For the past year, the Maker Foundation has been researching and experimenting how to generate additional value from the Maker Protocol by providing collateral which does not originate on the blockchain. This post intends to kick-off discussions on including “real world assets” (“RWA”) in the Maker Protocol and highlight questions we believe projects should consider if they are interested in seeing these assets on-boarded.
An important thing to remember is that any approach involving RWA – be they securities, commodities or otherwise – will touch on regulated products, players and markets. Therefore, a regulatorily compliant framework is the critical feature to successfully expand the collateral types available for Vault users. But given the complexity involved, we want to start the Community off with the incipient points below.
What kind of “RWA” are we talking about?
In the simplest terms, an RWA is anything that does not originate from a blockchain and uses the recourse of the relevant legal apparatus to maintain consensus over its ownership. A hybrid of a blockchain native and an RWA are fiat-backed stablecoins like USDC. They use the blockchain to track account balances but ultimately rely on the judiciary of the United States, or another jurisdiction of issuance, for recourse. Other more “vanilla” assets include tokenized equities and treasury bonds.
This simple definition, however, does not accomplish much for the Maker Protocol. To source assets that contribute to a robust, large and healthy financial ecosystem, the Maker Community should focus on their economics as well. RWA that are most useful to Maker should have large supplies, predictable demand for credit and a cost of capital over LIBOR/Fed Funds. Potential users that hold assets with these characteristics may be able to use the Maker Protocol to establish or replace credit lines and supplant private sources of capital by locking their RWA into Vaults and generating Dai.
In the legacy economy, bank credit is the source for nearly all of the money supply. Borrowers interact with originators and these originators sell or pledge their assets to banks. The originators then draw on these credit facilities to originate more loans, with banks creating new money in the process. Originators are essential because they act as middlemen with aligned incentives - they price individual loans and allow the bank to analyze a diversified portfolio when setting their risk parameters. In doing so, the calculus of originators is simple - interest paid in by the loans they extend minus the interest paid to the bank or to private investors equals their net interest margin. It’s important to note that since this calculus is predictable and scalable (in the sense that it reflects the current money creation process), these economic actors’ assets could fit well in the Maker Protocol.
Decentralization vs Diversification
There have been many comments in the forums and on social media that Maker should be targeting assets by how decentralized they are. This is an inaccurate premise and belies a misunderstanding of what makes a stablecoin resilient in the face of malicious actors. In contrast, the Maker holders should likely focus on developing a maximum level of diversification in the collateral portfolio in order to make Dai as resilient as possible. In this context, diversification refers to the minimization of any single type of risk, which goes well beyond volatility risk and centralization (illicit seizure) risk. To use an example, imagine that Dai was only backed by digitally native assets like ether. This means that no one can illicitly seize the collateral in the protocol – users have total independent control of their assets (unless one’s Vault is liquidated). But relying solely on ether, or a similar asset, forces the Protocol to depend heavily on trading and liquidity from centralized exchanges, some more reputable than others.
But the Maker Protocol depends not only on user’s custodying their assets, but also on those assets’ liquidity and price stability. If 100% of the protocol’s assets are based upon secondary fiat markets on centralized exchanges, a whole new host of risks emerges that can only be mitigated by diversification of marketplaces. In an ideal future, the DAO would minimize any single risk to Dai through diversifying asset types, price sources, liquidity venues and regulatory regimes.
None of this is to say that Dai itself will become any less decentralized in the process. It will always be true that no one can seize or freeze Dai. This concept is specific to the collateral portfolio which is abstracted away from Dai holders.
