Disclosure: Jake Lynch is an investment researcher at L1 Digital. One of L1 Digital’s venture funds is invested in Centrifuge.
Prelude
It’s July 2023 and we are deep into the bear market. I want you to take a moment to close your eyes and think about all that’s happened in the past year… FTX, Celsius Fahrenheit, Terra, Gensler, etc.
It’s time for a sober conversation about the future of DeFi. In other words, it’s time for some real talk.
While there is a nostalgic charm associated with the days of old in crypto that many of us would sell our tungsten cubes to get back, the industry needs to grow to accomplish our goals. So, naturally, we must ask ourselves what every young man and woman will find themselves asking at some point in their life: what does it mean to grow up? A question that is much easier asked than answered.
In this article, we’ll cover how lending to productive real world assets - assets outside the crypto ecosystem - directly grows the ‘economic pie’ in crypto.
Overview
Recently, I was asked to put together a talk for a Centrifuge contributor call. The premise I was given:
Situating Centrifuge in the midst of the challenges & opportunities of DeFi
There are two ways to approach this talk:
The 10,000 Foot Perspective. Talking about the challenges and opportunities of DeFi
The Centrifuge Perspective. Talking about the idiosyncratic challenges & opportunities for Centrifuge
I think both angles are interesting so, without further adieu, let’s dive in:
The 10,000 Foot Perspective
“Situating Centrifuge in … DeFi”… or, said another way…
So what is Centrifuge?
Centrifuge is an on-chain credit structuring and issuance platform for off-chain assets. If that doesn’t mean anything to you, perhaps an analogy will help: if MakerDAO is the “decentralized Federal Reserve”, Centrifuge would be a “decentralized investment bank”.
Still confused? Let’s walk through another example. When people swipe their credit card, it creates an asset for banks and a liability for the credit card holder - the bank now has a receivable and the credit card swipooor has a payable. The bank could hold onto this risk (in the form of credit), but the bank might want to take the risk off their books for various reasons: maybe they need to meet certain cash reserves; maybe they’re just not that great at underwriting and they know it, etc. So the bank goes to sell that asset (the receivable) to a credit trader. But the credit trader isn’t going to buy a single credit receivable, that’s (1) a lot of work, and (2) not fungible (side note: traders hate non-fungible things). Enter the investment bank (IB). The investment bank will buy up credit receivables from several counterparties to begin the arduous process of securitizing the credit.
def. securitize | The term "securitize" refers to the process of pooling financial assets to create new securities that can be marketed and sold to investors.
In this process, the IB will create financial structures that package the debt and then tranche the debt into different risk tiers, typically a junior and a senior tranche, sometimes a mezzanine, etc. In a typical two tranche structure, the senior tranche will receive the first payouts from the receivables in the structure up until they get paid out X%. The junior tranche will then get paid out the remainder of the payouts, so if the total payouts is Y% and the senior is X%, the junior tranche will get: Y% - X%. When done right, funds that invest in the junior tranche on a levered basis can make a decent amount of money. When too many borrowers default on a given instrument, the junior tranche investors can find themselves under water.
In traditional finance, this process of structuring and paying out parties costs quite a bit of money and resources. Investment banks make a killing on structuring fees, transaction fees, and pretty much any other fee associated with the securitization process that can be as high as 75-100bps. However, this payout process lends itself quite well to a smart contract - enter Centrifuge, stage left. Centrifuge is that smart contract - or more accurately, that set of smart contracts.
Where does Centrifuge fit in DeFi?
For a broader industry map, check out our twitter.
Centrifuge is nestled deep in the ‘Lending’ branch of DeFi, which is both literally and figuratively at the center of the decentralized economy. If currency were the blood, exchange and lending would be the heart and lungs.
Why is this the case? To paraphrase the credit king, Ray Dalio, an economy is the sum of all of the markets in a system and a market is simply the sum of all of the transactions. Each transaction consists of a buyer and a seller exchanging money or credit for goods, services, or assets. This relationship between transactions and the economy demonstrates how the central bank can influence the economy by printing new money and changing interest rates, which changes the velocity of money.
Credit is the most important part of the economy as it allows people to borrow against their future earnings and pay for something today. When used correctly, credit accelerates the growth of an economy. By nature, credit also creates cycles - credit cycles.
In the image above on the left, is the growth of an economy without credit. On the right is the image of an economy with credit. When we are able to borrow against our future earnings, the supply of capital expands and the market grows much faster than usual. Later, when we need to pay back the borrow, the supply of capital contracts, and the growth dwindles.
Now, at this point if you are following along, you might be asking:
What’s the point of credit if we always end up in the same spot, just with more volatility?
