FRANKFURT, GERMANY – The world of blockchain-based finance, generally called decentralized finance (DeFi), consists of various smart contracts which a user with cryptocurrency can interact with. You can think of smart contracts as programmed instructions that developers run on the blockchain.
Almost everything on the blockchain runs on smart contracts. Anyone can deploy a smart contract and they employ all sorts of different logic for different purposes. Every type of blockchain use case, including such things as identity, financial, medical and gaming, depends on smart contracts. A smart contract can be controlled by a single person, by other smart contracts, by or nobody at all.
Technically, Bitcoin pioneered smart contracts, but their functionality was intentionally restricted due to the philosophies of the developers and miners. Smart contracts emerged in full force with the advent of Ethereum, which is now the second most valuable blockchain network. Ethereum popularized the notion of ‘tokenization’. All tokens are smart contracts, and different industry standards define the various types of arbitrary tokens that can be used for different purposes, such as the currently popular non fungible tokens (NFTs). Here I’ll be focusing on a specific trend involving the tokenization of traditional finance, however first we need more context.
In the world of blockchain finance, smart contracts create mechanisms and systems that allow people to do things with their cryptocurrency, such as lend it at interest, supply it to a smart contract based exchange to earn trading fees, or take on debt using the crypto as collateral. Most major financial smart contracts are controlled to varying degreesby a “DAO” (Decentralized Autonomous Organization).
DAOs represent nothing less than the digital evolution of the corporate structure, where; bylaws, equity distribution, the board of directors and any other structural element of a business entity structure can be defined as code on a distributed ledger.
DAOs are just smart contracts governed by a defined mechanism. In most cases, the DAO uses a token to determine voting rights. The token is usually released by the DAOs founders and finances the protocol’s objectives. Usually the DAO can vote to modify smart contracts, which the DAO owns, and do things like issue more governance tokens or pay employees. But sometimes, certain addresses are designated to a council-type construct for emergency or other specific powers.
Since every DAO uses a unique governance framework, the ‘Decentralized’ part of a DAO is practically meaningless. Digital Autonomous Organizations would be an infinitely more accurate definition. Furthermore, analysis of a DAO, just like with any other organization, requires a holistic understanding of the controlling influences within the project.
MakerDao, Juggernaut of the Ethereum Financial World
Financial smart contracts exist on basically every blockchain, and interoperability between all blockchains increases by the day. However, the largest market remains Ethereum. Within Ethereum, MakerDao essentially birthed DeFi and remains one of the largest financial protocols on any blockchain, with approximately $18 billion dollars worth of crypto assets locked into the protocol.
So what is MakerDao? Even within the world of blockchain people regard MakerDao as obnoxiously complex. I’ll try to distill the relevant components. In the interest of full disclosure, myself and a couple of other people wrote the initial collateral onboarding process for MakerDao. I was an active participant in that community mostly from late 2019 to May 2020, which is why I understand how the protocol functions. I focused on governance and control and was respected by the community. I left because I realized some of the fundamental flaws with the narratives of blockchain and DAOs saving the world.
The MakerDao protocol consists of smart contracts that allow users to lock up their valuable crypto asset, such as Ether of Ethereum, in exchange for a loan denominated by a token pegged to the US dollar (called DAI). Any crypto asset with value can theoretically be used as collateral to borrow DAI.
Currently, the majority of DAI in existence comes from major crypto assets such as Ether, wrapped Bitcoin (bitcoin bridged to the Ethereum network) and a stablecoin called USDC. USDC is issued by a consortium called Centre, formed by Coinbase and a group of financial institutions under the name Circle.
MakerDao aimed to create a so-called decentralized stablecoin. Users can access money without selling their crypto assets by taking on debt. The collateral must always be worth more than the debt the user takes on (usually somewhere around 130-175%). If the value of the collateral decreases enough then that collateral is automatically liquidated. By doing this in a verifiable distributed ledger, Maker essentially takes on the role of a bank issuing currency (DAI, pegged to the US dollar) backed by collateral in the form of cryptocurrency assets.
