Research: The Retail Dilemma of RWA and Innovative Solutions Using DeFi

Author: DigiFT Ryan Chen et al.

Dilemma: Why Only Qualified Investors?

Apart from a few projects that implement RWA issuance schemes targeting retail investors under certain restrictions by complying with local specific laws, issuing special prospectuses, and registering specific securities (details of the schemes can be found in the RWA Innovation Module), most RWA in the current market can only target qualified investors. Depending on the regulations in different regions, investors are required to have a certain amount of financial asset proof to be considered qualified investors, such as Singapore requiring personal financial assets of 1 million SGD (approximately 730,000 USD).

The reason most RWA products, including U.S. Treasury-related products, can only target qualified investors or institutional investors is that compliant issuance to retail investors incurs high costs.

These costs arise from the lack of correlation between the underlying assets and the final issued tokens.

Securities laws impose strict requirements for issuing securities to retail investors, including the preparation and registration of prospectuses. Additionally, the laws in most jurisdictions require that ownership of assets such as stocks and bonds be recorded in a specific manner (for example, in a register maintained by the issuer). Currently, authoritative bodies do not accept tokens and blockchain as direct tools for ownership registration, meaning that token ownership cannot directly represent ownership of the underlying assets under these laws and regulations.

For RWA issued using an asset-backed model, such as RWA tokens backed by U.S. Treasuries, there needs to be a "bridge" between the underlying assets and the expected RWA tokens. The RWA token is a new security, and this "bridge" can be established by treating the RWA token as its own independent security, but this also means that the RWA token must independently comply with all relevant securities laws, i.e., the issuer needs to prepare and register a prospectus for the RWA token as a security.

To understand this, we can look at the traditional model of issuing securities to retail users. Whether issuing stocks or bonds, it requires going through:

• An internal preparation phase within the company to determine the characteristics of the company's securities, selecting and hiring investment banks (underwriters) and other financial professionals, such as lawyers and accountants, to assist in the IPO process.
• Selecting underwriters. Underwriters will assist the company in preparing and executing the bond issuance.
• Due diligence, auditing, and rating (for bonds), reviewing internal controls and governance structures to ensure compliance; for bonds, ratings will affect the credit quality of the bonds.
• Prospectus, which, if targeting retail investors, must be approved by regulatory authorities to ensure investors receive sufficient information.
• Pricing, determining valuation and issuance price conditions with underwriters.
• Marketing, conducting roadshows, interacting with potential investors, explaining the company's business situation, etc.
• Issuance and listing, which must meet the listing requirements and standards of the exchange.
• Post-transaction management, such as financial information disclosure, announcements, etc.

It can be seen that if securities-type assets are to be sold to retail investors, they must go through a complex process, and there are two main reasons why RWA finds it difficult to directly target retail investors:

1. High costs and insufficient returns. The entire process for issuing securities to retail investors can incur costs of millions of dollars and requires regulatory approvals; the overall crypto market is relatively smaller than the traditional market, unable to meet large-scale financing needs, making such compliant issuance costs too high and returns insufficient.

2. Inadequate infrastructure. Tokens do not have compliant securities exchanges providing trading services, and securities registration agencies currently do not support tokens as ownership registration, etc.

If issuers do not want to incur such high costs and trading friction, they can only issue products to qualified and institutional investors. Currently, the mainstream RWA assets in the crypto market are issued by SPVs established by startups. If traditional capital market securities, such as U.S. Treasuries, are used as underlying assets and issued using an asset-backed model, investors purchasing these issued bonds are essentially not buying Treasuries but rather corporate bonds issued by the SPV backed by Treasuries, which carries a very high counterparty risk, causing what was originally rated AA+ U.S. Treasuries to become BBB investment-grade corporate bonds through this structure. Other directly issued corporate bonds are also mostly issued by smaller companies and have not undergone the complete issuance process targeting retail investors, saving costs, resulting in the outcome of only being able to target qualified investors.

RWA Business Innovation Model: Combining RWA with DeFi

Since most securities-type RWA assets can only target qualified investors, the market space is very limited. Many RWA protocols explore innovative business models from legal, business, and other aspects to bring RWA into DeFi, allowing users to obtain the yields of U.S. Treasuries in a permissionless manner or to build infrastructure similar to on-chain money market funds.

