Blockchain Lending and Real Assets: Opportunities and Challenges

Background

An emerging trend in the blockchain and cryptocurrency space is the use of physical assets to expand on-chain credit. This involves creating digital representations of physical assets, such as real estate, commodities, or artworks, using blockchain technology, and using these digital assets as collateral for issuing on-chain credit. This approach can make it easier and cheaper for borrowers to obtain credit, while lenders can earn interest from their held assets by providing liquidity to the market.

This approach is expected to democratize and make access to credit more inclusive, especially for groups that have difficulty obtaining traditional financial services. Furthermore, by using physical assets as collateral, on-chain credit markets can be more stable and less susceptible to fluctuations and speculation that may affect other forms of cryptocurrency lending.

Overview of the Traditional Global Bond Market

The traditional bond market has a long history, tracing back to the 17th century when the Dutch East India Company issued bonds to finance its trade activities. Since then, the financial market has grown significantly, and bonds have gradually become an important financing tool for governments, enterprises, and other institutions.

The modern traditional bond market can be summarized as a decentralized global network of buyers and sellers, with transactions involving debt securities issued by borrowers seeking to raise funds. The market is highly diversified, with bonds issued by governments, corporations, municipal authorities, and can be further classified based on factors such as maturity, credit rating, and currency denomination.

Market Situation Summary

According to data from the Bank for International Settlements, as of 2021, the traditional bond market is large, with an estimated $123 trillion in outstanding bonds. The market distribution is highly globalized, primarily occurring in financial centers such as New York, London, Tokyo, Hong Kong, and regional markets around the world.

In 2020, the United States and Japan together accounted for nearly half of the global bond issuance, while Western Europe and China accounted for another quarter. This reflects the dominant position of developed countries in the market, which have well-established financial systems, deep capital pools, and stable political and economic environments.

In contrast, developing countries have a smaller share in the traditional bond market, partly due to relatively insufficient financial infrastructure and political-economic instability. However, in recent years, the participation of emerging markets has increased, with issuers from countries such as Brazil, Mexico, and Indonesia becoming more active.

Nevertheless, there are significant disparities in the distribution of the traditional bond market. Developing countries account for only about 20% of global bond issuance, despite representing about one-third of the world's population and a significant share of global economic growth.

One factor causing these differences is the "interest rate gap", which refers to the difference in interest rates between developed and developing countries. The interest rates in developed countries are generally lower, reflecting their stronger financial systems and stable political and economic environments. This makes it more difficult for developing countries to compete in traditional bond markets, as they must offer higher interest rates to attract investors.

Vertical Structure of the Bond Market

The financial infrastructure of the traditional bond market includes multiple participants such as issuers, underwriters, dealers, and investors. The process of issuing bonds typically involves steps such as selecting the type and structure of the bond, determining the interest rate or coupon, and finding buyers for the bonds. Issuers can collaborate with underwriters to promote and sell the bonds, or they can issue bonds directly to the public through a public offering.

After the bond is issued, it is usually traded in the secondary market, where investors can buy and sell bonds based on market value. The market value is determined by factors such as the credit risk of the bond, liquidity, and the prevailing interest rates. The market price of the bond is also influenced by the yield curve, which reflects the relationship between bond yields and maturity dates, as well as macroeconomic factors such as inflation and monetary policy.

The traditional bond market plays a key role in supporting economic growth and development, providing a reliable source of financing for numerous projects and initiatives. However, the market also faces a range of challenges and constraints, such as borrower default risk, the complexity of certain bond structures, and the potential for market fluctuations. As a result, there is growing interest in alternative financing models, such as blockchain-based lending platforms that use real assets as collateral.

Challenges of Traditional Loans

Traditional financial loans face many challenges, and these challenges have driven the demand for blockchain-based lending solutions. The main challenges include:

1. High transaction costs: Traditional financial lending involves numerous intermediary institutions, each of which takes a cut from the transaction. This can lead to high transaction costs, making it more difficult for borrowers to obtain credit and for lenders to generate sufficient returns.

2. Lack of Transparency: Borrowers often do not understand the loan terms and associated fees. This can lead to a lack of trust between the lending parties, making it difficult to establish a long-term relationship.

3. Slow processes and low efficiency: Borrowers often need to provide a large number of documents and go through a lengthy approval process. This is particularly challenging for small businesses and individuals with limited resources.

4. Limited access to credit opportunities: Traditional financial loans may be affected due to limited access to credit opportunities, especially in developing countries or for individuals and businesses with limited credit histories. This makes it difficult for them to obtain the funds needed for development.

These challenges have driven the growth of demand for blockchain-based lending solutions. Blockchain lending offers advantages such as higher transparency, lower transaction costs, and faster, more efficient processes. As blockchain technology continues to mature and evolve, we are likely to see ongoing innovation in this field, with developers and entrepreneurs leveraging the unique advantages of blockchain technology to create new innovative lending products and services.