The bulk of the work the DAO of MakerDao engages in revolves around what types of crypto assets are added to the protocol and the parameters of loans for those assets. A specific token, called MKR, owns the smart contracts comprising the Maker protocol. Anyone who owns the MKR token can vote on proposed changes or additions to the protocol, however the governance apparatus of MakerDao extends much further than just MKR holders, and has scaled to millions in payroll expenses per month.
In 2018, Andreessen Horowitz’ crypto capital fund a16z, bought 6% of all MKR tokens for $15 million dollars. This was the firm’s first investment in crypto and was managed by Katie Huan, who led US Department of Justice investigations into the Silk Road and Mt.Gox hack.
In March 2020, Maker suffered a serious software bug and in trying to maintain the DAI peg to the US dollar during the emergency, Maker governance decided to allow USDC as collateral at very favorable terms, and USDC remained the largest collateral asset for some time. As a side effect, Circle and Coinbase actually hold MakerDao somewhat hostage right now due to their blacklisting abilities, which are apparent given the companies’ make up – a who’s who of former tech and finance executives direct Circle from organizations such as, Google, Amazon, airBNB, Ebay, and Goldman Sachs. Investors include IDG capital Breyer Capital, General Catalyst partners, Goldman Sachs, CICC Alpha, Baidu, WanXiang, CreditEase and EverBright Bank.
For the concept of ownership to exist in societies with laws defined by governments; constructs managing ownership such as taxation, court precedents, and contract law, require the legal abstraction of assets. Blockchain-defined assets will continue to grow as long as legal authorities recognize digital representation of ownership, fulfilling the dream of MakerDao and blockchain finance in general, which is the tokenization of ‘real world assets’ such as real estate, stocks, commodities, bonds or any traditional asset class.
A stablecoin such as USDC, which is backed by cash, corporate and sovereign bonds, is only a stone’s throw from direct tokenization of such assets due to the legal recognition of stablecoins as a valid product. In addition, the focus on complete digitalization through blockchain exercised by commercial and central banks, guarantees the continued legal recognition of digital ownership.
Tokenization Completes the Digitization of Finance
Work on tokenized assets started in earnest around the 2017-18 crypto market euphoria. Hundreds of projects and pilot programs have been in the works, and every blockchain platform has some sort of tokenization of traditional assets. Generally, a holding company that owns the traditional asset creates a token representing a legal claim. The largest issuance of tokenized stock that I am aware of occurs on the Solana blockchain. A Swiss company called Digital Assets AG tokenized 100,000,000 USD-worth of stock from over 50 companies including names like Google, Tesla, Microstrategy, and Uber. However, this is fairly restricted, as trading only occurs on the FTX exchange for customers complying with Know Your Customer/Anti Money Laundering laws.
A company based in Florida, RealT has tokenized about 75 individual real estate properties. Redswan recently tokenized about 2.2 billion dollars-worth of commercial real estate. In Germany a company called Fundament earned approval from the relevant regulatory agency baFIN to tokenize about €250 million Euros worth real estate bonds. Recently, Fundament partnered with preeminent German real estate developer Bauwens to tokenize over US$7 billion dollars-worth of real estate. Bauwens owns a 15% stake in Fundament.
These projects highlight the progression of real world asset tokenization, but the crown jewel centers on a union with blockchain financial tools. Let’s explore how that union leads to extraction of more value (debt) from already convoluted arrangements in order to breathe new life into the game.
The first example ever of tokenized traditional assets merging with blockchain based finance occurred between MakerDao and a project called Centrifuge. Centrifuge facilitates the tokenization of different types of traditional assets and enables crypto capital to invest in those assets. One of the largest offerings, called New Silver Series 2, allows people with DAI to finance a company that offers loans to people building or fixing single family residences by investing in their token offering. Essentially, the token serves as a claim on the eventual repayment of the construction loans plus interest.
Those investors can use that token as collateral on MakerDao to take on debt themselves. So far, those investors have extracted an additional 12 millions dollars of debt using the token as collateral. If the original construction loans fail, then the investors who financed them will lose, and if they took additional debt via MakerDao, then they will lose even more.