Lending Model: Ondo OUSG - Flux Finance Ondo Finance

A lending protocol called Flux Finance has been designed for its U.S. Treasury token OUSG. Flux Finance replicated the code of the lending protocol Compound V2 and made a series of modifications to support assets with whitelist restrictions as collateral, adjusting its interest rate curve and collateral ratio to fit the characteristics of OUSG. Currently, the only collateral on Flux Finance is OUSG, with a collateral ratio of 92%.

On the other end of the lending protocol is permissionless, allowing any DeFi user to participate. Users can deposit stablecoins into the lending pool of Flux Finance to earn lending interest. Currently, Flux Finance supports four stablecoins: Frax, USDC, USDT, and Dai, with a utilization cap of 90%. OUSG holders can collateralize OUSG to borrow stablecoins from Flux Finance, obtaining liquidity. Flux Finance controls the borrowing interest rate to remain below the yield of OUSG, passing the yield of OUSG to USDC holders in a permissionless manner, while maintaining 10% liquidity in the pool for users to withdraw at any time.

Token Wrapping and Lending Model: MatrixDock - TProtocol

Recently, T Protocol announced a collaboration with MatrixDock to provide a lending pool for MatrixDock in the T Protocol V2 lending protocol, helping MatrixDock transmit the yield of its U.S. Treasury token STBT into DeFi applications.

TProtocol v1

In the previous TProtocol V1, the secondary wrapping of MatrixDock STBT enabled the permissionless sale of its U.S. Treasury tokens; TProtocol used the purchased STBT as collateral to issue corresponding tokens wTBT, following the changes in the number of held STBT, but without whitelist restrictions, thus better integrating with various DeFi applications and allowing cross-chain bridges to interact with different blockchains. The corresponding token wTBT currently has a circulation of 3.7M.

T Protocol V1 wTBT Token, Source: Etherscan, Data as of November 27, 2023

TProtocol v2

T Protocol V2 Product Flowchart

In September 2023, TProtocol and MatrixDock reached a collaboration to provide a lending pool for MatrixDock's STBT. MatrixDock STBT is a dynamically adjusting (rebasing) token, with each STBT pegged to 1 USD; the underlying assets of STBT are a basket of short-term U.S. Treasuries and money market funds, providing yields to holders, which are reflected in a dynamically adjusting (rebasing) manner, updating the token quantity daily based on the underlying asset prices.

In the future, TProtocol will open lending pools for related cooperative institutions, currently only supporting MatrixDock STBT. Users will deposit USDC into this lending pool and receive corresponding rUSTP tokens. Holders of MatrixDock STBT can use STBT as collateral to borrow USDC at a 99% loan-to-value (LTV) ratio.

The yield provided to USDC users by the lending pool is floating and will not exceed the interest rate of STBT itself. The protocol design aims to pass as much interest as possible to USDC users. The rUSTP tokens obtained by users depositing USDC are rebasing tokens, with each rUSTP pegged to 1 USD. The interest rate is reflected through daily quantity increases; theoretically, based on the design of the lending rate, the yield of rUSTP will follow the yield provided by STBT.

MatrixDock currently retains a certain amount of USDC in the lending pool. If users need to redeem their USDC, they will first redeem through this USDC. For the excess portion, if the amount is small, it will be directly sold through STBT on Curve. If the redemption volume is large, it will be realized through STBT redemption at MatrixDock, which, according to the current design, requires T+3 for redemption.

rUSTP can be converted into a stablecoin USTP that does not include yield. The remaining interest yield does not indicate where it will go (possibly to TProtocol itself). Users can also exchange it for iUSTP based on the internal exchange rate, which is a yield-accumulating token; the number of tokens itself will not change, and the value accumulates over time, allowing better integration with various DeFi protocols.

The overall process is as follows:

T Protocol V2 Product Flowchart

TProtocol V2 adopts a lending model to avoid the compliance issues that may arise from directly introducing securitized tokens, its structure is similar to Ondo Finance and Flux Finance. According to TProtocol documentation, users will be able to deposit USDC into funds managed by different institutions in the future, obtaining yields from RWA assets, backed by a stablecoin supported by RWA tokens.

