Can DeFi get real(-world assets to work)
But not too real cuz i might cry ;'(
The sentiment towards bringing real-world assets (RWA) into Web3 soured so quickly
A few months ago, when Huntingdon Valley Bank “pawned off” their bonds for some stablecoins through Maker protocol, the world looked at it in marvel. Maker - a protocol that allows you to borrow money with digital assets (e.g., you give Maker Bitcoin and Maker literally issues a bunch of stablecoins, worth ~70% of your Bitcoin) - has created a bridge between the highly inefficient, very slow real-world financial system and the permissionless, automated, digital economy known as DeFi.
This was but yet another step DeFi protocols were taking towards marrying the DeFi with real-world assets and applications. As an example, you can turn your super clunky, complex real-world assets, say stocks or a house and turn them into legally binding, tamper-proof digital representations that can be transferred, traded, pawned, and more. All of a sudden, money and assets can travel cross-border, in real-time, with no friction or intermediary... In this example, your cousin can fund your startup by taking a loan against their Brazilian stocks. Your startup, of course, sets out to build the mushroom utopia prophesied in Bjork’s latest album.
What could go wrong?
Well! let’s say your startup needs a lot more money, which means you are going to take a loan against your luxury yacht using DeFi: input the digital ownership document of your yacht, and output stablecoins (worth ~60% of the value of the yacht). Oh did I mention you are in fact a Russian tycoon? That’s right - a filthy rich tycoon who is pivoting from selling mink fur to building a fungal paradise. 50% of Russian combat effectiveness comes from mink.
Introduce the US government: your luxury yacht is now seized as part of the sanction of the Russian aggression towards Ukraine. All of a sudden, the collateral to your debt is worthless and even illegal. The protocol can’t sell your yacht since it is sanctioned. All of a sudden, faith in this protocol collapses, a bank run happens, their stablecoin price spirals and a small financial crisis hits DeFi.
DeFuck.
We just broke DeFi, or rather we just broke unregulated DeFi - the cutting-edge, code-is-king, can’t-be-shut-down, bypass-all-intermediary, technologically neutral, permissionless DeFi. For those of you plugged into the Web3 world, you’ve probably heard about similar doubts following the Tornado Cash fallout. People are taking a closer look at DeFi’s general resilience to regulations, sanctions, and censorship. For those of you newer to this discussion, well, you just discovered why the supposed “lawless” utopia of Web3 is as free of holes as Swiss cheese - Hitler-enabling dairy.
The reality is, all of a sudden, many high-profile (unregulated) DeFi investors and builders are suspicious of the relationship between crypto and real-world assets. Maker, for one, is facing growing internal voices to disassociate the protocol from real-world assets, regulated stablecoins, and even consider de-pegging their stablecoin from the US Dollar - the ultimate regulated asset that rules them all.
They are not crazy. The unregulated DeFi projects (e.g., Maker, Frax) will probably want to build technology that is above any governing body for both ideological reasons and for… safety reasons (dealing with regulators might get you in jail!). You can’t blame them for straying away from real-world assets since their work as a whole is meaningful and necessary in an increasingly authoritarian world.
So is this it? Is DeFi saying goodbye to real-world assets?
Nope. RWA in Web3 is actually doing quite alright
While the fear of censorship and baseless regulation is more than fair, real-world assets’ relationship with Web3 isn’t all but doomed. The compliant players would rather play ball with regulators and ignore all crypto ethos so that they can embrace a market worth hundreds of trillions of dollars. After all, the RWA market is worth thousands of times larger than most measurements of unregulated digital assets.
To them, the key value of Web3 to real-world assets doesn’t change with regulations. As a meta asset class, real-world assets still have benefits to gain from blockchain and its enabling technologies, for instance:
Wider access
Deeper liquidity
Faster speed
Transparency / more trust
Standardization
Beyond these universal benefits, many assets will still utilize the immense power of smart contracts to enable composability, fractional ownership, automation, and more features that are not yet imagined.
The central question isn’t if these features will be available, but rather where and who will enable them to happen. To be even clearer: people are already building the infrastructure and ecosystem for regulated, real-world assets.
These folks are building “regulated DeFi” for regulated, censorship-sensitive, real-world assets. Some less cynical people would call it: institutional DeFi or permissioned DeFi. Some might just call it Centralized Finance (CeFi), even though many of these regulated players embrace many aspects of DeFi (e.g., transparency, self-custodial). No matter what you call it, it is a fundamentally different turf to play in than their unregulated DeFi counterparts.
