Thank you for submitting this application. We understand how long these things take, and appreciate your team making the effort to submit everything.
I’ve been active as of late, commenting on several applications, including the other Centrifuge-related application ([CF-DROP] MIP6 Application: ConsolFreight DROP: Tokenized Freight Shipping Invoices) and more generally, I’m trying to bring up highly relevant and potentially problematic legal and regulatory issues where I see them in the sincere hope that MKR holders do not blindly wave tokens onto the approved collateral list. MKR Whales and all other MKR Holders, the big M signal has appeared in the sky! Into the breach once more my friends…
As is becoming a habit, we’ll need more color from the projects so the community can be informed. To that end, can @pcDan or @spin please address the following issues:
• Several application excerpts jumped out at me:
The asset type we are proposing for inclusion in MCD is slightly different to the majority of collateral applications: the Asset Originators will be using MCD directly as a line of credit to originate new loans against freight invoices (invoice factoring and reverse factoring).
Along with the necessary technical infrastructure to bring these assets into DeFi, the Asset Originator sets up a legal structure that provides the necessary support to ensure that anyone that owns a DROP token has a legal claim to the underlying assets. This is done with a legal structure very commonly used in the traditional financial system: The collateral for the individual loans are assigned to a legal entity, the “special purpose vehicle” and lenders get an ownership interest in the entire portfolio of this entity (with this entity the assets are in an a bankruptcy remote structure that is not influenced by the Asset Originators).
How is the applying collateral type currently used?
Centrifuge Tinlake has been in development since early 2018. We did a first technical POC where a pre launch version of MCD on Kovan was used to deposit an ERC20 token that was backed by an NFT in April 2018. Only a few months later we deployed the first version of Tinlake to Ethereum mainnet and worked with five different Asset Originators to facilitate loans in DeFi. In a joint effort with MakerDAO to develop a tool to bring real-world assets into MCD we financed four of those Asset Originators with funds provided by the Maker Foundation totaling a volume of 250,000 SAI. The Asset Originators included a residential bridge loan as well as a mortgage originator, a financing solution provider for music royalties and a logistics platform providing invoice factoring. This allowed us to gain first experience with the setup and iterate on the smart contract and risk architecture. The current version of Tinlake has been audited and tested with two running deployments.
Does one organization bear legal responsibility for the collateral? What jurisdiction does that organization reside in?
Paperchain has incorporated Paperchain Pilot LLC, a Delaware (USA) limited liability company (the special purpose vehicle, “SPV”). This SPV has been formed to finance Paperchain’s assets.
This SPV structure creates a bankruptcy-remote entity whereby owners, debt holders or interested parties of this newly created SPV are left unaffected by the parent’s financial, operational and/or legal health.
- (Optional) List any parties interested in taking part in liquidations for the proposed Collateral type.
The way this collateral type is used varies from how standard vaults are opened: DROP tokens have a stable USD price and any small fluctuations in the loan portfolio performance should be covered by the insurance provided by the TIN tranche. This means that under normal operation, the Asset Originator would not see their Vault get liquidated. A liquidation would only occur if a large amount of defaults occur across the portfolio that the risk model did not calculate.
In case the Vault gets liquidated, the Tinlake contracts enforce a rebalancing of the pool to bring it back to its required collateralization ratio and will not allow issuing any new loans. Instead the Tinlake contracts are from this point on taking all of the cash flows generated by the borrowers and disbursing these to DROP token holders. Trade finance assets are usually short term assets and the instance of Paperchain the entire pool can be liquidated in <55 days (45 day term invoices + a grace period for late payments).
Overall this means keeper liquidations will be a much less common occurrence that only happen when the risk model worked out for a given collateral type did not perform. In the debt finance world there are companies that specialize in buying distressed loan portfolios that can be onboarded as keepers for MCD that would be ideal candidates for buying any DROP that MCD wants to liquidate before the underlying portfolio is liquidated.
First of all, the above description of the DROP mechanics describes what most people around the world would understand as a debt security, or rather a transferable instrument representing a legal claim against the future disbursements of an entity’s proceeds in satisfaction of a debt. The security status of DROP is further raised by the uncertain cash flows into the SPV, following Vault liquidation, from the originator and Tinlake “rebalancing”. This presents a whole host of issues for MKR holders – not least of which are the implications of forced transfers pursuant to government action. Have Paperchain or Centrifuge undertaken any securities law analysis of DROP and/or obtained legal counsel regarding its status, including a legal memo reflecting such analysis that can be shared with MKR holders?
Second, while not fully explained or stated, it appears that potential DROP buyers (addressed below) purchase DROP exclusively through the MCD liquidation/auction process. I have only a lay understanding of this, but most jurisdictions generally require a regulated intermediary to conduct sales of securities. Certainly, in the US, one has to generally sell securities through an SEC-registered broker-dealer. MakerDAO is not such a regulated entity and, as far as I can tell, there is no provision for a broker-dealer in your plan to administer auctions. Has Paperchain or Centrifuge analyzed this issue? If so, what do the applicants propose as a solution to this? Is there some reason this is immaterial? What is it?
@spin suggests in a comment above that DROP may be available for purchase on the open market. How is this possible when each DROP will be specific to the Asset Originator’s deposited collateral (music proceed rights) with the SPV (begetting the detailed discussion in the application section “The Infrastructure beyond the Tinlake Contracts”)? How will DROP get to the open market but for an MCD auction after Vault liquidation, which grants buyers the rights to the SPVs assets?
