degree of transparency within a robust legal framework. To successfully integrate RWA into the on-chain ecosystem requires a trustworthy professional brokerage framework.

Centrifuge is currently developing an index token based on the assets held in the Centrifuge pool. Index token buyers will purchase the Centrifuge asset portfolio, which is the result of risk diversification considered by the collective wisdom of credit groups within the ecosystem. RWA pools can also be constructed as a portfolio of indices, which is probably the best case for RWA as an Aave GHO Facilitator.

3. Current status and future of RWA mortgage loan market

So far we have described the mechanisms used by the protocol for handling RWA tokens and why they are designed this way. In this section, we'll take a quick look at the current state of the protocol for handling RWA tokens. We will first look at the overall trend in loan volumes and then look at the performance of individual protocols.

3.1 TVL and Overall Loan Volume Trends

3.1.1 Growth and contraction of cryptocurrency fund loans

The chart below shows active lending volume for protocols based on RWA token lending. TrueFi accounts for the majority of RWA mortgages through 2022, in part because TrueFi is the first RWA mortgage protocol. Since then, Maple Finance has grown rapidly, and by the second half of 2022, Maple Finance and TrueFi will each account for half of the RWA mortgage market.

During this period, the borrowers of Maple Finance and TrueFi were mainly crypto funds engaged in market making and trading based on cryptocurrencies, such as MGNR, Auros capital, Folkvang Trading and Alameda Research. Until the second half of 2022, Maple Finance and TrueFi seem to experience rapid growth, as trading firms need more capital in the cryptocurrency bull market.

However, as we move into the second half of 2022, events such as the Terra protocol collapse and the FTX bank run have had a significant impact on major crypto funds, and lending volumes to crypto funds have decreased accordingly. Therefore, from 2023 onwards, the weight of Maple Finance and TrueFi in the above graph has almost disappeared.

3.1.2 Non-encryption fund loans grow steadily

While Centrifuge and GoldFinch haven't experienced explosive growth like Maple Finance, they have shown steady growth since 2022 and seem to have maintained overall loan volumes without much damage from the big event in the second half of last year. Centrifuge offers loans across a variety of asset classes, including loans secured by real estate and loans secured by shipping invoices. GoldFinch provides loans to fintech companies and real estate companies in developing countries. The image below shows the various sectors where Centrifuge lends, and they actually lend to various sectors, including real estate, developing countries, and institutions.

Centrifuge and GoldFinch don't seem to have suffered much damage last year as their lending was not concentrated to crypto companies but to non-crypto companies, given that demand to borrow from them remains strong and regardless of the state of the crypto market, Borrowing needs are growing steadily.

3.1.3 Adding RWA collateral to the DeFi lending agreement

In addition, as mentioned above, stablecoins and lending protocols such as MakerDAO, AAVE, and FRAX are actively entering the field of RWA mortgage loans, and slowly increasing the proportion of RWA assets in their respective protocols. Since June of last year, FRAX has been discussing the allocation of FRAX to the RWA mortgage pool through the governance forum and voting on cooperation with companies such as TrueFi and PropFi. Although we are still very new to the RWA collateral loan mechanism in DeFi, it will be very interesting to witness the rapid growth of this field in 2023.

3.2 Benefits of using RWA

3.2.1 Attract real economy players to join the DeFi ecosystem

Most users of products such as DeFi and NFT are still concentrated in a small number of people who own and trade cryptocurrencies for a long time, so in order to grow the Web3 ecosystem, we need to let more users enter the Web3 ecosystem. Various related initiatives are underway, such as the Web2 X Web3 collaboration and RWA token-backed loans could be a part of it.

If RWA mortgages can provide investment companies and institutions with value 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 the RWA protocol, the blockchain can be positioned as the infrastructure for emerging financial technologies. Introducing RWA tokens to the DeFi ecosystem is an important step in expanding the user base.

3.2.2 In addition to tokens, DeFi can also have other monetization methods

As mentioned earlier, RWA collateral allows blockchain projects to generate yield from sources other than cryptocurrencies. The problem with traditional cryptocurrency-based incentives is that they are too dependent on market conditions and do not provide meaningful or sustainable returns.

However, by utilizing interest income from RWA as a new revenue stream, DeFi protocols can have revenue streams other than newly issued tokens, which may be attractive from a DeFi perspective, especially if paired with The risks associated with RWA are well understood and managed. In fact, if you browse the rwa.xyz website, you will see that RWA processed by DeFi protocols has an average interest yield of 10%. MakerDAO generates most of its revenue from its RWA treasury, so the protocol can expand its own revenue stream if RWA is used correctly.