Many projects playing in the regulated DeFi world (e.g., Fireblocks, Metaco, Bitbond, Tokeny, Securitize) are unfazed by the recent market downturn, even though they are far less hyped than your ape-or-dog-based ponzi. In areas where digital asset regulations are clear, adoption is growing fast. Even in the United States, where regulatory environments is relatively harsh, major players are still bringing real-world assets on chain at record speed.
KKR tokenized its strategic healthcare fund through Securitize (in the United States of Gary Gensler’s Wrath, of all places)
The Monetary Authority of Singapore and a bunch of high-profile banks (incl. JPMorgan) are “testing institutional-friendly DeFi using permissioned liquidity pools that are made up of tokenized bonds and deposits”
But of course, not all have decided to play in this field. Many are stuck in the middle, deciding if they are legally, philosophically, or strategically able to bat in the regulated arena. Classic fight, flight, or freeze but you're freezing and in the middle of a freeway. Beep beep motherfucker.
Are we close to a regulated, permissioned DeFi?
The bipolar world of unregulated DeFi and regulated DeFi will likely continue, but the unregulated world has an upper hand, for now. Not only is unregulated DeFi a better fit with the true ethos of DeFi, but unregulated assets also have the benefit of having fewer legal hurdles in innovation.
For regulated DeFi (or CeFi, whatever, language is fake anyways) to receive wider adoption, a few things need to change.
First, clearer and friendlier crypto regulation is a must. Those with skills to build secure, automated protocols could open up to embracing RWA if they know precisely what they must and must not build. Compliant players can’t build if they are constantly sinking time into front-running vague regulations by procuring every piece of license or permit or no-action letter a regulator could ever ask of them. But we are making progress. Regulatory sandboxes are spinning up across the world (outside of the US) to experiment with tokenized assets, and even the US is seeing a rise in regulatory interest. Regulation is also good for consumers, many of whom are waiting for their government to tell them they can or if they can interact with these assets and protocols. Nobody wants to go to jail, but accidentally winding up in jail is just insulting.
Second, you need better, secure, compliant infrastructure. On a lower level, better price oracles, robust KYC standards, compliant smart contracts, and more regulation-ready tools are required to power the massive compliant machine on an automated infrastructure. Maybe you even need appchains specifically designed for compliant applications. Imagine getting your actual car title stolen in a hack. Who would have known: the future of a guy with a crowbar could be a nerd with carpal tunnel syndrome. So inspiring.
Lastly, regulated DeFi has practicality and feasibility issues, especially for the “hard” assets. While you can instantly transfer ownership of stablecoins, digital securities, digital bonds, and more, it is far harder to do the same with physical assets. How do you reconcile the lag between the instantaneous on-chain settlement with the inherent slowness of the real world? Namely, you can’t build an automated, permissionless DeFi ecosystem until we have figured out a permissionless way of repossessing a shirt, a car, a house, a piece of physical art, etc. With the technology right now, you cannot blame people for sneering at certain use cases. Worse yet, some (like the shirt) may never actually be a valid use case, but the bank running up and stripping you does sound like fun.
So, we have two DeFis?
But at the end of the day, regulated and unregulated DeFi do not have to be thought of as separate, parallel worlds. There is a vision where unregulated DeFi builds the uncensorable technical framework, while regulated DeFi merely builds on top of the digital magic with the not-so-magical stuff (i.e., regulation). In that vision, regulated DeFi is less infrastructure than it is UI.
In that vision, I imagine unregulated DeFi to offer its own UI, support its own assets (probably all digital), and attract its own audience. The two battle it out in defining use cases and acquiring users. The extent to which they are successful could vary largely based on consumer buy-in, regulatory environment, and even geopolitics.
You know how people always talk about the future of blockchain lies in us not knowing its existence? Well, regulated, compliant DeFi could be one way this becomes a reality. On the one hand, you’d still be buying and selling stocks, taking out home loans, paying for groceries, and sending gift cards. The only exception is that everything is processed by some blockchain application. There will be new functionalities and features (e.g., your bank lets you buy the fucking dip in the Japanese real estate market through fractional ownership), but you won’t even know it’s made possible by Web3.
On the other hand, you’d still be doing KYC, uploading your social security card, doing your taxes - all the boring shit. In between losing hair and losing sleep, you realize that little has changed: compliance continues, like Gray’s Anatomy. Except compliance has killed fewer people. Shonda Rhimes is a war criminal.