While Centrifuge represents the tech/trade finance startup side of crypto financial debauchery, major financial institutions are eager to adopt blockchain based financial schemes, and in order to offer tokenized financial instruments through blockchain financial applications they need to form relationships with the DAOs.
A major French Bank, Societe Generale, recently posted a collateral onboarding application to the MakerDao forum where they propose an experimental setup to refinance a tokenized bond backed by real estate. By refinancing we mean taking on debt against a financial instrument, in this case the asset is a tokenized covered bond. In theory, a covered bond refers to a type of debt instrument issued by banks, where loans or mortgages are backed by a separate pool of assets. Societe Generale also participates in CBDC experiments run by the Banque de France.
The representative from Societe Generale states the intention and goal behind this experimentation, carried out through the bank’s digital assets subsidiary SG-Forge:
If this first experimentation is conclusive, we would propose this refinancing setup to our clients, i.e. the investors in Security Tokens issuances. At this stage, SG-Forge is structuring debt instruments in the form of Security Tokens covered bonds, Notes (secured and unsecured) and structured products (Notes linked to underlying assets).
To effectuate the experiment Societe Genrale negotiates with MakerDao’s ‘Core Units and ‘Delegates’. Core Units basically refers to smaller groups within the DAO that work on a specific area such as communications, smart contracts, lobbying, business development and other areas of focus. Delegates refer to political actors who vote on proposals on behalf of anyone that pledges their MKR to the delegate.
Societe Generale tokenizes this traditional debt instrument through a security token framework called CAST. CAST, approved and trialed through their work with blockchain and the French central bank, provides an international basis for financial institutions to issue tokenized securities.
From the CAST whitepaper:
“The tokenization of financial instruments represents the second step towards the dematerialization of securities. The first step has consisted in transitioning from a paper representation of securities to an electronic representation (through book-entry account).”
Societe Generale has experimented with blockchain technologies since, at least, 2019. In May 2020 the bank Issued tokenized covered bonds on a public blockchain that were settled in Central Bank Digital Currency issued by the French central bank. Now in 2021, their experimentation with these tokenized covered bonds extends to the dominant blockchain based financial institution MakerDao. Just as with Centrifuge, Societe Generale explores this new debt instrument to advance the state of blockchain finance while acquiring a potential advantage over competitors.
Larger Context – El Salvador, Project Dunbar, and Beyond
El Salvador recently announced a billion dollar national bond to build the first “Bitcoin City”. The first 500 million will be allocated to build the Bitcoin mining and energy infrastructure of the city while the second half of the bond purchases Bitcoin directly. If the price goes up, then the bond pays an additional 50% dividend.
El Salvador plans to issue the bond on the Liquid Network, a Bitcoin sidechain governed by a Federation of approximately 60 organizations such as crypto exchanges and wallet providers. The company that built the network, Blockstream, has played a major role in the development of Bitcoin and is the source of many controversies within that community.
Blockstream recently netted a US$3.2 billion valuation during a series B fundraising led by Baillie Gifford and iFinex, the parent company of Bitfinex. The Paradise Papers revealed that the same people who control bitfinex control TETHER, the largest stablecoin in the crypto universe, which is currently facing legal challenges from other quarters of the cryptocurrency space vying for jurisdictional primacy in the burgeoning digital marketplace. . iFinex will process the Bitcoin bond on the Liquid network.
Samson Mow, the Chief Strategy Officer of Blockstream, expects this bond to pave the way for other tokenized securities in the country:
El Salvador also aims to create a government securities law and grant a license to Bitfinex Securities to process the bond issuance. This could pave the way for other Liquid security tokens like the Blockstream Mining Note (BMN) or Exordium (EXO) token to be listed on a regulated El Salvadorian securities exchange.
Liquid, despite backing from some of the deepest crypto players such as iFinex and Digital Currency Group, fails to capture a significant market share of tokenized Bitcoin. Liquid sidechain currently holds about 3500 btc, currently valued at just under $200 million dollars. Compare this to Bitcoin linked to other blockchains such as Ethereum.
