Collateral Tokenization: The Evolution of On-Chain Creditby@andreydidovskiy
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Collateral Tokenization: The Evolution of On-Chain Credit

by Andrey DidovskiyMarch 28th, 2023
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DEFI is the idea of creating a financial ecosystem built on infrastructure that is not owned by / dependent on any single entity. It is predicated on the combination of traditional financial infrastructure (credit/lending / etc..), distributed computation (blockchain & other DLTs) & the power of open-source software (tokenization) At the core of **DEFI**, as with *tradFI*, lies the credit concept.
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This article has been written with the assumption that the reader has a basic knowledge of cryptocurrency, DEFI & the digital asset industry.

As we know, Credit is highly dependent on reputation & identity. In a young emerging digital world where reputation hasn’t had the chance to be properly built in yet, where everybody is pseudonymous & rarely holds themselves accountable, providing credit becomes a herculean task.

DEcentralized FInance is the idea of creating a financial ecosystem built on infrastructure that is not owned by / dependent on any single entity. It is predicated on the combination of traditional financial infrastructure (credit/lending / etc.. ), distributed computation (blockchain & other DLTs) & the power of open-source software (tokenization).

At the core of DEFI, as with tradFI, lies the credit concept.

I forgot where I heard it, perhaps Mr. Ray Dalio:

“Credit is the grease to the gears of the modern financial system.”

To build any kind of serious financial system, credit must be a fundamental design component.

Credit provides a broad range of sophisticated financial tooling including:

- Leverage

- Lending / Borrowing

- Asset Issuance

- Inverse Options

- & basically everything else…

The creation/implementation of credit has been explored by humanity for thousands of years & by the brightest of minds. Ultimately, the provision of credit is distilled to Collateralization.

Collateral is the Holy grail when it comes to DEFI. Value in DEFI is primarily derived from its TVL (total-value-locked). TVL is a direct measure of collateral that users commit to a DEFI protocol.

As it stands, the open-source world of cryptocurrency & blockchain has prolifically utilized the 3 variations of Collateralized models for the provision of On-Chain credit.

Each variation of collateral has its own unique focus based on assumptions & tradeoffs in risk.

Equal (1-to-1) Collateralization

The most popular model sometimes referred to as “pegging”, equal collateral simply means that 1 token is issued per 1 unit of value. These tokens have the function of tracking the value of their underlying collateral.

This system works based on 2 assumptions;

  1. Tokens-to-collateral redemption, where it assumed that in the event a token holder would want to leave that system, they could do so by claiming the underlying value tool rather than having to trade.

  2. Token-to-collateral price equanimity, where tokens are always at par with the underlying collateral.

The best examples of this are stablecoins & Wrapped tokens.

USDT, USDC, and BUSD are stablecoins that back their circulating token supply with a treasury of that exact amount. 1USDC=1USD

WETH, WBTC, & others are Wrapped tokens that are issued in direct proportion to the amount of ETH/BTC committed, 1WBTC=1BTC

USDC is issued by Circle.

It is worth $1.

If the MarketCap of USDC is $10 Billion;

then Circle must have $10,000,000,000 in paper dollars/dollars in the bank

WETH is issued by WETH protocol.

If Eth = $1,500 then Weth = $1,500

if ETH moves, Weth follows; if Weth moves, Eth should not follow.

Supply of Weth depends on ETH input;

Over Collateralization

As the name might suggest, the over-collateralization model demands that users provide more value than they borrow. Popularized by projects such as Synthetix (SNX) & MakerDAO (MKR), tokens are issued based on collateral surplus.

The reasons for an over-collateralization system are risk-based assumptions in its operations:

  1. Price Volatility since tokens do not have to be of equal value (& carry a capital cost) where if a user takes a $10,000 loan using $10,000 of ETH as collateral & the price of Ethereum falls by 50%, then the user will not be incentivized to pay back their loan.

  2. Liquidation,** a necessary part of any risk mitigation system, liquidation is an automated protection mechanism against unfavorable price movement.

  3. LTV Ratio,** Loan-to-value ratio is a live measure of the “health” of any position.

The leading benefit of the Over collateralization model is heavily rooted in risk aversion. However, this design favors protocols>users & diffuses capital velocity.

This model is too complex & sensitive for mass adoption. Large upfront demands of collateral keep out the vast majority of the population from participating. The contact LTV monitoring & position balancing can be overwhelming for non-professionals.

The more subtle nuance of over-collateralization relates to large amounts of capital that become stale as a byproduct of it having to sit in reserves. That non-productive capital creates a drag on supply capital flows, constricting the system.

Under (Fractional) Collateralization

*A quick note, this model has been around for decades, & is still in use around the world in TradFI systems (view fractional reserve banking)

The most modernized of collateral models; fractional collateral dampens the severity of risk deterrence in over-collateralized models & frees up the constrained capital.

Crypto project FRAX is implementing this model for its crypto-native CPI & stablecoin project. Attempting to bridge the chasm of on-chain collateral by providing price guarantees through a sophisticated combination of digital asset reserves & algorithms.

It is still too early to assume whether this model will (or will not) work.

Types of Collateral in the Crypto ecosystem

When thinking about posting collateral On-Chain in cyberspace the options quickly become very constrained;

  • Stablecoins
  • Cryptocurrencies
  • NFT’s
  • RWA’s

  • Stablecoins

    Are the accountant's best friends. Stablecoin collateral makes the determination of risk & return much more predictable, which in turn makes it better for commercial activity. This will likely become the most common collateral due to its ability to keep its price target.

  • Cryptocurrencies

    The most obvious form of collateral to be posted on-chain, cryptos innately possess more highly volatile price profiles than stablecoins. This makes it difficult for non-professionals to know when to post & how to manage their on-chain credit profiles.

  • NFTs

    Lord have mercy. If you think Crypto is volatile, wait until you own a few NFTs. Theoretically, representative of ANYTHING, Non-fungibles are the latest technological boon in digital value experimentation. Slowly making their way into the credit markets through Fine Art (Fidenza) & Community memberships (BAYC), NFTs are a few short years away from becoming viable assets for posting collateral. This might even be NFTs that represent identity which garners creditworthiness through on-chain activity/signaling.

  • RWA — Real-World Assets

    The most exciting development in the world on on-chain collateral is the introduction/expansion of Real World Assets. The list of RWA assets, & in turn the real market value of those assets, is incredible.- Real Estate- Government Bonds- Corporate Bonds- Stocks- Derivates- Options- Cash Advance- & more…

    RWA’s tokenization can happen as either Fungible or Non-fungible (Currencies or NFTs), it is all dependent on the issuing entity & their community's preferences.

As we “bear” witness to the next phase of the crypto markets, it is important to understand that new systemic risks will constantly be arising in the presence of ever-evolving on-chain credit markets.

There is no going back.

Prepare accordingly.

I hope to see you all on the other side 🥂

Also published here.