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Ajit Tripathi: How to Bring Off-Chain Assets to DeFi

coinnewsdaily by coinnewsdaily
February 17, 2021
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Ajit Tripathi: How to Bring Off-Chain Assets to DeFi
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The recent GameStop short squeeze has brought decentralized finance (DeFi) into mainstream public consciousness. Well-known crypto influencers such as Caitlin Long have espoused decentralized exchanges as an alternative to traditional clearing and settlement infrastructure. Others, including me, have suggested that decentralized credit markets can reduce systemic risk by enhancing financial market transparency.

Ajit Tripathi, a CoinDesk columnist, is the Head of Institutional Business at Aave. Previously, he served as a fintech partner at ConsenSys and was a co-founder of PwC’s U.K. Blockchain Practice.

In this article we examine some of the key considerations for transitioning from crypto-native decentralized markets to decentralized real-world asset markets at institutional scale.

Institutional interest in DeFi

In my experience, the level of institutional interest in DeFi is currently much stronger than commonly assumed. This is because of five main reasons:

First, unlike enterprise blockchain projects and proofs of concept, which in my opinion have struggled to deliver returns on investment, public permissionless DeFi protocols have delivered clear proofs of value reflected in DeFi trade volumes, market liquidity and fee revenues.

Second, custodians, secure wallets and neo-banks that have built the rails for institutional adoption of bitcoin have already done much of the heavy lifting required for enabling access to DeFi.

Third, family offices, proprietary hedge funds and corporate treasuries flush with cash are actively searching for yield in a low or zero interest rate environment and the digital asset crypto lending environment facilitates 5%-20% yields on a given day.

Fourth, centralized liquidity pools need much more liquidity than they can find currently.

Fifth, decentralized lending provides far more transparency in terms of risk and capital position than centralized lending platforms are capable.

Off-chain assets and NFTs

I really don’t like the term “real-world assets.” This is because crypto assets or digital assets are as real as a paper dollar bill or a stock for me. Therefore, I much prefer the terms crypto-native assets versus off-chain assets. That’s the terminology I will use in the rest of this article.

Most off-chain assets, unlike money tokens and listed stock, are not fungible.

Most people in crypto use nonfungible tokens (NFT) and digital art interchangeably. This conflation is understandable because the most hyped-up application of NFTs in the previous bull run was CryptoKitties, a collection game that pretty much jammed up the Ethereum network at its peak. In the current crypto bull run, 24-by-24 gifs called CryptoPunks have reached valuations of nearly $1 million.

See also: Ajit Tripathi – Why I’m Long Crypto, Short DLT

However, NFTs aren’t just digitally signed gifs and videos for owning and showing off to friends. Nonfungible tokens can point to any asset that is not fungible. For example, unlike publicly traded stock, just about every private equity contract comes with bespoke, idiosyncratic terms and conditions. The same thing applies for bonds with bespoke, contract-specific restrictions and covenants. This “idiosyncratic” or “specific” nature of an asset makes just about anything a non-fungible token. In fact, most financial assets, and not just non-financial assets like art and music, are in fact NFTs and not fungible tokens like money tokens or publicly traded shares.

This ‘idiosyncratic’ or ‘specific’ nature of an asset makes just about anything a nonfungible token.

The most relevant application of NFTs that I’ve personally worked on is the U.K. land registry PoC with HMLR. My house is indeed not substitutable for my neighbor’s house and even if identical in shape, design and size, they appeal to different people and sell for a different price. What makes NFTs even more interesting is that you can bind a fungible token, e.g., fractionalized real estate, to a nonfungible token, i.e., a token representing Buckingham Palace. DeFi protocols are proving a range of these concepts and delivering value with natively digital assets and adding overlays to bootstrap off-chain asset markets already.

The challenge

Let me state at the outset that the main complexity in deploying off-chain assets on on-chain markets is not technology. While decentralized technology can significantly enhance transparency, automation and efficiency, addressing three other factors is much more challenging. These factors are a) bootstrapping the market, b) implementing a robust legal framework for property rights and custody and c) asset servicing. Let’s explore each of these in turn.

