Decentralized finance is designed for digital assets, but what happens when these assets represent an underlying security that exists off-chain? How do DeFi and digital securities work together? DeFi is a fascinating space with rapid growth and many interesting innovations. In a recent Medium post, Securitize CEO Carlos Domingo writes that with the right checks and balances and the involvement of regulated entities when necessary, these innovations can also be applied to digital securities in a hybrid finance “HyFI” format and benefit the capital markets space.
DeFi enables functionality that already exists in traditional capital markets in various forms, but that typically is performed by intermediaries requiring complex value chains and manual processes. Capabilities like programmatic AMM (automatic market-making) can drive liquidity and generate arbitrage opportunities for digital securities, in which their value will factor market demand in the short term, but also long term value based on some traditional performance indicators (revenue flows, dividend distributions, repayments from asset redemptions).
The advantage of composability (defined as the ability to leverage capabilities available in the ecosystem that have not been built with a specific asset in mind) comes from digital securities behaving in a consistent way in relation to digital assets, which in the DeFi world currently means being represented as ERC20 tokens on the Ethereum blockchain.
There are specifics to consider when dealing with digital securities, which are not simple “tokens.” One of the main issues is that securities are regulated and have several control mechanisms that must be enforced. If we want to consider the implication of using digital securities in this context, then the solution will not be pure “DeFi”, but more likely a “HyFi”, which combines some decentralization aspects when dealing with smart contracts and protocols, with some centralized aspects derived from regulatory obligations from the asset manager and their agents.
Securitize partnership with Centrifuge
Tinlake’s set of smart contracts pool NFTs (non-fungible tokens) that represent non-fungible real-world assets and use them as collateral to finance an asset in a stable cryptocurrency such as DAI or USDC. Asset Originators are able to create individual Tinlake pools per asset type, such as one dedicated pool for invoices and one pool for mortgages. For funders, risk and proceeds are shared for each pool but not across pools.
Currently, the receipt tokens for investors on Tinlake pools cannot be used by other investors (tracked by their wallet) to receive contributions from the pool, and the current pools enabled by Tinlake and its asset originators are short term loans that return the money to the investor within a short period of time. Therefore, there is little relevance in enabling liquidity for these tokens.
Centrifuge is looking at enabling rolling pools that reinvest the dividends, thereby enabling meaningful liquidity, but this will require more integration work with the DS Protocol to control the transfer restrictions and this will be an interesting extension of the current work.