Crypto Watch column | Real world assets will be crypto’s anchor as bottom falls out of speculative leveraging

(This article is first published on the Business Times)

In the past two months since its spectacular collapse, TerraUSD’s deep dive continues to send ripples through the crypto ecosystem. Coupled with broader macroeconomic headwinds in the form of persistent inflation and relentless interest rate hikes, an overwhelming fear has impelled retail and institutional investors to prioritise liquidity and increase cash holdings.

Bitcoin has plummeted almost 70 per cent from its record high, and the crypto market value of roughly S$900 billion is only marginally better than the peak of US$830 billion in 2018 before the previous “crypto winter”.

With the value of cryptocurrencies taking a nosedive, a slew of liquidity crunches at prominent crypto institutions have also flooded the news. Crypto lending firm Celsius Network suspended withdrawals and is undergoing restructuring with a plausible US$2 billion liability gap, while crypto hedge fund Three Arrows Capital filed for Chapter 15 Bankruptcy after its over-leveraged bets went completely wrong.

This contagion over the crypto market has put many other crypto firms in a liquidity crisis, as the highly leveraged nature of the industry makes them vulnerable to defaulting on margin calls. At this moment, it is still unclear whether the worst is over.

The current shake up in the crypto markets is not merely a result of diversification away from this risky asset class in a high inflationary and possible recessionary environment. At its core, a fundamental deleveraging of the industry seems to be transpiring.

Castles in the air? Deleveraging DeFi and its value to the real world

Crypto as a risky asset attracts some of the most risk-loving investors. Over the last 5 years, the crypto ecosystem has evolved into a full-fledged financial ecosystem – with lending, borrowing and interest-bearing accounts. These developments not only inject liquidity into the system but also make leveraging much easier.

During the bull run peaking in November 2021, many crypto investors applied leverage, and demand stimulated by borrowed money induced a positive feedback loop that led other traders and investors to apply more leverage. Today, with the macroeconomic fears paralysing markets and TerraUSD’s collapse catalysing a further sell-off, the cycle of sharp price decline reinforces itself. As investors liquidate their holdings en masse, margin calls are triggered, inducing a further liquidation of positions from investors who fail to meet these margin calls, culminating in a massive wave of selling pressure.

Is there any silver lining amidst the doom and gloom? From a long-term perspective, I believe deleveraging will actually benefit the crypto ecosystem. One of the reservations I held with regard to decentralised finance (DeFi) in its early years was that its use case centred around its utility for crypto investors looking to multiply speculative gains through leverage. Though I find it hard to invest in a more speculation-driven thesis, I can appreciate how some speculation is beneficial to the ecosystem, as it drives investment, increases liquidity, and thus accelerates infrastructure building.

If lessons are learnt, one outcome of the current catastrophic deleveraging could be that financial activity revolving around short-term arbitrage opportunity will taper off. The ecosystem will - hopefully - rebalance the ecosystem towards real economic activity - a healthy sign for the long term.

As DeFi continues to evolve, I believe more and more innovation in the lending space will be redirected from speculative leveraging towards productive lending. Personally, among the many new categories of DeFi applications, I find the tokenisation of real-world assets (RWA) particularly interesting. While real-world asset tokenisation as a DeFi concept started a while back, it was only recently that I started witnessing adoption by South-east Asian lending startups. In the past year or so, companies like Aspire and Lend East have started to obtain lending capital from GoldFinch, where crypto lenders facilitate real-world loans.

Other DeFi projects have also expanded into non-crypto lending. Earlier this year, TrueFi announced that Mexican based Y-Combinator startup Delt.ai was its first non-crypto financial partner, using the loans obtained to lend to Latin American businesses. Centrifuge has also expanded from its initial focus on supply chain financing. It now bridges invoices, real estate and even royalties to DeFi.

Is real world asset lending yield attractive for DeFi investors?

I have been following South-east Asia’s fintech lending landscape over the last few years. Within the region that mainly consists of emerging economies, there exists a large credit gap across the small and medium enterprise (SMEs), micro business and consumer segments. It is amazing to witness credible fintech companies with a high capital cost ranging from about 10 per cent to 18 per cent still achieving profitable productive lending. This is certainly a high risk asset class, but the new generation of low-cost Internet-based loan origination/servicing and big data/AI-based credit scoring are facilitating better management of loan quality, making it more economically sustainable while attaining net societal benefit.

DeFi has traditionally delivered around 3 per cent to 7 per cent annual percentage yield (APY) for low risk assets and over 10 per cent APY for high risk assets, but these usually come with a yield farming component that is generally transitory.

Given the prevailing trends, the real world asset sector is likely to provide more appeal to DeFi investors, as real world assets such as real estate have survived through the pandemic, global recessions, and typically have a longer track record of consistent performance as opposed to many crypto assets.

Can DeFi add value to real world assets beyond capital?

Despite the attractive yield, connecting the crypto world with the non-crypto world will not be an easy task. Many existing DeFi projects are marketplaces connecting lending capital to borrowers. This is typical infrastructure, with over-collateralisation at its core. However, with unsecured lending, asset quality or credit scoring is critical, and this is a far more difficult task to accomplish.

While there are existing marketplaces such as Mintos who connect global online capital to South-east Asia fintech lending startups, the open nature of decentralised finance platforms facilitate entrance of new participants and new capabilities. The new actors bring in new value, potentially addressing the gaps present in a traditional two-sided marketplace.

Take GoldFinch as an example. Besides borrowers and lenders, the open nature of the system allows new players to enter in roles such as backers (who supply capital and carry out extensive due diligence on borrowers) and auditors (who guard against fraud by voting on the borrowers’ ability to borrow from the protocol). This could potentially curate a better quality portfolio on a global scale.

Although DeFi does not automatically bring in new data to enhance the robustness of credit scoring, its key advantage lies in building an ecosystem of players that can collaborate to improve credit quality. In this regard, the decentralised designs of GoldFinch, TrueFi, and Centrifuge do have their merits in enhancing “decentralised credit scoring”.

Towards a next-generation credit bureau

Personally, the most enticing aspect of current developments to me is the wave of DeFi players that are helping non-crypto businesses build up their on-chain credit profile. Such credit profiles are not merely digital, but are also captured on a public blockchain database. This could potentially pull traditional credit ecosystem players onto DeFi – think of your credit analysts, credit insurers, new data source providers and researchers. The end result? A next-generation global credit bureau powered by an open protocol.

While the crypto market undergoes large-scale deleveraging, DeFi continues to evolve under the prevailing noise, and the developments in real world asset financing are particularly interesting. I look forward to more and more crypto projects making an impact on real world businesses in the coming years.

Like the article? Read the rest of the Crypto Watch Column here.

Edited by: Elise Tan and Jing Zhe Ang

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