Approximately 250,000 Bitcoins, $13 billion dollars, are tokenized as “Wrapped Bitcoin” (WBTC), and even the smaller platforms on Ethereum such as RenVM boast multiples of Liquid with over $1 billion dollars of bitcoin tokenized through their platform. The other touted “scaling solution” for bitcoin developed by Blockstream is the Lightning Network, which similarly fails to gain any traction.
The only other organization that I am aware of that has taken on significant debt to buy Bitcoin is Michael Saylor’s Microstrategy, which issued a $500 million dollar bond explicitly to buy Bitcoin. If the El Slavador bond is successful, significant international dominos could fall as other debt ridden countries try to replicate El Salvador. The precedent of issuing sovereign debt on a blockchain network could shake up the world of international finance and accelerate the digitization of the globe. Some view El Salvador as ‘sticking it’ to the IMF, but these actions also buoy long standing interest of global capital. To explain that, let’s explore project Dunbar, the Bank for International Settlements’ (BIS) bid for large scale multi-currency Central Bank Digital Currency.
With Project Dunbar, The Bank for International Settlements aims to create an interoperable multi CBDC network for global trade.
The BIS is building this system in conjunction with the Ethereum Foundation, PWC (one of the “big four” accounting firms) and Consensys. The latter is a technology company started by Joseph Lubin, co-founder of Ethereum, which both helps large enterprises implement blockchain and incubates cutting edge blockchain technology. The BIS is building this network on an Etherum clone called Hyperledger which serves as a private blockchain for companies.
Building this multi-CBDC system on hyperledger, ensures levels of interoperability with the crypto universe. In their publication, the BIS refers to the m-CBDC system primarily as a payments system. This qualification downplays the reality of building on an Ethereum-like smart contract platform. Instead of a simple payment system, this approach ensures the programmability of money and the ability to keep up with accelerating crypto technology. In September 2021 the BIS published a report on the completed phase two test results:
Phase 2 achieved a prototype that enables three participating central banks to control the flow of their CBDC and to monitor transactions and balances of their issued CBDC, with programmable levels of transaction privacy and aspects of automated compliance.
The project chose the Consensys-developed ‘Universal Token Standard’ for the basis of tokenization and smart contract development. This standard, in a nutshell, merges the basic Ethereum token standards (ERC-20, and many others) with other standards that allow for more control and compliance:
“The standard also allows for restricted usage based on the holder’s identity, legal jurisdiction or asset type. For example, the prototype can be built to limit the number of tokens in a specific wallet, impose thresholds on transaction sizes or whitelist potential holders in secondary markets all via smart contracts in the blockchain layer”
The main innovation beyond blockchain itself revolves around programmability, meaning the institutions with power can automatically enforce any rules or restrictions they desire. The examples they cite only scratch the surface of blockchain-based programmability.
After completing the phase two prototype stage, Project Dunbar entered Phase three in September 2021. This stage advances the project into deeper development, creating a ‘minimal viable project’ with an increased focus on testing out business use cases and policy choices.
The project is governed by a steering committee from the BIS Innovation Hub Hong Kong, previously covered by Silicon Icarus, and which is overseen by four subcommittees working on different aspects of the system: The Peoples Bank of China’s Digital Currency Initiative, which leads the technological subcommittee; the Hong Kong Monetary Authority, the Bank of Thailand and the Central Bank of the United Arab Emirates, which lead the legal, policy and business subcommittees, respectively.
As blockchain economies continue to grow, and the push for interoperable digital identity becomes more forceful, the value of the data increases significantly. Instead of financial, social media, gaming, commerce and other data existing in separate silos, all of that information can be analyzed together at once automatically and continuously, feeding the singularity.
The unification of traditional finance and so-called ‘Decentralized Autonomous Organizations’ propels the evolution of legal abstractions to digital standards. These standards, along with their legal counterparts, form the infrastructure for the large-scale control of society through impact finance, revamped educational credentials, digital health records, fake environmentalism, geo-fencing, smart cities, internet-enabled nanotechnology and all of the other crazy ‘use cases’ such technology makes possible. The move towards robust CBDC networks by central banks all over the world, provides even more momentum to this future.
Cover Photo: G20 Finance Ministers and Central Bank Governors in Shanghai 2016 | Rolex Dela Pena/AFP/Getty Images