MakerDAO Weighs Accepting Real-World Assets as Crypto Loan Collateral

Decentralized finance (DeFi) could soon boast a real-world use case. 

MakerDAO, the organization behind the dollar-pegged stablecoin known as DAI, is in the process of voting on whether to further diversify the collateral it accepts for loans beyond cryptocurrency and tokens to include real-world assets (RWAs). 

Specifically, Maker would also allow supply chain invoices and musicians’ future royalty streams as security when it lends out DAI. These assets would be represented on the Ethereum blockchain by non-fungible tokens (NFTs), the innovation that spawned CryptoKitties. Small businesses and artists could take the borrowed DAI, which usually trades 1-for-1 with the U.S. dollar, to crypto exchanges like Coinbase and convert it to cash.   

If approved, the proposals would pave the way for the first application of DeFi to solving a tangible business problem outside the rarefied realm of crypto. The current crisis, like the 2008 financial meltdown, has seen big firms apply the brakes across supply chains, to the point where innovative ways of freeing up working capital for suppliers awaiting payment could be a lifesaver. 

“The average crypto user that bought bitcoin when it was a few hundred dollars and is using DeFi to trade and manage their wealth is a very different user from a business that is actually quite cash-strapped,” said Lucas Vogelsang, CEO of Centrifuge, a startup focused on bringing real world assets to DeFi. 

“These businesses are looking to DeFi as a way to get money quicker and get it on their own terms, without having to go to a bank,” said Vogelsang, whose firm has pilot-tested the financing of freight forward invoices with DeFi loans. “They don’t have crypto to get their DAI loans, so they need to be able to use their invoices or their inventory.” 

Centuries-old conventional trade finance works by allowing banks to become third parties to supply chain transactions so they can guarantee payments and remove risk. Suppliers can also receive cash payments to keep their business flowing based on accounts receivable. Simply put, if Bob orders a crate of herring from Alice, his bank will front part of the payment and send the balance when the shipment arrives.

DeFi, which emerged about two years ago, broadly aspires to remove such intermediaries, opening up areas such as lending to a mass of participants rather than a handful of banks. But so far, the most active area of DeFi has been lending and borrowing crypto assets to facilitate margin trading – in other words, locking up crypto to borrow more crypto to buy more crypto. 

The first companies ready to work with Maker on RWAs are ConsoleFreight, a platform for supply chain finance, and Paperchain, which makes musicians’ royalty payments from Spotify instantly available (similar to the bonds David Bowie issued in the 1990s backed by his catalog’s revenue streams). 

“These should be seen as the first two [RWAs] in the greatest portfolio of assets that’s ever been built,” said Rune Christensen, founder of the MakerDAO project. “It’s just the first step. Thousands and thousands of assets will exist alongside them.”

The catch for lenders is that in the event of default, they would have to rely on the flesh-and-blood legal system to enforce their rights to the collateral, rather than an automated smart contract that can do so with on-chain assets.

“Each Tinlake pool has a legal structure (an SPV) that mirrors what happens on-chain,” Vogelsang said, describing his firm’s tokenization process. “It has a contractual relationship with both the borrowers and the investors ensuring that a claim on the RWA can be made by the investors.”

Holders of MakerDAO’s governance token, MKR, are voting on the proposals. As of Thursday, 96% of votes cast favored inclusion of trade finance assets, with a similar proportion supporting the addition of music royalties. The polls close in about four days.

Tough sell for corporates

Before DeFi, trade finance has long been a favorite use case for enterprise blockchain.

These types of private or permissioned networks are owned by groups of banks or large tech providers like IBM, and tend to be focused on making existing infrastructure more efficient, which would have the knock-on effect of making finance more accessible to small businesses. 

DeFi’s take on trade finance combines openness and transparency, with settling value on-chain, something that is much harder to do, said Vogelsang. It’s a concept banks and more traditional players are going to struggle with, he added. 

Having said that, he was optimistic about an interoperable blockchain future where DeFi could coexist with permissioned networks.

