As the blockchain ecosystem has developed, there have been ongoing attempts to tokenize Real World Assets (RWAs) on the blockchain. In 2022, we’re seeing a move to go further and use RWA-based tokens directly within the DeFi ecosystem. MakerDAO, for example, has created a committee to handle the research and administrative work required to issue DAI against RWA and is gradually increasing the amount of DAI issued against RWA. In addition, lending protocols like AAVE are discussing about facilitators that can issue their own stablecoin, GHO, against RWA. With Financial Services Commission in Korea releasing a proposal to allow the issuance and distribution of security tokens in 2023 and global private equity firms like Hamilton Lane announcing their intention to launch tokenized funds, and a Swiss private bank called Cite Gestion tokenizing its shares, we can expect to see more moves to utilize RWA tokens in DeFi.

RWA tokens have different characteristics than traditional tokens that are issued, owned, and traded on the blockchain. Considering that the main elements of the blockchain ecosystem have been developed independently of the real world, one might ask, “Since blockchains are designed to create systems that operate outside of the influence of real-world regulations, isn’t bringing RWA into the DeFi ecosystem going to make philosophies like decentralization obsolete?” And when designing a protocol, one might ask, “Do we need to create a specific mechanism that takes into account factors that are different from existing DeFi?”.

This series of articles aims to answer these questions, and more specifically, to provide an overview of the factors that need to be considered when trying to integrate and utilize RWA on top of a DeFi protocol. In the first part of the RWA article, I’ll give an overview of the concept of RWA, broadly describing the narrative that has been trying to address RWA in the blockchain ecosystem. After that, I’ll describe the similarities and differences in how protocols that handle RWA tokens are designed.

1. RWA Protocol Overview

1.1 Overall Concept

1.1.1 Definition of RWA Token

RWA tokens can be thought of as a tokenization of a real-world asset on the blockchain. Real assets that can btokenized include government bonds, corporate bonds, real estate, dollars, art, and gold. Freight invoices, consumer loans, receivables, and debt financing are other examples of tokenized RWA. Stakes in funds with market-neutral strategies are also tokenized as RWA.

1.1.2 Glossary

RWA tokens: In this article, we will refer to RWA tokens as tokenized RWAs on the blockchain, It can also be interpreted as RWA when lending occurs based on credit. When we talk about a specific asset class, we’ll specify which RWA we’re talking about.

Vault: As will be discussed below, one of the greatest utilities of RWA tokens is the ability to borrow stablecoins from the RWA-collateralized lending protocol. This process typically involves borrowers supplying their RWA token as collateral and information related to the collateral, and borrowing stablecoins from stablecoin depositors. Depending on the protocol, there are various names such as pool, but in this report, we will refer to the smart contract where this process takes place as Vault.

Borrower: An entity that seeks to borrow or raise funds from the protocol using the RWA they hold.

Lender: An entity that supplies assets (stablecoins) to the Vault that the Borrower needs.

3rd party: An entity that manages a vault. They provide the necessary infrastructure or brokerage for the lending process and rely on fees as their primary source of revenue.

1.1.3 RWA Token-based Blockchain Ecosystem

The RWA token ecosystem consists of two main components: the RWA tokenization protocol and the RWA token-backed lending protocol. RWA tokenization protocols include Centrifuge and Ondo Finance. Centrifuge enables the issuance of RWA as an NFT token and provides a framework for the legal structure required to utilize the token for financing. Users who tokenize their RWA through Centrifuge can then take it to other blockchains and use it in DeFi. In fact, MakerDAO operates a vault where you can borrow DAI against RWA tokens created through Centrifuge. Ondo Finance has tokenized investment products such as US Government Bond Funds and Investment Grade Bond Funds, and provides a platform for DeFi users to invest in these funds via stablecoins. Users invest in these products and receive fund tokens, which can be used to perform additional activities in the DeFi protocol, such as lending.

