Bringing Real-World Assets on Chain: A Case Study of the Securitize/Centrifuge Alliance from DeFi to HyFi
Centrifuge has been a focus of ChainNews as an application example of blockchain technology that brings assets from the real economy on-chain. Recently, Centrifuge partnered with Securitize, and these two pioneers in asset tokenization are attempting to explore hybrid finance "HyFi" together, introducing real-world assets and compliance services to the DeFi ecosystem.This article was published on November 26, 2020, by ChainNews, authored by Mike Rogers, a research analyst at the blockchain media The Block.
Key Points
Securitize is a digital securities platform and a registered transfer agent with the SEC, assisting users in managing the entire lifecycle of tokens.
Centrifuge is a FinTech company based in Berlin that has developed a P2P protocol to help asset issuers access the DeFi ecosystem.
Centrifuge plans to address some challenges in the DeFi space with its Securitized DS protocol and regulatory-compliant investment services.
The so-called "Hybrid Finance HyFi Solutions" can introduce appropriate checks and balances to DeFi systems while allowing more real-world assets to be incorporated into open finance smart contracts.
Asset tokenization is a hot topic in the digital asset industry. As early as the "colored coins" era of Bitcoin, developers saw the opportunity to track real-world asset ownership on the blockchain, enabling secure asset transfers in a peer-to-peer (P2P) manner. Innovators have been creating protocols that use distributed ledger technology (DLT) for online asset creation, representation, and ownership exchange, continuously modernizing the relevant technologies.
Redesigning assets as digitally native assets brings a wide range of opportunities from trading efficiency to programmability. However, the genuine interest of decision-makers and traditional financial services firms in these network tools remains to be seen. The potential benefits of such solutions are evident, but the risks are still being calculated and discussed. Global monetary authorities want to ensure that time-tested laws and regulations are migrated into the future digital financial system.
Overall, the digital asset industry provides relatively low-risk options for generating protocol concepts and conducting on-site experiments. As a smaller parallel financial system based on the internet, it currently does not pose a sustained threat to the global monetary order. Moreover, digital assets can be segmented into virtual niches, where applications can be tested against the visions outlined in project white papers and team roadmaps.
Certain niches, such as digital securities (security tokens) and fiat-backed stablecoins, primarily focus on assisting traditional assets and related regulatory processes in transitioning to a DLT-based environment. Due to advancements in lending, trading, and open-source protocols related to infrastructure, decentralized finance DeFi has recently garnered significant attention. In September of this year, the trading volume of the decentralized exchange protocol Uniswap surpassed that of the centralized cryptocurrency exchange Coinbase.
For DeFi, this is indeed a milestone moment, considering that Uniswap was only launched two years ago in November 2018. Some view this as a "turning point," as Coinbase has raised $547.3 million to date, while Uniswap has only raised $11 million. It is essential to remember that the DeFi ecosystem is still in its infancy, and the activities within it are at best speculative activities.
Those who experienced the 2017 ICO bubble are very familiar with the challenges of profiting from nascent open-source protocols. Quantifying value requires the creation of new metrics, such as Total Value Locked (TVL), which necessitates testing the longevity and stability of protocols. Unfortunately, too many blockchain metrics can be manipulated, so only time will tell if specific metrics are genuinely useful.
Nevertheless, DeFi innovations indicate what may become reality, after which programmable FinTech engineering processes will be needed. Recognizing the importance of creating compliant user access to the DeFi ecosystem, some projects in the digital securities space have begun collaborating with DeFi protocols. One example is Securitize integrating with Centrifuge's Tinlake protocol to create a so-called "HyFi" solution.
Understanding Securitize
Digital asset security tokens include issuance and compliance platforms, trading and liquidity protocols, token exchanges, and digital securities application developers, with the primary market mainly composed of digital securities platforms like Securitize. In addition to issuance, Securitize also helps manage the entire lifecycle of digital securities ownership and provides services tailored to each stakeholder (issuers, investors, and exchanges).
As of September 25 of this year, there are over 130 issuers using the Securitize Software as a Service (SaaS) platform and related technologies, along with nearly 30,000 investors. Securitize is not just a technology platform; it became a registered transfer agent with the SEC in July 2019. According to Securitize CEO Carlos Domingo, "Becoming a registered transfer agent is important for us, allowing us to provide regulated services globally around the issuance of securities and asset services, represented by digital tokens on the blockchain. We are not just providing a technology platform; we are also bringing overall transparency to the space, as we are now under the jurisdiction of the SEC."
