Asset Pricing in Defi
It’s liquidity that moves markets.
— Douglas Adams
Finance has three key foundations: one is the intertemporal transfer of value through time, the ability to contract on future outcomes, and the negotiability of claims.
— William Goetzmann & K. Geert Rouwenhorst
What can we learn from the past?
In today’s blockchain realm, innovation has already come to be expected. Brand new ideas spring from the blockchain innovator’s mind, then developed and implemented by developers, and finally summarized into whitepapers, spread amongst the social media. This continuing process in the past few years, also foreseeable in the coming future, might seem like a stochastic movement for an amount of Defi practitioners or some of those who eager to lead the cutting-edge development of blockchain. However, if we try to go through the history of financial innovation, we might understand the tremendous information flow on Twitter, Medium and in blockchain’s world, does not seem as chaotic as we thought to be.
Bearing the ultimate goal to replace the current financial system, Decentralized Finance will also be built based on certain basic principles that are conducive to financial development. As Ned Downing demonstrated, the prosperity of the existing financial system is something developed in response to historical trends. Its preeminence of is not preordained, but evolved along with the concrete demands of society functioning, economy governing, and corporate financing.
Now, Let’s come back to the very question proposed at the beginning: What kind of demand is driving the financial system to evolve? As long as we could figure out this question, we could be more or less enlightened to discover a picture of how Defi would be in the future.
Liquidity, or negotiability, is definitely one of the most important pursuits in financial innovation. Here, liquidity is not strictly confined to the concept about how easy and quickly an asset holder could liquidate his assets in a secondary market, but refers to the feasibility, the diversity, and universality of how liquid/illiquid assets trade, quasi-assets exchange, or any financing activities can occur within the system. Just take the birth of mutual funds as an example, it initially served as a means of providing small investors access to financial securities that would otherwise be difficult to obtain . By subscribing to a set of Russian loans, Dutch investment bankers could issue loan-backed bonds themselves in Amsterdam, which not only saved cost and time for a cross-nation trip but also created an international market for the Russian bonds. Another example is the first Eurobond issued by Rothschild Bank. The Prussian loan underwritten by Rothschild proved that government funding need not be constrained by borders. In the above examples, investment bankers all tried to turn cumbersome, illiquid financial contracts into liquid instruments with small denominations that could easily flow in the capital market. Today, this manner is named by securitization. Through such a process, nonnegotiable financial claims can be repackaged into a number of liquid assets in the market. The ultimate beneficiary of the initial claims might be thousands of miles away from its origin, which significantly enhanced the liquidity and the broadness of the financial world.
Risk hedging is another important driving force in financial innovation. Although investor and financial entities might finance their corporate and realize hundred times of return in the capital market, we should never underestimate the shadow that is camouflaged behind its tempting profit. The possibility of downside loss confined the development of capital markets. Actually, since the emergence of financial investment, risk has always been its inseparable partner. And, investors have sought to alleviate their risks for centuries. In order to avoid the large loss incurred by the company, limited liability was incorporated into the company’s financial structure; In order to avoid the fluctuation of commodity values, forward contracting was introduced to hedge against the market risk; In order to avoid the fluctuation of interest rate, interest rate swap was created to hedge against the floating interest.
Why is blockchain one of the best scenarios to apply ABS?
The blockchain technology has brought natural advantages to its combination with asset-backed securities (ABS).
Blockchain uses the idea of storing transaction data in the form of a distributed ledger where each node in the network stores a current copy of transactions (ledger) in the form of a hash chain. The data integrity and consistency are guaranteed by the Merkle tree structure. Since the data on the blockchain is maintained by all the qualified nodes, a single node’s collapsing would not affect the operation of the whole system. Besides, as each node has a complete copy of the ledger, there is no need for investors to build a centralized database system, which enhances the overall security and reduces the cost.
Immutability of data
Data on the blockchain is safe and reliable. Every byte on chain is traceable from the genesis block. Each block contains a pointer to the previous block’s hash. The blockchain is organized by the chronological order of the hash information, which makes all the data transmission public and transparent. Other nodes would not recognize any unilateral attempt to tamper with data unless one controls more than 51% of the nodes in the system.
Trackability of Cash Flow
Due to the complex due diligence and issuance process, overcrowded participants, and high purchase requirements, ABS have problems such as information asymmetry, inaccurate rating, and limited product liquidity . Through the application of blockchain technology in ABS business, some of them can be effectively solved. Upon issuing an ABS product, public keys and private keys are delivered to all the participants, and they can send their confirmation backward through encrypted signatures. All the investors can simultaneously acquire the fundamental cash flow and other information involved. Whenever there is an update on the asset’s financial data, every investor would be informed simultaneously, which is conducive to every stakeholder’s risk control. In addition, rating agencies and regulators can use blockchain to monitor ABS more quickly and effectively. Since the data is open to all the participants, the rating agencies can observe the change of the asset pool in real-time. At the same time, developers could embed monitoring software on the blockchain of the platform. Once the refunding deviates from the expected cash flow, alerts can be triggered automatically to inform the participants to carry on the corresponding measures.