RWA token-backed lending protocols allow people who own RWA to use it to borrow money for their needs. Most of these protocols work by allowing regular DeFi users to deposit stablecoins into the protocol, and the entity holding the RWA can then borrow the stablecoins deposited by DeFi users against the RWA tokens. Existing DeFi protocols such as AAVE and MakerDAO also offer such platforms, where institutions can borrow stablecoins from the protocol using RWA tokens as collateral. The Maple Finance, Fortunafi, and Goldfinch Finance protocols operate platforms where users can borrow stablecoins against RWA tokens or credit. These protocols are designed specifically for RWA token collateral, and most vaults accept RWA tokens as collateral. This report aims to describe these protocols. A description of the features they have in common and the design elements that make them different will be discussed in more detail in the following parts.

Protocols dealing with RWA tokens often specialize in the type of RWA they are dealing with and who they are targeting as RWA owners or borrowers. For example, Ondo Finance focuses on relatively low-risk, stable yielding RWA such as US Treasuries and short-term bonds, while Goldfinch Finance focuses on RWA-backed loans to businesses and borrowers in developing countries. Maple Finance lends to investment firm in both DeFi and traditional financial markets.

1.2 RWA Narrative

1.2.1 Narrative from a DeFi Perspective

Since 2018, when Security Token Offerings was a hot topic in the Web3 ecosystem, RWAs have been receiving constant attention from the blockchain ecosystem. The same is true for the DeFi ecosystem, with claims such as “RWAs should be actively attracted to the DeFi ecosystem” and “RWAs will play an important role in the expansion of the DeFi industry in the future” starting in 2022. Here’s a quick summary of why these claims are being made from the perspective of the DeFi ecosystem.

RWA can increase the overall size of the DeFi ecosystem — With the rapid development of DeFi technology and ecosystems over the past few years, the DeFi industry has grown to a market worth more than $50B. However, even as large as the DeFi market has become, it is still small compared to traditional financial markets. For example, the fixed-income securities market, which is a typical RWA, is estimated to be $127T, the global real estate market is $362T, and gold is $11T (reference). If DeFi can successfully capture even a fraction of these RWA markets, many expect the DeFi industry to grow by leaps and bounds once again.

DeFi can increase the diversity of assets covered — So far, DeFi protocols have only covered assets that are issued and managed on the blockchain. While there are many different types of tokens being issued on blockchains, including native tokens, governance tokens, and stablecoins, they are all subject to the cycles of the cryptocurrency market, which is represented by the price of Bitcoin. What we’ve seen is that the value of all assets in DeFi has risen and fallen in the same direction as the price of Bitcoin. This has been a big problem for protocols like MakerDAO, because all of their collateralized assets drop in value equally, destabilizing MakerDAO’s lending market. But by bringing RWA into DeFi, DeFi protocols can become more stable because they have assets that are not affected as much by crypto market fluctuations.

Stable revenue streams — One of the biggest selling points for DeFi protocols over the past few years has been interest income, but the collapse of the Terra protocol in 2022 made the DeFi ecosystem realize the importance of consistent, stable revenue streams, and that simply minting tokens and sprinkling them with interest isn’t enough to sustain high interest income reliably. But if we can reliably onboard real-world yielding assets into DeFi, DeFi protocols can find a new source of revenue, especially since these yields can be maintained regardless of crypto market conditions, making them more valuable than traditional token yields in terms of stability.

1.2.2 Other narratives

Smart contracts can reduce financial costs — In the existing financial system, whenever a financial transaction occurs, an intermediary is required to confirm and process the transaction, and the intermediation process costs a lot of money. However, if RWA is tokenized and financial transactions for RWA are processed through smart contracts, the processing cost can be reduced to some extent. Also, since the transaction is executed and confirmed through the blockchain, the time delay caused by human processing can be avoided.

Increase access to financial markets — Many types of financial instruments still tend to be traded within their home country. This is because there are many costs associated with conducting financial activities in other countries, and access to these products is often not easy. However, by distributing these products through RWA on the blockchain, the blockchain can greatly improve access to financial products in other countries.

These benefits are especially evident in developing countries, where the cost of finance is often high and the lack of in-country financial infrastructure often prevents ordinary people from accessing financial products. One of the main narratives around RWA protocols is the expectation that DeFi protocols that address RWA will improve the accessibility of many financial products around the world.

