The rampant expansion of DeFi: How to embrace trillion-dollar real-world assets?

This article was published on ChainNews, authored by Kira Sun and Ruby Wu, partners at the blockchain investment firm Incuba Alpha.

We know that DeFi is developing rapidly, but we didn't expect it to be this fast.

About three months ago, we envisioned the "horizontal expansion" of DeFi balance sheets and the "vertical expansion" brought by interest rate markets. In less than a quarter, many bold ideas and predictions we once thought were daring are being rapidly validated. The variety of income-generating underlying assets or synthetic asset categories is increasingly rich, more lending protocols are beginning to support the collateralization of various LP Tokens, and Iron Bank's attempts at non-fully collateralized lending between DeFi protocols, along with the endless innovations in algorithmic stablecoins, are leading to a diversified and multi-layered DeFi credit system that is becoming systematic and three-dimensional.

The development of DeFi is always inseparable from assets. In a financial market like DeFi, which has characteristics similar to fixed income, if you want to achieve excess returns, there are basically three methods: one is to increase leverage, the second is to extend the cycle, and the third is to sink credit.

DeFi users are generally proficient in using lending tools and are familiar with leveraging operations; extending the cycle requires the completeness of corresponding interest rate market tools. Currently, the fastest development trend is the sinking of credit in the DeFi market, which is also the core thread of our judgment on the horizontal expansion of the DeFi market—bringing more types of credit onto the blockchain as on-chain assets and including these assets within the scope of qualified collateral. By introducing more collateral, credit and monetary liquidity can be released, thereby achieving the expansion of DeFi balance sheets.

In addition to the aforementioned innovations of blockchain-native crypto assets as qualified collateral, along this thread, we are pleasantly surprised to observe that DeFi is "breaking the circle" by connecting to real-world assets. MakerDAO's acceptance of Real World Assets as collateral marks the emergence of a brand new track.

DeFi newcomers like Centrifuge, Naos Finance, ShuttleOne, Persistence, and Convergence are committed to serving as a bridge between DeFi and CeFi, bringing various real-world income-generating assets such as consumer finance, supply chain finance, corporate credit, and real estate rental income rights onto the blockchain, greatly extending the boundaries of the DeFi world. Incorporating real-world assets into DeFi will make the current stock of DeFi assets seem extremely insignificant.

From a financial logic perspective, the business models of these projects are not complex. Many fintech companies in the real world provide financing services based on specific asset income rights in a centralized manner. Their business essentially mirrors the "structured finance" business logic in traditional financial markets.

In traditional structured finance, we need the borrower to package underlying assets with future cash flow income into an SPV (a type of trust or asset management product) and issue senior and subordinated shares. Investors pay the borrower by subscribing to the corresponding shares, with the subordinated shares providing a cushion for the principal repayment of the senior shares. If the senior or subordinated shares are listed on an exchange, these shares become relatively familiar "asset-backed securities." Fintech companies are responsible for customer acquisition, due diligence, financial advisory, asset management, process management, information disclosure, risk control, and settlement in this process.

In essence, protocols like Centrifuge and Naos Finance map the positioning of fintech companies in traditional structured finance onto the blockchain and replace the offline financial business processes with a "NFT + DeFi" technical design, achieving "asset tokenization." The protocols will tokenize offline income-generating assets (such as accounts receivable) into NFTs, over-collateralize the NFTs (for example, financing at 70% of face value) to borrow stablecoins from lending protocols like Compound or Maker, and then the accepting merchants will exchange the stablecoins for dollars to lend to real-world borrowers. Investors can then invest in the corresponding assets through lending protocols to earn interest income.

The business logic of Centrifuge and Naos Finance replaces the entire cumbersome business chain of packaging SPVs, asset management channels, structured layering, and fund matching with DeFi, achieving structured financing in a decentralized manner and fully utilizing the characteristics of DeFi's liquidity pools, transforming point-to-point P2P transactions into point-to-pool transactions, changing the risk management structure and improving capital matching efficiency.

This business model may sound familiar; from the underlying assets and business logic, it is very close to the internet finance model that was all the rage a few years ago. Looking past the demonization of "internet finance," DeFi's connection to real-world assets should be the financing model closest to the original concept of internet finance. The upcoming short-term development is expected to rapidly replicate the early wild growth phase of internet finance, bringing significant business opportunities while also introducing unfamiliar risk points for DeFi users.

Breakthrough Opportunities Are Very Obvious

For the native DeFi market, bringing physical assets on-chain essentially introduces a new type of credit that is completely different from the current attributes of native blockchain assets, creating a new asset category that can provide DeFi users with a richer selection of on-chain assets, thereby driving the expansion of the DeFi liability side and achieving the overall expansion of the DeFi balance sheet.

In traditional financial markets, similar underlying quality assets have thresholds for qualified investors in structured investments. Through the NFT + DeFi approach, investors can access the yield dividends of the structured financing market without any thresholds. This investment opportunity will further enhance the market penetration level of DeFi, attracting more users to participate in the DeFi market.