Were the pilots you all conducted with the Maker Foundation, MakerDAO or both? Please note that the Foundation and the DAO are separate concerns. Also, it’s stated that Centrifuge and MakerDAO “develop a tool to bring real-world assets into MCD” – aside from Centrifuge’s public blog posts and the answer to the above question, what did the Maker Foundation or MakerDAO do to develop Tinlake, if anything?
Since the pilots were directly funded by the Foundation, were you still able to test DROP deposits, auctions and DROP holder redemptions (on Kovan at least)?
Who owns the SPV? Is it a Paperchain or Centrifuge controlled parent? Please name the directors, members, shareholders and management of the SPV’s parent.
Will you disclose the names of each ultimate beneficial owner of the SPV’s parent?
If the SPV cannot liquidate its assets to pay DROP holders, what’s next?
What happens if the SPV fails to hold the underlying collateral and is unable to redeem DROPs for the collateral or cash? What then? Who can keepers (or MKR holders, for that matter) pursue?
How does the structure ensure that the SPV is bankruptcy remote? And remote to whose bankruptcy – the originator’s? Tinlake’s? Its own?
Do the SPVs have guarantors? Typically, with SPVs, although they are bankruptcy remote (if structured correctly), companies will establish a guarantor to ensure payment to creditors. Has Paperchain and/or Centrifuge considered such a structure?
Will Paperchain (or Centrifuge) guarantee redemptions or is it publicly going to disavow liability?
Will Paperchain (or Centrifuge) provide legal insurance surrounding the SPV for its guarantees?
Do Paperchain and Centrifuge envision other potential keepers for the Tinlake program aside from typical purchasers of distressed debt, i.e. hedge funds? Regardless, what happens if other entities do act as keepers? This suggests there may be some whitelisting/blacklisting for DROP keepers; is that so?
Are there ideal characteristics of a DROP keeper? What are they and why? Is that because it is implicitly understood that DROP would be a security and thus necessitate certain types of purchasers to avoid violation of the securities’ laws?
I’m presuming that Paperchain and/or Centrifuge has not interacted with any regulatory agency regarding TinLake and/or DROP, correct?
The Tinlake organizational graphic and application response to question 9 suggest that both an operating memorandum and loan agreement will be executed by the Lender, presumably MakerDAO. Please correct me if I am wrong.
9. Where does exchange for the asset occur?
The SPV enters into a subscription agreement with lenders who are receiving DROP from the SPV in turn for providing DAI. The DROP token can be redeemed against the cash flows of the underlying collateral directly from the SPV by any DROP holder. This is ensured by the Tinlake smart contracts and the primary way for interacting with these tokens.
There are a number of questions I placed in the Consulfreight application, but I will include them here for completeness’s sake:
This graphic is a bit confusing, so let’s clarify: the lender is MakerDAO; the SPV is the entity Paperchain(?) spins up; the Asset Originator is Paperchain; and the final borrower is the company that creates the invoices, right?
Where does the SPV’s parent sit? With this graph it looks like Centrifuge is the parent. That can’t be right, can it?
I’ll repeat the same question How are you going to have a loan agreement and an operating memorandum with MakerDAO – who can sign on behalf of “MakerDAO”? How can it be enforced by or against MakerDAO? Have you guys thought about these questions – they seem basic. And if there is no contract between the Lender – MakerDAO – and the other entities, how does your proposed arrangement work?
How dependent is the structure on off-chain legal agreements?
Back to the SPV, how will the system you describe ensure the preservation of SPV assets, and thereby value to DROP holders, i.e., by contract, bylaws, etc.?
Does your team have any suggestions on how auctions should be differently structured to handle this security collateral? I’ve reviewed the MCD documentation and it appears that the current auction system is not geared for this white listing feature. So, even if the community onboarded Paperchain, the system as currently designed cannot support its function without potentially violating securities law (admitting that DROPs are clearly debt securities). That seems like a real problem and one that a project hoping to be onboarded should have a possible solution for.
Ok, so that was incredibly redundant, save for one or two spots. As always, this may open a pandora’s box of comments and then questions and then comments and then questions, and so on. That said, I can’t be the only MKR holder with these comments and questions rattling around in my head. In the end, I hope these questions garner the information that MKR holders require to fully assess Paperchain DROP, and include it as collateral in MakerDAO.
Let me make two more points, however. First, I am not one of the dogmatic “only Eth and nothing more!” maxis. Ultimately, from my view, the DAO needs multiple collateral types, including securities and more exotic financial instruments. But it doesn’t strike me as wise to consider regulated products ripe for onboarding yet, given the system’s current structure.
Second, I also note Centrifuge’s responses in the Consulfreight post stating that the burden for any legal analysis related to these projects and onboarding sits with the “DAO” and “domain teams.” That might be the long-term case but Centrifuge has to realize that this process is still quite immature, and there are no legal domain teams able to do this analysis so arm-chair non-lawyers with time on their hands get the chance to ask questions. That’s not scalable though, so perhaps a more appropriate question is geared to Long for Wisdom and others – when will the push come for legal domain teams? If the DAO wants to onboard new collateral types and protect itself from predictable problems (imminent regulatory threats, etc.), a competent legal team should be an area of immediate focus. Or perhaps a big whale or group of whales can sell some MKR and pay a young, ambitious lawyer’s salary for a year to help the community through this next phase.