The smart contract can also play an essential role in ABS. When the collateralized assets’ cash flow is coded into the contract, every participant can analyze, estimate and predict the cash flow based on their synchronized data. In the meantime, the smart contract can collect the latest loan repayment status and manage the cash flow towards the investors in different tranches based on previous settings. The immutability of data guarantees the timeliness and consistency for investors to receive their principal and interests and lowers the time and information cost throughout the process.
Why Defi needs ABS?
In the last year, the increasing liquidity becomes less supportive to the crypto economy. From July 1st, 2020 till now, the total value locked in various protocols increases by 25.86 times, but the performance of the total market cap is not as astonishing. In the same period, the total market cap of cryptocurrencies increases only by 4.36 times. The enormous amount of liquidity release did not drive the economy to rise as expected.
One of the possible reasons is that a huge proportion of cryptocurreny is locked up in the liquidity pool and these TVLs could not release an equivalent liquidity as itself. Due to the anonymity in Defi’s realm, almost all the lending protocols adopt over-collateralization as the cornerstone for their contracts. In order to eliminate default risk, the value of the collateral will exceed the value of the loan. For example, borrowers in Compound are usually required to collateralize their loan, at minimum, of 150% of the loan value. Thus, as TVL soars up, the velocity of circulation slows down. Based on Irish’s equation MV=PT, the stimulative effect of currency on crypto economic growth is reduced. Considering the deflation in the circulation process, cost of loan can be higher than Defi users could burden. In the first quarter of 2021, the composite rate of Compound once reached 14%, which is higher than the ROE 8.25% of US listed companies.
From the liability perspective, the total outstanding debt has increased by 16.6 times in the last year. Overreliance on financing through lending protocols could concentrate the risk of balance sheet deterioration, leading to an increase in systemic risk. Just as said, if a crypto token with an available supply of $100m in the market has a substantial portion of the owners using this token as collateral, the lending protocol would have real exposure to this token. If, say, $40m of this token is collateral, and the collateral value started dropping rapidly, it should be clear that trying to get rid of 40% of the available supply (even in a liquid market) would directly impact the price and cause a downward price spiral. As the TVL multiplier decreases, we would face a more concentrated exposure risk in the Defi system.
To solve such problem, the effectiveness of relatively expedient liquidations in crypto could be taken advantage of. Complex securities can be priced, packaged, and reused in ways that are way more difficult in the traditional financial world. Asset-backed securities are one of the examples and they have several natural advantages:
1. ABS can release the deposited liquidity and promote financial support for the development of the crypto economy without increasing the base currency.
2. ABS can gradually establish risk isolation and decentralization, reduce the maturity mismatch of the financial system, and realize the active management of the balance sheet.
3. Through product design such as active credit rating, investment tranches and re-arrangement of term structure in the formation of ABS, the default and liquidity risk can be released and repriced in the market.
According to US fixed income market share, Defi ABS could have a 1.64 billion market cap.
Potential ABS Products
The essence of an ABS product is to securitize an illiquid asset with predictable cash flows into a liquid and standardized security in the market. In order to price the overall risk, the price of an ABS product can be estimated by
Based on the current development in Defi, I think the following products are most possible to appear in the market.
Protocol Fee ABS
During the last year, Defi lending protocols have accrued more than $383 million interests. To eliminate the liquidation risk, some protocols choose to mint tokens or set up an insurance fund. However, either method would inflate the protocol token or distract the team from updating their protocol to the new version. Since the active users, locked value, and interest rate model are transparent on the blockchain, and the accrued interest is predictable and priceable by speculators or investors. The protocol could also use funding from ABS to relieve the liquidation stress for different maturities.
Hash Rate ABS
As point out, given the upfront cost of hardware, miners tend to have liquidity issues as they wait to amortize their machines and earn a profit. Should a miner’s expenses go up, say due to increased energy costs, they may have to borrow cash to pay for electricity. Currently, miners execute such loans by borrowing against earned coins. In theory, they could use their mining hardware as collateral to borrow cash. However, Anicca Research’s Leo Zhang reports that thin secondary markets for mining hardware make lenders skittish of accepting machines as collateral. Instead, miners directly borrow against their coins, which has been a major contributor to the explosion in leverage provided by lenders such as BlockFi and Nexo.
Since miners and GPUs could not be upgraded frequently, and the block reward is known, the hash rate of a mining pool can be regarded as an asset with predictable cash flow. The mining power of Bitcoin, Ethereum, and Filecoin can be securitized, and the mining power owners could sell or pledge them to obtain liquid funds. The market risk of mining can be priced as well. Mining is a capital-intensive industry, and if we could explore more financing opportunities in it, we could dig out a huge market.
About Huobi Ventures
Led by Huobi Group CFO Lily Zhang, Huobi Ventures is a wholly-owned subsidiary of Huobi Group focusing on Huobi’s global investment. Composed of four divisions — strategic M&A, venture investment, asset management and global cooperation, Huobi Ventures has already launched three funds targeting typical fields: Metavers, HECO Ecology and NFT. We aims to empower further growth of Huobi Global, and create a global community with our partners for mutual benefits.