2. Structure of the RWA Token-Based Lending Protocol

As of 2023, the most active RWA protocols in the Web3 ecosystem are lending protocols based on RWA tokens. The leading decentralized lending protocols, Compound and AAVE, are operated by lenders and borrowers, with borrowers borrowing tokens supplied by lenders.

RWA token-based lending protocols are based on a similar structure. In this part, I’ll provide an overview of what DeFi protocols that offer lending services backed by RWA tokens have in common, as well as how they differ. The discussion will be based primarily on Centrifuge’s Tinlake, Maple Finance, TrueFi, and Goldfinch Finance.

2.1 Loan pools

2.1.1 Lender → Vault → Borrower

Like AAVE and Compound, RWA token-based lending protocols require lenders to provide the capital needed by borrowers to the protocol, so the protocols incentivize lenders by offering to pay the interest paid by borrowers. Lenders deposit their assets into a vault that exists on each protocol, typically a stablecoin like USDC or DAI. Once enough stablecoins have been deposited into the vault, borrowers will lend their assets to the vault.

2.1.2 Vault Structures by RWAs and Borrowers

While the above may not seem like much of a difference between RWA token-based lending protocols and traditional DeFi lending protocols, there is one very important difference between traditional DeFi and RWA lending protocols: in RWA token-based lending protocols, the lender’s assets are only supplied to vaults created for each borrower or RWA token. In other words, the lender targets a specific vault and provides liquidity directly to that vault.

TrueFi is a coexistence of individual vaults where liquidity is pooled by borrower and loans are made, and DAO vaults where liquidity is pooled by token, such as USDC or USDT, and loans are made after the DAO’s vetting of the borrower.

Source: rwa.xyz

If you look at the list of vaults provided by RWA.xyz, you can see that there are separate vaults for the entity that will receive the loan or for the RWA that will be used as collateral and the terms of the loan. For example, in the Goldfinch protocol, there is a separate vault for each borrower, such as Cauris Fund and Lend East, and within that, they are categorized as Fund #1 and Fund #2.

Left: GoldFinch Finance, Middle: GoldFinch Finance, Right: Maple FInance

Lenders will decide which vault to supply their stablecoins to based on information provided on the protocol’s site, such as the stablecoin interest rate offered per vault, the protocol’s governance rate, the frequency of interest payments, and what happens in the event of a default. In addition, the protocol will provide information on how the borrower intends to use the loan, and what their history is of previously borrowing and repaying tokens on the protocol. There are even analytics and opinions about the pool shared by experts from the traditional financial world.

2.1.3 How to manage your vault

In existing DeFi lending protocols, loan pools are operated by smart contracts, and parameters such as whitelisting tokens to accept as collateral and setting minimum collateral ratios per token are determined through governance. However, in RWA token-based lending protocols, a third party is often set up as a separate manager for each pool. In TrueFi, only entities called managers who have been vetted and approved by the protocol can create their own vault. Managers lend to borrowers from the assets accumulated in their vault. In Maple Finance, each vault also has a set of actors called pool delegates who manage the vault. They are responsible for vetting borrowers to borrow assets from the vault, setting loan terms, and liquidating in case of default. At GoldFinch, it doesn’t have a separate custodian for each pool, but it has legal agreements in place that govern what happens to the collateralized assets in the event of a loan default.

2.1.4 Why are vaults created individually?

As you can see from the above, one of the biggest differences between RWA token-based lending protocols and existing DeFi protocols is that the assets in the protocol are kept separately by vault in the RWA-based protocols. Furthermore, the way the assets are managed is often managed by a third party per vault rather than fully automated by smart contracts, and the decision to lend is often made by them.

In existing DeFi models, the collateralized assets are all in the form of ERC20 tokens and have similar characteristics in that pricing and trading is done through an on-chain DEX. This allows all loan positions and collateralized assets created in the protocol to be managed using common logic defined in smart contracts. In RWA token-based lending protocols, however, the spectrum of collateralized RWAs is too wide and their stability or price volatility varies greatly. In addition, the probability of liquidation depends on who is borrowing, i.e., the borrower profile. As a result, the risk of each RWA asset and borrower is too different to lump all RWAs and borrowers into a single protocol. For this reason, lending protocols dealing with RWA tokens have separate vaults and manage assets on a per-vault basis.