Blockchain Lending with Physical Assets as Collateral

DeFi represents a significant shift in the traditional financial system, offering greater accessibility, transparency, and efficiency. As technology continues to evolve and mature, we can expect to see ongoing innovations in this space, with the launch of innovative products and services aimed at meeting the needs of global users.

Definition and Characteristics of Real Asset Blockchain Lending

The blockchain loan for physical assets ( RWA ) involves the use of blockchain technology to create digital representations of physical assets, such as real estate, commodities, or artworks, and using these assets as collateral to issue loans or other forms of credit. This type of loan is commonly referred to as "asset-backed loans" and has the following key features:

1. Stability: RWA provides a more stable and reliable foundation for the valuation of blockchain-based financial products and services, helping to reduce risks and improve the stability of the blockchain ecosystem. This is because RWA is backed by tangible assets that have intrinsic value and are associated with real-world cash flows, making it less susceptible to volatility and speculation than purely cryptocurrency-based lending.

2. Democratization: RWA Blockchain loans can make access to credit more democratic and inclusive, especially for groups that find it difficult to obtain traditional financial services. RWA can be used as collateral to issue loans and other forms of credit that are easier to obtain and less expensive than traditional loans.

3. Transparency: Using blockchain technology can enhance the transparency and accessibility of the lending process, as all transactions are recorded on a public ledger. This helps reduce the risk of fraud and increases trust between lenders and borrowers.

Overall, blockchain loans are expected to transform the lending industry by making credit more accessible, stable, and transparent in relation to physical assets. The new mechanisms will reduce the risks for all participants, thereby fundamentally changing traditional lending models.

The advantages of Blockchain lending over traditional lending

Blockchain loans using real assets have advantages over traditional loan models in several key aspects:

1. International Accessibility and Global Market Integrity: Blockchain lending is available for borrowers and lenders from anywhere in the world, without geographical and regulatory restrictions. This provides greater flexibility and capital acquisition opportunities for both parties.

2. Accessibility of Crypto Financial Instruments: The certificates issued by the RWA loan project can be refinanced by other DeFi projects, creating a more interconnected lending ecosystem. On-chain activities can serve as evidence for a DeFi-based identity (DID) and credit system. Borrowers can choose borrowing assets with different risk exposures based on their risk tolerance and investment goals.

3. Consensus and Democratization: The decentralized nature of blockchain lending means that all participants have a voice in the decision-making process. Decisions regarding borrowing eligibility and interest rates are made through a consensus-driven process, ensuring that all participants have a say. This democratic lending approach helps to enhance transparency and fairness, reducing the risk of bias and discrimination that may exist in traditional lending models.

In summary, blockchain loans have several advantages over traditional loans with physical assets, including higher international accessibility, availability of crypto financial instruments, and a more democratic decision-making process. These factors make loans more inclusive and transparent, facilitating a broader range of borrowers and lenders while promoting the stability of the loan ecosystem and reducing risks.

Limitations of Blockchain Loans and Physical Assets

Although blockchain loans for physical assets have many advantages, there are also some limitations:

1. Credit Risk: Even if the assets are backed by physical assets, borrowers may still default, exposing real-life settlement and jurisdiction issues. Consensus on the Blockchain cannot completely eliminate the risks associated with physical collateral assets. Additionally, there may be challenges in asset valuation, making it difficult to assess the appropriate level of collateral.

2. Global Compliance Issues: Cross-border lending faces regulatory frameworks and compliance requirements from different countries, posing legal and operational challenges for blockchain lending platforms operating across multiple jurisdictions. Adhering to Anti-Money Laundering ( AML ) and Know Your Customer ( KYC ) regulations is particularly challenging for blockchain lending platforms.

3. Technical Risks: Blockchain technology is still under development and may face technical challenges regarding security, scalability, and interoperability, which can impact the stability and reliability of lending platforms. Smart contract programming and execution may also pose challenges that affect the performance and accuracy of lending contracts.

Overall, while blockchain loans have several advantages over traditional loans with physical assets, it is important to consider the potential limitations and risks associated with this new form of lending. By carefully assessing risks and implementing appropriate risk management strategies, blockchain lending platforms can ensure the continued growth and development of this innovative emerging industry.

Blockchain Lending Project Case Study

After the FTX crisis, the prosperity of DeFi and DeFi related to RWA has diminished. The main participants in RWA from the last bull market have scaled down, with survival becoming the primary goal. However, their strategies are still worth noting. At least during the bull market, they created explosive business scales.

"Waterfall" Financial Structure

To mitigate the credit risk of pollution from physical assets, most RWA lending has introduced a waterfall structure, which seems to have become the mainstream in the RWA loan industry.

The waterfall structure in CLO( collateralized loan obligations refers to the priority of payments made by the parties involved in the CLO. This structure is called a "waterfall" because payments flow down in a predetermined order, just like water flowing down a waterfall.

The waterfall structure is typically divided into several "parts," which are different layers of debt issued by CLOs. Payments are arranged in order of priority, with the most senior receiving payments first, followed by the subordinated, and so on. The payment waterfall starts at the top of the structure and flows down through each part until all payments are completed.

This structure was originally