Potential Types of Asset Portfolios Available for the Maker Protocol
Conceptually there are two ways two think of the structuring process that allows a token to represent a claim on an asset in the Maker Protocol:
- Tokenize a claim on a particular underlying asset itself
- Create and tokenize a debt instrument which represents a claim on proceeds of the underlying asset in the event of a liquidation
Method number one involves properly classifying and/or registering the instrument (e.g., some assets could be securities and require registration with the appropriate authorities) before its inclusion in the Protocol. Price discovery would need to happen on appropriately licensed secondary markets and, in countries such as the United States, be subject to the various transfer restrictions of a security offering. One can envision a future where users may access a regulated UI (a “walled garden”) operated by an appropriately registered entity and lock their equity tokens in a Vault to generate Dai. This example assumes several developments, such as regulated markets/portals and user’s willingness to register and submit KYC information, but is not beyond the imagination.
Method number two is another possible means for on-boarding RWA to the Maker Protocol. In this construct, an asset originator (e.g., a loan originator or receivables holder) would identify, isolate and collect assets (e.g., loan revenues or receivables) they wish to onboard into an entity they controlled called a Special Purpose Vehicle (SPV). This SPV would serve the limited purpose to custody the specific assets being entered into the Maker Protocol.
The originator could then mint an NFT that represents each asset in the SPV (not equity in the SPV or a right to the asset’s cash flows) and contains enough metadata to price the asset independent of context. Though the NFT is not a claim on the asset, it is a way for Oracles and Keepers to price the portfolio in the event of a liquidation. If the asset holder does not wish to mint NFTs, they likely will need to publish this data in a readily accessible format.
Finally, the SPV would mint tokens representing a pro rata share to the pool of assets held by the SPV. Those tokens would be placed as collateral into the Vault and subject to the same parameters and rules as all other collateral, including liquidation. The NFTs (or supplied data) would be used by an Oracle to continuously price the collateral tokens and inform the Protocol’s parameters and rules. This process can also be done manually by governance, should digital price feeds not be available. For liquidation, more likely than not, an intermediary like a registered broker-dealer or Futures Commission Merchant would have to administer the token auctions. Auction winning Keepers, or other holders, would then seek redemption on their collateral tokens from the SPV.
In a perfect world, the originator would use the SPV and Vault, continuously exchanging assets, to create Dai to fund its operating costs until it no longer had liquidity needs. When complete, the asset holder would return the borrowed Dai funds to the Vault and close it, via the SPV, and then dissolve the SPV. With these steps done, the process would conclude.
The above is a high level, simple review of two asset types that could be considered for inclusion in the Maker Protocol, so please do not take this post as gospel. In combination with these initial thoughts, we want to elaborate on questions the token issuers may consider when deciding whether to proffer their assets for inclusion as Maker collateral. The following are not exhaustive, though, and please feel free to add your thoughts and inquiries in the comments:
- Q: Does the Protocol provide a benefit to the asset or originator and will the asset provide a benefit to the Protocol?
- Q: What is the underlying asset to be included in the Protocol and then how will it be included in the Protocol?
- Q: Are there ready and secure price feeds available for the proposed asset?
- Q: How will a trusted Oracle or Price Data Feed be established and what will be the requirements of its duties?
- Q: Does the asset attempt to separate cash flow from the entity looking to borrow (generate Dai from a vault)? If so, how will that be accomplished – legally, functionally?
- Q: Does the asset trade on secondary markets? Is it typically sold in private placements?
- Q: What is the legal classification of the asset? What is the legal structure within which the asset was issued (e.g., securities offering, e-money issuance, factoring, etc.)? What would be the legal classification of a bespoke method for including the asset in the Protocol (e.g., Method 2 above)?
- Q: Based upon the legal classification of the underlying asset or its representative token, what are the additional requirements for its inclusion in the Protocol (e.g., regulated intermediaries like broker-dealers, specific registration with a regulator of the token, limitations of Keepers, reporting requirements, etc.)?
- Q: What are the specific risks associated with the asset: technological (e.g., transfer restrictions), legal (e.g., AML/KYC requirements), economic (e.g., availability of real-time performance data) and regulatory (e.g., asset classification as a security or derivative)?
- Q: Who will bear those risks and how will that be accomplished?
Our next post will cover a potential design for on-boarding a RWA and review the glaring gaps we believe need to be filled.