Securitize's backers seem to agree, as the company successfully raised $14 million in July 2020. To date, its Series A funding has expanded to $30 million. Backers include Blockchain Capital, Nomura Holdings, MUFG, Ripple's Xpring fund, Tezos, Santander InnoVentures, Global Brain, and Coinbase Ventures.
The Securitize platform is built on the DS protocol (Digital Securities Protocol), which is a flexible, adaptive ownership architecture detailed in its white paper.
As shown in the above image from the Securitize white paper, the interactions between tokens and stakeholders (issuers, investors, and exchanges) are managed by a layered and scalable DS protocol. This smart contract infrastructure provides a range of services and DS Apps (Digital Securities Applications) within a flexible internet ecosystem; these components provide value to stakeholders while addressing compliance issues by leveraging the immutable, public, and distributed ledger nature of blockchain.
By providing an appropriate ownership architecture for digital securities, the DS protocol covers all aspects of the investment lifecycle, making digital securities an ideal tool for regulated financing and asset tokenization. Programmability means that terms can be customized according to the unique regulatory requirements accepted by each issuer and can be continuously updated throughout the token lifecycle.
From the issuance phase, terms and conditions are embedded in the smart contracts of each token to ensure compliance with appropriate regulations when raising funds from investors. After issuance, investment-related operations can continue through the Securitize online platform, such as receiving dividends, participating in token buybacks, and/or voting on company decisions. A programmable, automated web-based platform helps streamline processes typically associated with such lifecycle events; tokens can also serve as automated investment tools: the underlying DLT tracks subsequent exchanges of tokens, while smart contracts execute automated operations.
The first-generation DS protocol implementation utilizes Ethereum, supporting token information on the Ethereum blockchain, but the flexible architecture model can be combined with other DLT systems. Securitize ensures that the DS protocol will never become outdated by allowing developers to create new DS Apps as open-source. Additionally, the DS architecture created by Securitize is not bundled with the protocol, meaning it can be compatible with other blockchains as long as the management team approves.
The upcoming integration with Centrifuge's Tinlake protocol indicates that this work is already in progress.
As mentioned earlier, the digital securities market involves multiple participants, including token issuers, investors, issuance platforms, liquidity providers, exchanges, trading and liquidity protocols, and DS App developers. Securitize does not aim to maintain control over the entire market or specific networks; rather, its goal is to establish an application ecosystem, the DS Protocol Ecosystem, to enable security token stakeholders to interact in a regulatory-compliant manner.
According to the DS Protocol white paper, the main elements of this ecosystem include:
DS Tokens: ERC-20 compliant tokens that leverage the functionalities of the DS protocol.
DS Apps: Smart contracts designed to manage specific lifecycle events of digital securities. For example, DS Apps for issuance, exchange-specific DS Apps, voting rights DS Apps, or dividend issuance DS Apps.
DS Services: The foundational infrastructure of the DS protocol that facilitates the management of lifecycle and DS token compliance. DS Apps can access these services to achieve their objectives. DS Services include:
Trust Services: Managing relationships between different stakeholders.
Registration Services: On-chain registration of investor information.
Compliance Services: Executing specific regulatory provisions for DS token issuers.
Communication Services: Keeping investors informed about relevant events.
Secondary ecosystem elements include defining the APIs for interaction between software. To enhance the investor experience, the DS protocol uses exchange-specific (Ready For Exchange, RFE) off-chain APIs that have been extended on the Securitize platform.
RFE API allows approved exchanges to access the DS ecosystem for relevant investor information, such as verifying customer identity KYC and anti-money laundering AML information, which is too sensitive to share on-chain. Issuers and exchanges can privately share this data off-chain to maintain investor investment caps and provide contact information for clients to access securities token lifecycle events. Additionally, the Representative State Transfer API (REST API) provides investor pool information for online investor dashboards, such as specific allocations based on regulatory categories.
Understanding Centrifuge
Centrifuge Inc. was founded in 2017 and is a FinTech startup based in Berlin, aiming to build the financial supply chain infrastructure of the 21st century. Its team consists of 16 members who have developed a global trade protocol, Centrifuge OS, enabling asset originators—online lenders, payment services, financial institutions, and embedded software solutions—to access the DeFi ecosystem.