Bootstrapping the market

Bootstrapping the market involves finding and incentivizing buyers and sellers or borrowers and lenders that have a compelling need to use new, more efficient and transparent infrastructure that DeFi enables.

This is somewhat involved. Crypto market participants who are comfortable with crypto user experience and self-custody generally have much higher return expectations and risk tolerance than those in off-chain asset markets.

See also: Paul Brody – Enterprises Would Use DeFi if It Weren’t so Public

For example, a 10% annual return on tokenized invoices is quite exciting for participants in the invoice financing market. In crypto markets, expectations might be 10x, which of course reflects the market risk of the crypto asset class. Conversely, hardly anyone in the invoice financing markets is familiar with using MetaMask, paying Ethereum gas fees or experiencing 10% daily price volatility.

To beat the inertia of legacy financial institutions, innovators working with off-chain assets will have to focus on finding early-adopter segments where they are.

Property rights and custody

In crypto, the idea of self-custody i.e., “not your keys not your crypto’” is axiomatic. But the concept doesn’t work so well for ownership of off-chain assets such as real estate, receivables, stocks or bonds. In the off-chain world, being in possession of private keys is generally not sufficient proof of ownership and property rights need to be enforced via contracts, regulation, arbitration and court proceedings.

In both off-chain and on-chain worlds, custody is not merely the ownership of a private key but a  legal obligation to safekeep assets on behalf of a customer. The licenses and permissions that crypto custodians require in the U.S. tend to be broadly similar to those required by securities custodians. This makes the role of custodians quite critical in the emerging decentralized markets for off-chain assets.

Systems of record

In information management, a “System of Record (SOR)” is the authoritative data source for a given data element or piece of information. For crypto-native tokens such as ERC-20 tokens or NFTs, the public Ethereum blockchain is generally the definitive official ledger of who owns what and the corresponding transactions that effect changes in ownership. This provides efficiency of crypto native asset transfers and locking assets in smart contracts for DeFi primitives such as algorithmic stablecoins, vaults, collateralized lending and liquidity mining.

For off-chain assets, the on-chain ledger is generally not necessarily the system of record which means locking an asset in a smart contract requires an off-chain legal framework that honors the concept in the off-chain world. In the off-chain world, there’s generally an appointed authority, such as the land registry, enshrined in national legislation that is tasked with maintaining the integrity of the ledger.

Asset servicing

All assets involve the expectation of future benefits, generally written into a contract. For example, a share in a company often pays a dividend, can be split, can be acquired in a tender offer and so on and so forth. Similarly, a rental property hopefully provides an income stream in the form of a rent.

Asset servicing is the task of processing these “events” and delivering the benefits to the owners of such assets through the life of the asset. In securities markets, this task is normally performed by regulated intermediaries such custodians. In on-chain markets, smart contracts are written to automatically deliver such benefits in the form of tokens, native protocol tokens, rebasing and so on.

The path forward

The biggest upside of decentralized finance protocols is that they are like an open road for innovation. As of today, major DeFi protocols have implemented many asset-agnostic primitives such as collateralized lending, automated market making and essential derivative contracts. Essentially the foundational layer of market infrastructure has been laid.

DeFi entrepreneurs working with off-chain assets can leverage all of this open-source technology and on-chain liquidity to innovate and venture capital is available in abundance to do so.  Further, unlike enterprise blockchain projects that require big budgets and recurring funding approvals and endless bureaucracy, innovators can combine these DeFI primitives and liquidity with their expertise in off-chain asset markets. This is already happening today.

See also: DeFi Dad – Five Years In, DeFi Now Defines Ethereum

The important thing here is to not bite too much too soon and iterate quickly.

This “composing” markets using existing DeFi protocols is exactly what DeFi innovators are doing today. As they prove the value of their innovation, they will start to deliver the economic evidence needed to change the rules that are built for legacy technology.

In summary, DeFi 1.0 for crypto-native assets is here and it’s a spectacular achievement of technology. DeFi 2.0 will be incredibly exciting and it will involve off-chain asset markets and legal tech.

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