3.2.3 Security requirements not affected by the DeFi cryptocurrency market

In any field, whether it is DeFi or NFT, one of the biggest problems of blockchain projects is that they are extremely vulnerable to the cryptocurrency market represented by Bitcoin. This problem is exacerbated for DeFi lending protocols, because people who store fiat tokens (ETH, UNI, etc.) on DeFi lending protocols and try to lend them are usually people who are trying to leverage long positions by borrowing. Conversely, someone depositing stablecoins on a DeFi lending protocol and looking to borrow fiat tokens represents a short position.

So if you look at a DeFi protocol like MakerDAO or AAVE, you can see that the size of the protocol increases or decreases dramatically depending on market conditions. However, if protocols have entities with RWA among their user bases, the demand for these protocols will be relatively insulated from the crypto market and allow for some degree of predictability in terms of protocol size.

3.3 Disadvantages or limitations of using RWA

3.3.1 A trust problem occurs

In addition to the advantages in terms of cost and transaction speed, the ability to achieve desired results through blockchain and smart contracts without trusting a centralized party has always been one of the most important values of DeFi. However, most DeFi activities using RWA tokens as collateral are based on trust. When lenders deposit money in a vault, they must trust a third party, and they must also trust that the borrower will repay the loan in good faith.

Look at what has happened to RWA agreements over the past year, with vaults defaulting and borrowers not being able to redeem their principal because a third party in the vault misbehaved. We’ve been through this and we’ll continue to face these trust issues until a stronger legal and institutional foundation is formed around RWA tokens, and even then, the protocols we use may still Has a certain level of trust issues.

3.3.2 Only some users are eligible for loans

In the RWA lending protocol, we mentioned that a certain level of trust is required between lenders, borrowers, and third parties, and that loans backed by RWA tokens are indeed used for low-collateralization loans. However, due to the need for trust between the various entities, the user group that can borrow through the RWA lending agreement is still concentrated in certain institutions. Look at products such as Centrifuge, GoldFinch, Maple Finance, etc., and you will find that the entities that borrow or act as administrators through the protocol are mostly institutions with a certain reputation and expertise. There is no market where ordinary people can easily mortgage RWA for borrowing.

**3.3.3 Can it really reduce costs? **

Smart contracts can indeed reduce a lot of arbitration costs in financial transactions. However, in the case of RWA protocols, the RWA tokenization process, identification of borrowers, and RWA risks incur additional costs as it requires experts with RWA knowledge and entities handling legal and administrative tasks. In fact, some protocols require the establishment of a dedicated facility for each vault. In this regard, there are still various costs associated with RWA. This limitation will continue until the infrastructure for each RWA is in place and the risk assessment criteria for each asset are basically formed.

3.4 Personal opinion on the RWA protocol

RWA has great value because it can simultaneously solve some of the limitations of the blockchain ecosystem and some of the inefficiencies of traditional finance. Once we get some administrative guidelines on RWA in 2023, RWA will get more attention from the blockchain market, which is why RWA tokens are attracting a lot of attention today and the market will grow in the future.

3.4.1 Need to identify different identities from traditional financial or Web3 products

But for a protocol that handles RWA, it’s said to be based on a very different philosophy than many DeFi or blockchain projects. This is because everything is not handled through smart contracts like existing Web3 products, but somehow, you have to trust someone and accept the problems that come with it. This is very different from existing Web3 products that people in the Web3 space have seen, and the protocol to handle RWA is between the existing financial system and Web3 products.

From this perspective, when protocols deal with RWA, they need to have a clear understanding not only of the value they can bring to the existing financial sector and blockchain ecosystem through their services, but also why they are trying to deal with RWA , and various problems and constraints that may arise in the process, both for the existing financial sector and the blockchain ecosystem. The protocol should be aware of the problems that may arise due to the transparency and centralization of information during the operation process, and improve these problems so that the RWA market can develop into a more mature industry.

3.4.2 The Importance of Risk Management

As I keep mentioning throughout this article, protocols dealing with RWA are still centered around lending protocols, where borrowing and lending occurs based on a form of credit. Since the loan itself is often for leverage purposes, the lending system itself may become unstable at any time during the process of over-expansion and investment. This risk is more disruptive to the protocol, especially since such lending is not regulated and monitored like traditional finance, but can be left to the discretion of third parties in the various vaults.

Most RWA protocols are not yet fully prepared to deal with these risks, so protocols are currently forced to rely on opaque disclosures (compared to traditional Web3 offerings), the behavior of certain parties, and the unregulated nature of their mechanisms. Against this backdrop, agreements must always focus on how these risks are managed.