Volatility is an inherent characteristic of DeFi, as many projects are built on Ethereum and use ETH to drive their smart contracts. The high correlation between cryptocurrencies becomes apparent during price drops, and collateral issues can severely amplify this correlation. Some cryptocurrencies (e.g., DAI and ETH) are often used as collateral in DeFi smart contracts. Furthermore, while the current DeFi trading volume may be staggering for digital assets, it is merely a drop in the bucket compared to the overall trading occurring within the global financial system.
Centrifuge firmly believes that incorporating real-world assets into decentralized finance will help DeFi overcome its stability issues and trading volume-related problems. If traditional financial assets (such as the $30 trillion in unpaid invoices) were tokenized as collateral, the trading volume and stability of DeFi would significantly improve.
Backers of Centrifuge have shown strong support for its blueprint, investing $7.5 million to date, with investors including Crane Venture Partners, Atlantic Labs, Inflection Capital, Compound founder Robert Leshner, Fabric Ventures, Mosaic Ventures, BlueYard Capital, and Semantic. Centrifuge Inc. also received a €400,000 grant and a €1 million subsidized loan from the city of Berlin and the European Regional Development Fund (ERDF) in September 2019 to create its own blockchain, Centrifuge Chain. The latest funding round led by Crane Venture Partners was completed in October 2019, raising $3.7 million.
Regarding this funding round, Crane Venture Partners founder Krishna Visvanathan stated:
Centrifuge is one of the few decentralized projects that initially focused on supply chain finance and attracted us. The development and evolution of the Tinlake protocol, the expanding range of real-world assets that can now be financed, and the collaboration with the Maker Foundation make Centrifuge one of the most exciting decentralized enterprises covering a broad range. We are pleased to work with this team and our co-investors, and we hope to support the company as it expands globally.
The Centrifuge P2P protocol serves as the underlying infrastructure for Tinlake. A set of smart contracts is built on Centrifuge OS. Tinlake uses non-fungible tokens (NFT asset pools) to connect collaborators, operators, investors, and users in Centrifuge's global financial supply chain in the open market. NFTs are on-chain representations of off-chain unique assets, covering royalties, invoices, warehouse receipts, collateral, etc., which can be pledged in DeFi lending protocols or sent to investors as collateral to obtain financing in stablecoins like DAI.
According to the Centrifuge developer page:
Tinlake allows lenders to invest at two different levels: the senior tranche issues a token called DROP, while the junior tranche issues a token called TIN. The senior tranche has a lower/stable yield and carries less risk, while the junior tranche offers a higher/yield with more volatility and has a higher risk of loan default, thus providing protection to the senior tranche. This structure is similar to the common A/B or senior/junior structure in finance.
In traditional finance, structured financial products are divided into different parts based on the risk of the underlying investments in each tier. Different classes of stock allow investors to access the same asset class, but they receive different yields and risk exposures. Compared to the junior tranche (B/junior), the senior tranche (A/senior) typically receives more stable but lower returns. However, the junior tranche bears the default risk first, meaning its returns are more variable in exchange for a higher yield. Thus, the senior tranche is protected by the junior tranche.
As liquidity flows into Tinlake, DROP and TIN tokens will be minted based on appropriate risk and return parameters, and over time they will earn interest. When funds are allocated and tokens are burned, this mechanism is reversed. Asset originators can obtain protocol-based credit lines using Tinlake, in exchange for tokenizing their assets, while investors can earn returns based on the specific risks and returns of the senior and junior tranches.
As shown in the above image, Tinlake currently has 10 asset pools, financing $3.4 million in DAI. DAI is currently the most favored stablecoin for investors when investing in Tinlake asset pools, with borrowers borrowing DAI in exchange for depositing NFTs into the smart contracts. Assets tokenized using NFTs include invoices, goods, trade receivables, bridge loans for real estate, prepayments, and inventory financing. The average annual percentage rate (APR) for DROP associated with these 10 asset pools is 9.3%.
The "HyFi" Solution
On October 12, 2020, Centrifuge and Securitize announced a partnership.
The collaboration between these two companies, which develop protocols to convert real-world assets into on-chain securities, seems natural.
Clearly, Securitize has been monitoring the progress of DeFi for months, aiming to find a way to integrate its DS protocol and related services into the open finance ecosystem. Currently, ERC20 tokens on the Ethereum network possess this composability.