Well consider two scenarios, Scenario 1 and Scenario 2:
In Scenario 1, a lender extends credit to a borrower who buys a productive asset - a cow. Cows are great because they produce milk, which can be turned into cheese, or butter, and they can also be turned into delicious, mouth watering steak that capitalists all seem to love.
In this scenario, the borrower has used leverage to buy a productive asset, which will allow them to pay off the debt and earn money doing so. The borrower here will earn money on a quicker schedule than if they had not borrowed, which allows them to compound their returns. On aggregate, with many other borrowers buying productive assets, this behavior tilts the economy to perform better than if it did not have credit.
In Scenario 2, a lender extends credit to a borrower who buys a non-productive asset, like a peacock. While fly fishers might argue that a peacock’s feather is in fact a productive asset because they can use it to tie their fancy flies, I will remind them that it’s just an example and they should chill. In this example, buying a peacock with credit is analogous to buying a television with credit - it is a non-productive asset that will not generate any growth or accelerate business activity - hence it is not going to result in a net positive outcome for the economy.
When credit is used to increase the efficiency at which capital is allocated to resources, it is good for the economy. A short seller that has high conviction that a company is fraudulent borrowing capital to express their viewpoint on the market is an efficient allocation of capital. A developer borrowing capital to build houses in a supply constrained region is an efficient allocation of capital.
The Centrifuge Perspective
So back to Centrifuge - Centrifuge is a marketplace. Specifically, Centrifuge is a two-sided marketplace. On one side, Centrifuge has borrowers (issuers) and, on the other side, Centrifuge has lenders.
When there are a lot of strong borrowers, a new entrant on the borrow side reduces the availability of credit on average, whereas a new lender increases the availability of credit.
The inverse is also true: when there are a lot of lenders, a new lender will increase the availability of credit, pushing the rates down, which is net negative for lenders, but a new borrower in an environment with a lot of lenders will push the market towards equilibrium.
In such a marketplace, the marginal utility of a new high quality borrower is inversely correlated to the marginal utility of a new high quality lender. This is common sense as there is an equilibrium value where borrowers and lenders are matched.
This concept was actually explained explained to me beautifully by Seth Priebatsch - who is a marketplace wizard - so I want to make sure to give him proper credit.
With this formula in hand and the goal of identifying what Centrifuge should pay attention to now, let’s take a look at what they have paid attention to in the past:
Many people don’t give credit where credit is due here, but Centrifuge was started in the same year that Aave and Compound were, which means that Centrifuge, Aave, and Compound, all contributed to a true 0 → 1 innovation in DeFi: crowdlending. Crowdlending allows many small lenders to work together and provide the quality credit that a large lender would.
Lender #1. Crowdlending was Centrifuge’s solution to the cold-start problem and Centrifuge’s first high quality lender.
Borrower #1. This new credit attracted many borrowers, but most notably, it attracted New Silver to the platform. New Silver is a high quality borrower that specializes in real estate backed financing.
Lender #2. The New Silver pool caught the eye of MakerDAO’s Real World Finance Core Unit.
Borrower #2. MakerDAO is a very attractive lender, specifically because the DAO can afford to offer rates that are at or below market because, like the Fed, the protocol is a currency issuer / credit facility. With MakerDAO in the mix of lenders, BlockTower’s Credit Fund entered the chat. This is a fascinating fund and I have to give major props to Kevin Miao who is at the helm. Kevin is a true force pushing this industry forward.
Lender #3. Naturally, the cycle continues and the Centrifuge community must seek a new high quality lender to continue along their stepwise function. There are already a few strong candidates out there, but in an high interest rate environment it is certainly a challenge. Interest rates change, however, and there are already two particularly strong candidates for the next major lender slot: DAOs and Aave.
Conclusion
A few weeks ago, shortly after the SVB drama, I was chatting with a traditional fund manager. This manager didn’t know much about crypto, but I asked him anyways what he thought of the space. I was surprised by how simple and insightful his answer was.
He said, “I don’t know much about crypto, but I do know that when a bubble pops, it dies, and the fact that crypto is still around today tells me what I need to know about the space.”
Source: rwa.xyz
In the chart above, many people see a bubble. I see steady growth obfuscated by a bubble. The active loans metric on Centrifuge has increased by over 100% since January of this very year. Mind you, that all this growth occurs with the overture of:
Traditional markets enduring the harshest lending environment in over a decade, and
Crypto markets experiencing turmoil on par with the infamous Mt. Gox era.
Real talk: Without real world assets and efficiently allocating credit this industry will not grow beyond a (fun) theme park.
For anyone interested, here are the Centrifuge Docs and here is a deep dive by Kevin Miao - who runs a fund on top of Centrifuge.
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