Secondly, similar underlying assets typically have fixed financing terms and interest rates. With the introduction of real-world income-generating assets, the long-awaited DeFi interest rate market will have the foundation to take off. Users will need to leverage various interest rate protocols to participate in investment opportunities in new asset categories, and interest rate protocols will welcome catalysts for simultaneous increases in penetration and TVL. The explosion of the DeFi fixed income market is merely a matter of time.

The most significant innovation lies in the combination of protocols like Centrifuge and Naos with Maker and other stablecoin protocols. Maker's acceptance of over-collateralized NFTs mapped from real assets can issue more Dai stablecoins, and this portion of stablecoins will genuinely enter the real economy for circulation. Embracing real payment, lending, and commercial circulation scenarios is a surprising monetary creation and issuance path for all stablecoin protocols. The circulation of stablecoins is inherently cross-border, and once real assets are tokenized into NFTs, they will circulate freely on the blockchain. We look forward to seeing various financial assets globally exchange value within the same borderless network.

On the risk front, connecting real-world assets through DeFi will pose significant challenges to the DeFi world.

Due to the relatively long overall business chain and the significant differences in risk-return characteristics of the underlying assets compared to current on-chain native assets, many investors are still haunted by the chaos of the previous internet finance industry, including self-financing, fund pools, maturity mismatches, and frequent defaults. Investing in real-world assets in the DeFi market will inevitably face similar risks.

In the early wild growth phase, internet finance companies often raised short-term funds to pool into fund pools and invested in long-term financial assets with high credit risk in a non-transparent "black box" manner. This fund pool made it impossible for users to correspond each investment with specific underlying assets, shifting the risk from the default risk of individual underlying assets to the overall default risk of the internet finance platform. Moreover, this borrowing short to invest long maturity mismatch led to a mismatch in duration between the asset and liability sides, easily accumulating the platform's own funding turnover vulnerabilities. Once there are significant defaults in the underlying assets, a liquidity crisis can occur.

However, unlike P2P in CeFi, DeFi operates on public ledgers. In the designs of protocols like Centrifuge and Naos, each user investment can correspond to a specific underlying asset NFT, reducing the occurrence of fund pools and maturity mismatches on both the asset and liability sides, significantly decreasing the likelihood of an overall liquidity crisis in the protocol.

Additionally, since the business involves real-world assets, it inevitably faces the credit risk of the underlying assets themselves and the moral hazard of asset managers, which is also the greatest risk that led to the widespread defaults in the internet finance industry. The risk-return characteristics of various income-generating assets differ greatly; for instance, supply chain assets have very complex rights confirmation and verification risks, and unsecured credit income rights have the highest default and bad debt rates among all financial assets. Some small microloans may face a 50% default rate, and there may even be complex risks where some underlying assets cannot be liquidated or disposed of, leading to unrecoverable debts. General DeFi users may find it difficult to discern these risks and easily suffer significant losses.

In extreme adverse situations, traditional internet finance platforms may mix junk assets into asset packages, fabricate non-existent underlying assets, and even establish guarantee companies for false credit enhancement while setting up shell companies for self-financing or defrauding user financing, creating false contracts, and misappropriating funds by platform founders. This series of behaviors constitutes financial fraud. However, due to the inherent information asymmetry between online and offline, and the lack of legal compliance constraints and regulatory jurisdiction in the industry, investors have virtually no control over the underlying assets and offline business processes. DeFi cannot fundamentally or technically eliminate the existence of these core risks.

Ultimately, in the off-chain aspects, especially in the early stages of industry development, we need to rely heavily on the professionalism of teams like Centrifuge, Naos, ShuttleOne, Persistence, and Convergence to self-regulate moral hazards and ensure the authenticity and quality of the underlying assets. Furthermore, in the event of risk incidents, investors can only rely on DeFi protocols and their partners for the disposal and liquidation of collateral assets offline.

Users should carefully consider the nature and risk-return characteristics of the underlying assets when choosing to invest in DeFi protocols involving real-world assets. Platforms may promote their assets' low default or bad debt rates, but such claims are difficult to substantiate and are not sufficient as effective references. We should pay more attention to the risk control measures introduced by these DeFi protocols in response to these risks.

Regarding risk control measures, some good designs currently observed include Centrifuge's introduction of over-collateralization of NFT values and the prioritization of funding layers, which alleviate the credit risk for senior investors through a structured approach. Additionally, Naos has introduced an Insurance Mining risk protection fund on-chain and has partnered with real-world insurance companies to insure the underlying assets, enhancing credit quality, and has obtained compliant lending business licenses in various Southeast Asian countries to meet regulatory and compliance requirements. These risk measures can help DeFi protocols and investors control certain risks in the early stages of development.

Overall, the competition among these DeFi newcomers will be a complex and multi-dimensional dimension. Beyond technology, products, and user experience, it will require competition in asset acquisition scenarios and capabilities, the quality and credit risk of the assets themselves, as well as the ability to respond to regulation, compliance, and risk management. We firmly believe that DeFi breaking the circle and embracing real-world assets is imperative. When DeFi and CeFi collide in the field of fintech, it will be the Big Bang of the next generation of mobile financial infrastructure.