In addition, in traditional DeFi, the responsibility for ensuring that loan positions are liquidated well and that defaults do not occur rested solely with the protocol mechanism. However, in protocols dealing with RWA, the protocol mechanism alone cannot guarantee that defaults do not occur, as the nature of RWA prevents liquidation from occurring instantaneously on-chain. Therefore, in addition to the logic implemented in the form of smart contracts, there is a need for an entity to manage and be responsible for the loans and collateral assets. For this reason, these protocols give vault management rights to entities that have a certain degree of alignment with the protocol, trust in the borrowers, and creditworthiness.

2.2 Liquidation

In RWA token-based lending protocols, as in DeFi lending protocols, it is very important to liquidate loan positions when a borrower fails to repay the loan. This is to preserve as much of the protocol’s assets as possible in the face of a high probability that the loan will not be repaid, and to preserve as much as possible for Lenders to get back. Without a proper liquidation process, Lenders may not be able to retrieve the assets they deposited, and the protocol may default. In this part, we’ll explain how liquidation works in the RWA token-based lending protocol.

2.2.1 Liquidation Conditions

In DeFi lending, which was based on over-collateralization, liquidation occurs when the ratio of the assets borrowed by the borrower to the collateral pledged by the borrower fails to meet the protocol’s requirements. The idea is to quickly liquidate the collateral before this happens, and return the assets gained from the liquidation to the lender in full, as the borrower has an incentive not to repay the loan if the value of the collateral pledged by the borrower becomes lower than the value of the tokens borrowed.

Unlike traditional protocols, where the value of the collateral determines whether a liquidation should take place, in RWA-based protocols, the decision to trigger a liquidation is based on whether the borrower is on track with their repayments. Each vault has configured a frequency and timing of loan repayments, interest payments, and fee payments, where the liquidation process is triggered when the borrower fails to pay what they owe on time. Another difference from traditional protocols is that unlike traditional protocols, where liquidation is semi-automatically executed by the liquidators as soon as the conditions for liquidation are met, in RWA-based protocols, the administrator of the vault communicates with the borrower to determine the likelihood of repayment and reschedule the repayment.

2.2.2 Liquidation Methods

In traditional DeFi protocols, liquidation involves selling the borrower’s collateral to the market and using it to force the borrower to repay the loan. However, in the case of RWA token-backed loans, it is impossible to sell the collateral to the market like ERC20 tokens and use it to repay the borrower’s loan (more on this in the next article.) This is why RWA token-based lending protocols use a different liquidation mechanism.

Many RWA protocols have a built-in fund to cover the outstanding amount in the event of a default. TrueFi, for one, runs an organization called SAFU, which attempts to cover as much of the outstanding balance as possible through the protocol’s insurance fund. Maple Finance, GoldFinch, and Centrifuge have separate funds that don’t directly cover non-repayments, but have prioritized exposure to asset losses caused by borrower non-repayment. This is called the Junior Tranche, and it is funded by deposits from lenders who are willing to take on a more risk for a higher APY.

When a default is declared, Lenders will not be able to withdraw the assets they have contributed to the vault. This is to prevent a first-come, first-served race between Lenders to withdraw their assets, whereby Lenders who withdraw early get to keep their assets and Lenders who are late will loss all their deposits. After the vault assets have been frozen, the third party managing the vault will go through a sale of the Borrower’s collateral assets for those that can be disposed of. This process usually happens off-chain. If the loan was made based on credit without sufficient collateralized assets, the protocol will pressurize the borrower to repay the loan off-chain, depending on the legal contract it has with the borrower. The repayment amount is then distributed to the Lenders in proportion to their deposits.