According to Securitize CEO Carlos Domingo:
When dealing with digital securities, there are some details to consider; digital securities are not simply "tokens." One of the main issues is that securities are regulated and must enforce several control mechanisms. If we are to consider using digital securities in this context, it means that the solution will not be purely "DeFi," but more likely " Hybrid Finance HyFi," which combines some decentralized aspects of smart contracts and protocols with centralized elements derived from the regulatory obligations of asset managers and their agents.
In April of this year, Securitize launched Instant Access, beginning to build a bridge from digital securities to DeFi. Instant Access provides regulated digital securities P2P atomic swap transactions, allowing owners to privately offer security tokens to another investor in exchange for stablecoins.
Digital securities are incorporated into the DeFi market through Instant Access, marking the first step toward HyFi. However, Domingo noted that challenges regarding the composability of existing protocols still remain:
KYC identity, AML, and transfer controls: Digital securities require knowing the holder's identity beyond just a simple wallet address, AML checks must be performed, and transactions may be restricted due to certain regulatory requirements. This must also be the case when interacting with DeFi protocols.
Authorization to store digital securities in DeFi smart contracts: Most DeFi protocols require the ability to deposit tokens into smart contracts rather than wallets, generating contracts with pool assets. The issues of custody and control of securities arise, depending on who controls the smart contract. Regulators will also closely monitor the security of the assets.
Pool assets: If a holder deposits their securities into a liquidity pool, the transfer agent must be able to clearly identify the corresponding nominal holder of the securities in the liquidity pool. Such records are maintained off-chain by the transfer agent, often referred to as the "master file of security holders" or "cap table."
Receipt tokens: These are tokens issued by DeFi protocols representing deposits made into their smart contracts. Many new questions must be resolved, such as: Are receipt tokens securities? If so, how do we control their movement in wallets, potentially leading to turnover among investors? Even if the underlying securities represented by the tokens are not securities, are receipt tokens a carrying instrument?
The plan is to alleviate some of these challenges by integrating Tinlake with Securitize's DS protocol and using the compliance services provided by Securitize. The DS protocol and Securitize ID can easily address the first challenge regarding KYC, AML, and transfer controls.
Securitize ID is a portable investor verification service launched by Securitize in May 2020, designed to improve the onboarding process for digital asset users. This one-click access tool provides investors who have been verified by the Securitize compliance team with access to investment issuer websites.
According to the Securitize ID product page, the benefits for issuers and investors include:
Issuers:
Investors do not have to undergo KYC/B verification each time a new product is launched.
Comprehensive online KYC filtering for individuals and institutions.
Continuous nightly filtering of each investor against foreign and domestic watchlists, such as OFAC, EU, Interpol, etc.
Ongoing monitoring to eliminate " Not In Good Order" (NIGO) issues.
Investors:
Secure one-click login process to access registration and new services.
No need for repeated identity checks and document submissions for each investment.
Personal information is protected with bank-level security, and the secure process allows immediate access.
Access through a single portal with diverse security measures, including two-factor authentication (2FA), giving complete control over their data.
By integrating Securitize ID into Tinlake, investors can access Tinlake's asset pools through one account, eliminating the need to repeat the investment identity verification and approval process. Investors using the Securitized platform for trading and management will assist with KYC/AML checks, investor certification, subscription agreement signing, etc. This will also encourage the maturation of the DeFi space and bring more real-world assets into open finance contracts.
Centrifuge Product Partnerships Manager Lea Schmitt outlined the benefits that investors and asset originators can gain from this service on Centrifuge's Medium page:
Investors:
Visit tinlake.centrifuge.io, click "Start your onboarding process now," or visit https://centrifuge.invest.securitize.io/#/Login.
Securitize will verify your information and whitelist your ETH address. Once the account is verified, you can invest in any publicly available Tinlake asset pool.
Select which funding pool to invest in from the Centrifuge dashboard, then sign the registration documents.
Visit tinlake.centrifuge.io, select your registered asset pool, and start investing.
Asset Originators:
The dashboard for asset originators will organize all important documents for investors. Below, you can see tax filings, country of residence, and KYC documents:
The so-called "HyFi Solutions" can bring appropriate checks and balances to DeFi, allowing more real-world assets to enter the development of financial contracts. Both Securitize and Centrifuge believe that bringing traditional financial investments into the digital asset ecosystem will lend more legitimacy to the industry in the eyes of regulators and global decision-makers.
If DeFi can achieve a higher degree of integration with traditional financial systems, it may experience exponential growth in the coming decades, akin to the early stages of traditional asset securitization during the first iteration of the IT revolution.