RWA-Based Stablecoin: MatrixDock - USDV

The stablecoin project USDV (Verified USD) issues a stablecoin based on RWA with STBT as the underlying asset. Compared to centralized stablecoin issuers like Circle and Tether, RWA-based stablecoins have more transparency in their underlying assets as on-chain assets, thus providing a more solid credit foundation for the stablecoin.

Generally, stablecoin issuers obtain U.S. dollars, mint the corresponding amount of stablecoins, and use the dollars to purchase U.S. Treasuries or high-rated bank bonds as one of their sources of income; some stablecoin issuers like Circle distribute a certain proportion of their income to ecosystem partners. USDV adopts a similar approach, directly sharing the yields of the underlying assets with ecosystem participants through smart contracts to promote the development of the stablecoin ecosystem, such as issuers, market makers, and liquidity providers.

Holders of STBT who have undergone KYC certification can become issuers of USDV, minting new USDV by depositing STBT into the contract. USDV uses a special coloring design, similar to Bitcoin's UTXO mechanism, to identify the issuer of this portion of stablecoins on-chain. The corresponding yield generated from the dynamically adjusted underlying asset STBT will be retained in the contract, with 50% of the yield distributed to the corresponding issuers of these stablecoins and the other 50% distributed to market operators and liquidity providers, allowing these market participants of USDV to obtain yields or use these yields as a basis for further incentivizing ecosystem development.

Bearer Instruments: Backed Finance

The aforementioned schemes transmit yields through wrapping and lending via another associated party in a permissionless manner, retaining the original entity's compliance requirements. Backed Finance and the subsequent Ondo Finance USDY model are more breakthroughs at the legal and regulatory level.

Before understanding how Backed Finance operates, let's first understand registered and bearer instruments:

• Registered instruments: Generally, the notes circulating in the market, especially securities-type assets, are registered instruments, where the issuer or an authorized registration agency must record the holder of the note for each transaction and transfer.

• Bearer instruments: The issuer or registration agency only needs to know the identity of the note holder when necessary, such as during subscription/redemption/trading; there is no need to record the holder's information in real-time during circulation.

Backed Finance issues "tracker certificates," a type of derivative, to track the prices of underlying real-world assets. Each token represents a "tracker certificate," and the token holder has relevant rights to the value of the underlying asset in the contract.

Backed Finance has registered the "base prospectus" for the "tracker certificates" with the financial market authority in Liechtenstein. Since Backed Finance is a company registered in Switzerland, under Swiss law, Backed Finance can only promote to qualified investors. "Authorized participants," i.e., licensed banks, securities firms, and non-Swiss regulated financial institutions authorized to sell securities, can purchase from Backed Finance and then sell Backed Finance's products to retail clients. On the Backed Finance platform, the token subscription can only target qualified professional investors, but retail investors who purchase Backed Finance-related products from elsewhere can redeem after KYC with Backed Finance.

In the prospectus, the tokens issued by Backed Finance are designed as bearer instruments, with only a blacklist mechanism in the token contract design, allowing for permissionless transfers after issuance or direct interaction with various DeFi protocols. Only the process of subscription and redemption with Backed Finance requires identity verification.

Trading records of Backed Finance tokens on Ethereum, showing liquidity on Uniswap, Source: Etherscan, Data as of November 27, 2023

From the subscription and redemption situation, the short-term Treasury ETF token bIB01 from Backed Finance has only two subscription addresses, 0x43 and 0x5f, with no redemptions. After subscription, they provide the tokens to other investors through token transfers, so these two addresses may be authorized dealers transferring Backed's tokens to DeFi protocols or users. Tokens sold through dealers may only need to meet KYC, thus bypassing the restrictions that end users may encounter regarding qualified investors and institutional investors.

Yield-Generating Stablecoin: Ondo USDY - Mantle Ondo Finance

The newly launched USDY has landed on Layer 2 network Mantle as the yield-generating stablecoin for the Mantle network. Users of the Mantle network will be able to purchase USDY directly on DEX. Backed Finance achieves embedding RWA into DeFi through special European laws, while Ondo Finance has chosen another route.