2.3 Incentive Structure

Regardless of which collateral asset is used, multiple entities use lending protocols because they have the incentive to do so: Lenders earn interest income by lending their stablecoins to borrowers via RWA protocols and borrowers gain liquidity in exchange for paying interest costs. Trusted third parties can earn fees for providing the transaction infrastructure for the Lender and Borrower.

Actors participating in DeFi protocols have a set of expected behaviors and are incentivized to perform them. However, in traditional DeFi, there is sometimes the potential for certain actors to violate their legitimate behaviors if the benefits of doing so are large enough to outweigh the costs. For example, rug-pulling in DeFi projects, or identifying a structural weakness in a protocol and utilizing flash loans to siphon liquidity from the pool.

Since most protocols require a KYC process to bring RWA tokens into DeFi, it’s unlikely that the parties involved will openly rug-pull. However, the risk of default still exists. In lending protocols that deal with RWA, in the event of a default, rather than the third party paying separate compensation to the lender, the third party can also preserve the lender’s assets while minimizing their own losses. In other words, these protocols have designed incentive mechanisms to align the interests of the third party with the lender who deposited the assets in the vault.

2.3.1 Incentive mechanism to align interests between Lender ↔ 3rd party

Truefi’s stkTRU liquidation — By staking TRU tokens with stkTRU, you can participate in the loan approval process for the Truefi DAO pool. TRU stakers can participate in the approval/decline vote on loan cases and earn additional TRU and protocol fees in return. However, TRU Stakers are part of the risk management entity for the vault they voted for and may be subject to liquidation up to the Maximum Liquidation Rate of the stkTRU they staked in the event of a default in that pool. The liquidated funds will be sent to the vault where the default occurred. This liquidation mechanism encourages stakers to vote carefully on the loans they make.

First-loss mechanism in Maple finance — In Maple finance, there is a concept called first-loss capital. If a Borrower in a given vault defaults and a default is declared, the losses will be covered by the funds deposited in the first-loss capital. The sole provider of first-loss capital is the 3rd party in that pool, and this mechanism is an important structure that aligns the interests of the Lender and the 3rd party.

2.4 Overall Overview

In this part, we’ve outlined the elements that RWA token-based lending protocols have in common in three parts: the vault, the liquidation mechanism, and the incentive structure. We’ve also outlined how each element is set up differently from traditional DeFi and how each protocol is designed. For a more in-depth explanation of each element, we recommend reading the protocol’s docs.

To summarize the above, RWA token-based lending protocols connect borrowers who want to raise funds on the blockchain using RWA as collateral and lenders who want to earn interest on their assets. Specifically, through vaults, borrowers’ RWA and profiles are shared with lenders, giving borrowers the opportunity to borrow against lenders’ assets. Conversely, Lenders are provided with the ability to deposit assets according to the logic of deposit and earn interest rate defined through smart contracts for each vault. In the process, the protocols are also providing a liquidation mechanism to maximize the protection of Lender’s assets in the event of Borrower’s bankruptcy, as well as determining the interest rate to be earned from the vault.

Traditional DeFi lending protocols and RWA token-based lending protocols have a similar overall structure. However, when looking at each element, the following mechanisms are unique to RWA protocols because they deal with RWA tokens.

See also: Where can I find information about my collateral assets?

Centrifuge

Tinlake provides detailed information about collateralized assets through pool-specific executive summaries. Let’s take a look at what information is being shown here. The example below is a portion of the executive summary related to the New Silver Pool.

Originator Details

Source: NS Pool LLC’s executive summary

An originator is the individual or entity that owns the target asset underlying an asset-backed security. Typically, a limited liability company (LLC) will often act as the originator of a real world asset (RWA). The Originator Details also often include information about the issuer, which is the administrator responsible for the offering of the vault. A special purpose vehicle (SPV), which is identified in the Offering Details, acts as the issuer. An SPV is a special purpose vehicle that maintains legal independence by segregating its assets, allowing it to spread the risk of an asset-backed transaction and manage the interests of originators and investors.

Asset Details

Source: NS Pool LLC’s executive summary

A section where you can find detailed information about the target asset. It contains parameters related to the loan, including the Payment Obligation.

