Why Uncorrelated Assets Are The Key to Stable Crypto Lending

Lending and borrowing are one of the crypto niches that have witnessed tremendous growth since the debut of Decentralized Finance (DeFi) innovations. According to DeFi Llama metrics, the total value (TVL) locked across lending protocols currently stands at $34.3 billion and had at one point surged above $50 billion during the previous bull run.

It is also intriguing to observe the rise of niche asset classes, particularly Real World Assets (RWAs), which are expanding DeFi’s lending and borrowing market by integrating off-chain assets (real estate, private credit, and treasuries) with the blockchain economy. 

Today, the DeFi market not only caters for crypto natives, RWA platforms such as SOIL are making it possible for stablecoin holders to generate real yield. Instead of focusing on yield generation through incentivized tokenomics, this protocol introduces a decentralized corporate debt marketplace where SMEs and MSMEs can access loans. More importantly, the loans are invested in markets that are largely uncorrelated to crypto. 

That said, it’s not been a bed of roses for the crypto lending ecosystem. While DeFi lending and borrowing are among the core finance concepts replicated from tradfi, this market is yet to become of age, both fundamentally and technically. 

In most cases, there is a high correlation of the assets staked as collateral and the larger crypto market, which explains why there have been several instances where DeFi lending protocols have failed when crypto prices took a sudden and volatile plunge.

Correlation: A Big Risk in DeFi Lending

If you’re an avid follower of the financial markets, you probably understand that most crises often mutate as a result of asset correlation.

For example, the 2008 U.S. financial crises spiraled out of control since almost every other investor in the market was exposed to real estate products, be it a mortgage or the infamous mortgage-backed securities (MBS). When the house of cards came tumbling down, the global financial market almost came to a standstill.

Similarly, DeFi lending and borrowing, although a novel concept, has in the recent past exhibited what could happen if the market’s fundamentals are based on highly correlated assets. To make it worse, for a volatile market like crypto, things have a tendency of moving faster than the typical bank run.

MakerDAO Black Thursday and Luna’s Collapse

Of course, there have been several instances where DeFi users got wiped out due to their collateral taking a sudden and quick plunge. Two major incidents are worth noting: MakerDAO’s Black Thursday liquidations and Luna’s $60 billion collapse.

In the former, a good number of the protocol users who had collateralized debt positions (CDP) on MakerDAO lost close to $8.3 million after ETH’s value (collateral asset) plummeted by over 45% in hours on the news of the COVID pandemic. At the same time, MakerDAO’s native token ‘MKR’, which is inherently a crypto asset, also took a nosedive of around 65%, leaving users with no backup options to prevent their open positions from liquidation.

But perhaps the biggest setback in DeFi lending history was Luna’s crash. This DeFi lending protocol rose the ranks, thanks to its generous 20% interest on staking the UST algorithmic stablecoin. But where were the yields coming from and what backed UST to ensure it is consistently at parity with the dollar?

While touted as one of the most innovative ideas in DeFi at the time, Luna’s biggest mistake was building an ecosystem that revolved around the crypto market alone. The ecosystem token $LUNA was part of the mechanism to maintain UST’s 1:1 dollar value, alongside a huge reserve of BTC.

However, as fate would have it, when UST depeged from the dollar, a bank run followed. This triggered Luna to print more $LUNA to defend the peg and deploy more BTC capital. Although a ‘solid’ strategy, the selling pressure was too much; BTC, LUNA, UST were all losing value, ultimately resulting in a $60 billion hole that left Luna’s founder Do Kwon a marked man.

These two DeFi ecosystems are just a few of the examples that have faced turbulency as a result of asset correlation. The question then becomes, what does DeFi lending and borrowing need to sustain stable lending, especially when the crypto market is not performing well? 

RWA: The Alternative Source of Real Yield

One of the very basic concepts of investing is diversification. Well, it seems that the DeFi market is no exception. But how can crypto innovators and users move away from over-reliance on token-generated yield and speculation narratives? As mentioned in the introduction, Real World Assets (RWAs) are emerging as the potential solution for on-chain economies to tap into more asset classes. 

This crypto asset class is currently the talk of the town hall. Even more intriguing, it’s not only crypto natives who are interested in RWAs. The world’s largest asset manager BlackRock is one of the tradfi institutions embracing RWAs.

At the core, RWAs introduce a novel way for the integration of DeFi with traditional markets. While still a relatively nascent area of innovation, the rate of innovation is certainly moving faster than it was three years ago. As of writing, tokenized U.S. treasuries are well above $1.1 billion while tokenized private credit stands at $608 million. 

With decentralized credit marketplaces such as the one pioneered by SOIL fast gaining traction; the protocol’s TVL eclipsed $2 million in less than half a year, we’re bound to see more capital trickling into the RWA ecosystem. Currently, a lot of interest is in tokenizing financial market instruments, including treasuries, the U.S. dollar, and credit; however, it is only a matter of time before precious commodities such as gold and silver start trading on-chain as tokenized assets. 

Historically, some of these assets have been known to hold a steady value, especially gold which is to date a safe haven during turbulent times. Integrating more stable assets with the DeFi lending economy will be a win for traditional financial institutions and the DeFi economy. 

On one hand, traditional assets such as real estate will become more liquid while on the other hand, DeFi lending and borrowing now have a more diverse portfolio to generate yield from or hedge against the volatility of the crypto market.

Moreover, with the U.S. SEC approving Bitcoin Spot ETFs, DeFi’s true value proposition is also becoming more evident to institutions that were once rigid.