USDY Product Structure Diagram

USDY is issued by Ondo Finance Inc.'s wholly-owned subsidiary Ondo USDY LLC, a bankruptcy-remote SPV. USDY is a token backed by short-term U.S. Treasuries and bank demand deposits, and can be sold to non-U.S. retail users under certain restrictions through U.S. Reg S registration. Currently, the restrictions on USDY include a 40 to 50-day lock-up period after sale, meaning users must wait for the lock-up period to end before obtaining on-chain tokens and cannot sell them to U.S. investors within a year.

The USDY token contract issued on Ethereum has whitelist and blacklist designs. Unlike other RWA token designs, USDY's whitelist design is special; anyone can add their address to the whitelist by calling the contract, with the user experience resembling an authorization transaction. The USDY official website directly provides the function to send this transaction, allowing users to add their address to the whitelist without KYC after detecting their IP address and agreeing to the terms. Additionally, the USDY token contract is associated with a legal document stored on IPFS, which may indicate that users agree to the legal terms when adding their address to the whitelist.

Currently, USDY is a yield-accumulating token, accumulating yields over time. Subsequently, Ondo Finance released USDY and mUSD on Mantle, removing the whitelist and retaining only the blacklist function. mUSD is a dynamically adjusting (rebase) stablecoin pegged to the dollar, with balances adjusted periodically based on yield. mUSD can be directly exchanged with USDY at the current ratio on the Ondo Finance platform.

The above five models address the compliance requirements for qualified investors regarding RWA assets from different angles of technology, business, and law, bringing RWA assets into DeFi to target a broader audience. For RWA project parties, this can enhance their platform's sales volume; for DeFi, it increases the variety of asset classes, providing stable foundational yields and enabling more diversified financial products through asset combinations.

However, regardless of the model adopted, there are many challenges:

1. AML Restrictions. DeFi protocols cannot prevent non-compliant assets, such as stablecoins from risky addresses, from entering their protocols; RWA protocols need to convert stablecoins into fiat currency to purchase real-world assets, which usually involves scrutiny of the source of funds, with strict KYC and AML requirements. Such mismatches can affect some DeFi protocols' ability to strengthen the review of funding sources. If more RWA enters the DeFi space, the compliance of funding sources in DeFi will also strengthen.

2. Time Mismatch. Traditional financial asset markets are only open five working days a week, for only a few hours each day, and close on holidays. Asset trading requires banks, brokers, and other systems, often needing T+1 or even longer settlement times. In contrast, DeFi protocols operate 24/7. If liquidity demands arise, such as market fluctuations during holidays, DeFi protocols need to liquidate assets, while RWA assets will require longer processing times and procedures. Protocols allocating RWA assets need to consider liquidity adequately.

3. Sales Restrictions. Many of the aforementioned RWA projects require investors not to be residents of certain countries and regions, possibly due to tax (e.g., the U.S. tax system is very complex), AML (some regions are sanctioned), or the complex financial systems of certain countries and regions. Through DeFi protocols, there is a high likelihood of selling assets to residents of regions or countries where they should not be sold. Since most RWA assets are defined as securities, they are subject to strict legal restrictions, which can lead to sanctions against the RWA project by the laws of that region or country.

4. Asset Ownership Confirmation. It is difficult to confirm what entity the DeFi protocol uses to complete KYC for the RWA protocol, how the assets are stored after acquisition, and the legal ownership of RWA assets purchased with stablecoins deposited by users. Generally, DeFi protocols open accounts under a foundation or establish SPVs, using the assets deposited by users in the protocol to purchase relevant assets from the RWA project through that entity. Legally, the ownership of the RWA assets is attributed to the foundation or SPV, with the ultimate beneficiaries being the shareholders behind the foundation or SPV, rather than the users of the DeFi protocol. However, DeFi users are generally anonymous or use DAO forms, having only a code-based claim to the DeFi protocol, without legal claims. How to ensure users' asset rights remains a challenge.