Offering Details

Source: NS Pool LLC’s executive summary

Source: NS Pool LLC’s executive summary

All important information related to raising funds through Vault is included in the offering details section. As described above, the SPV is the same entity as the Issuer and is effectively brokering and managing the Vault. The role of senior and junior tranches for risk management is played by two ERC20 tokens, DROP and TIN, on-chain via Tinlake. The Distribution Waterfall section specifies that the repayment of TIN holders’ funds will occur after the repayment of all principal, including interest, to DROP token investors. Other information includes the TIN Ratio and information about investors.

In this way, Tinlake can see the details of the legal entity or contract for the RWA in the form of an executive summary. Since the link to the executive summary is provided through the webapp rather than through a smart contract, only limited information about the owners of DROP and TIN and the amount raised are available on-chain. (Of course, in the case of tinlake, there is no need to put all the information on the blockchain since the lenders, borrowers, and issuers are known and publicly available.) However, the fact that funding through RWA was executed on top of a blockchain protocol is significant in itself.

ELYFI

ELYFI is a real estate-related DeFi project developed by the Elysia team, similar to Centrifuge, that enables real estate to be used as collateral for loans. Unlike the ERC20-based DROP and TIN tokens used in Tinlake, ELYFI uses NFTs with an ERC1155 interface to sell Bond NFTs. Those who purchase Bond NFTs become Lenders, and when the repayment due date is reached, they will receive funds equal to the NFT purchase amount plus interest.

Information about a Bond NFT’s collateral can be found in the Bond NFT’s metadata hosted on IPFS.

{ "name": "Bond NFT", "description": "Right to receive principal and interest income. Bond NFT holders can receive principal and interest on the ELYFI site, www.elyfi.world, on the maturity date of the bond. Expected interest income is calculated from the execution date of the loan to the maturity date of the bond. Learn more on the ELYFI website.", "image": "ipfs://QmYz39eco2xHegDDD9RngJXGPH6qddDixhNww1zTJQS99X", "attributes": [ { "display_type": "date", "trait_type": "Expected Loan Date", "value": 1662562800 }, { "display_type": "date", "trait_type": "Expected Maturity Date", "value": 1694012400 }, { "trait_type": "Average APR", "value": "15%" }, { "trait_type": "Additional Overdue APR", "value": "3%" } ], "documents": [ { "type": "Loan agreement", "link": "ipfs://Qmb3SpPa14HfLDQynTHWk7Jea6R7tYyADuFK9SRCg9hZ6q" }, { "type": "Pledge agreement", "link": "ipfs://QmYSLrvzVX8jjtdo2u6c3JtAKjmREx8dyQPV1gbqstcjJ5" }, { "type": "Loan notarized copy", "link": "ipfs://QmWFVaTwPSRqPS14xzXezKMrAFq5tYeBx6Y2kPkHRNtsqV" }, { "type": "Certified copy of the housing register", "link": "ipfs://QmP5xBnzrLfpvfL9uzj1GKVPCT3JQjaGfDJbT6rW9kx7kj" }, { "type": "Seoul Station Area Youth Housing Agreement", "link": "ipfs://QmTbecRUtGBoD9BQ95mFhRGCKGzT7ajE82jgdmEryUAyuA" }, { "type": "PF Loan Agreement", "link": "ipfs://QmeKJYvQoECHxfUvSHL5VzA2zuRXbmrhAkt3kEKTkKmTt3" } ]}

If you look at the metadata of the Bond NFT, you can see that the documents and various loan agreements related to the actual collateralized real estate have been uploaded to IPFS through an attribute called documents, and the links to them have been collected. You can see that the parameter values set on-chain, such as the principal amount, interest rate, and guarantee period, match those specified in the loan agreement. You can also see that the uploaded documents are all legally recognized documents.

documents contains the following documents

These documents consist of the contracts needed to make a loan secured by real estate or conduct a PF business. By uploading these agreements to decentralized storage and leveraging smart contracts and blockchain infrastructure to execute them, ELYFI proved that RWA secured lending can be done in the real world as well as on DeFi protocols.

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