“I think in the long term all these projects will find a way into DeFi,” said Vogelsang. “Many projects have good ideas and decent systems. I think they might exist alongside DiFi, move assets into DeFi, and borrow liquidity from DeFi. Being truly open, ownerless and permissionless has the potential to be the fairest market of all.”

Alejandro Gutierrez, CSO at ConsoleFreight, said his company had been experimenting with blockchain and had looked at the likes of IBM’s TradeLens and we.trade (which IBM recently became part-owner of), before connecting with Maker and Centrifuge last year. 

“Our view was that, at the moment, Hyperledger is for big players like Maersk, Kuehne & Nagel and Walmart,” said Gutierrez, whose family has been freight forwarding for two generations. “TradeLens is not cheap at all for an SME [small and medium-sized enterprise],” he said. “We.trade is the same story, backed by big financial institutions, they are not really trying to extend finance to the masses.”

IBM would not comment on any particular startup or project, but said it is committed to the broader principle of connecting networks together, what it calls a “network of networks”.

Richard Stockley, Europe Business Development Executive for IBM’s TradeLens, said the platform is “actively working with a wide array of application and platform providers – some using blockchain, others not – where the collaboration brings enhanced offerings to our clients.”

MakerDAO had a closer connection to enterprise via Tradeshift, the supply chain payments unicorn, which started testing DAI in mid-2018 to tokenize unpaid invoices of small businesses. 

“Tradeshift has been doing experiments with Maker for a long time, but always experiments,” said Christensen. “This is completely different because we are talking about the first time ever a real company is actually engaging in the DeFi  governance process, which is completely unprecedented and futuristic.”

Brave new world

Futuristic indeed. As Christensen admits, the entirety of the Maker community is about equivalent in size to a fairly popular indie computer game.

On top of that, crashes and failings are a given.

“There are going to be crashes, there is going to be fraud, and all the ways things can fail in DeFi, they will fail. That’s guaranteed,” said Christensen.

“Individual failures are actually meant to happen,” he went on. “They are meant to be absorbed and hedged by diversification, so you need other assets that are not correlated, and through that the system can continue to be learned about and evolve and ultimately adapt.”

There are also trade-offs in the ongoing collateral diversification of MakerDAO, such as the recent addition of the Coinbase and Circle-backed USD Coin (USDC), a dose of crypto centralization to make DAI stablecoin more stable. 

Christensen said bringing the real world into DeFi means introducing new risks, adding that the Maker community is also introducing gold in the form of the Paxos Gold token, and there is a lot of interest from various quarters in real estate. 

“It’s a simple principle of not putting all your eggs in one basket. You have to spread your risk across many different points of failure, so in the end that means you are not going to see DAI holders get a haircut,” Christensen said, referring to the risk that those who redeem the stablecoin get less than 1-for-1 dollar value.

Regarding a decentralization trade-off and the risks that come with it, Vogelsang said some asset originator from the real world may be a legal entity, but that doesn’t mean it has unlimited power. 

“Just because there is a legal contract in place, the asset originator cannot do whatever they want and just pull the plug.”  

Skin in the game

Centrifuge’s asset tokenization process, called Tinlake, is complex. 

Freight invoices, or royalties in the case of musicians’ rights platform Paperchain, are represented on-chain by unique NFTs. The individual loans are bundled together in a set of smart contracts that issue an interest-bearing ERC20 token against the pool of NFTs. 

ConsoleFreight and Paperchain are “solid lenders,” said Vogelsang, with loans that are due in 60-120 days being relatively easy to price because macroeconomic circumstances normally don’t change too much in that time. 

“I think that given the current economic climate, and the very short-lived nature of trade finance assets, it makes them very interesting. I don’t know if I would want to try and bring a 10-year or 20-year mortgage on-chain right now,” he said. 

The trade finance industry’s default rate is under 1%, while Paperchain records over 99% confidence on its predictions on invoices, thanks to easily accessible data from platforms like Spotify, according to the platform’s chief operating officer, Budd White.

“This is quite different from car loans priced at 30% given to people with a credit score of less than 650, or something like that,” Vogelsang said.