Why have government bonds become the only landing point for mid-term and short-term RWA?

Author: Colin Lee

In the previous article, we mentioned that the most likely sub-category of RWA to achieve explosive growth in terms of scale and user base in the short to medium term is government bond RWA. According to data from rwa.xyz, the tokenized government bond assets in the government bond RWA projects (excluding US bonds in MakerDAO) currently amount to nearly $700 million, representing an increase of about 240% since the beginning of the year. In addition, the government bond RWA in MakerDAO has also rapidly grown to the level of several billion dollars. The overall growth rate of government bond RWA is fast.

Source: https://app.rwa.xyz/treasuries

Based on the above industry background, let’s analyze the mainstream government bond RWA in the market.

1. Significance of Government Bond RWA

In the previous articles “How to Define the Native Benchmark Interest Rate in the Crypto World?” and “Outlook for the “Native Bond Market” in the Crypto World”, we discussed the native benchmark interest rate and the possible bond market in the crypto world. Roughly speaking, the PoS yield of a public chain is the risk-free rate of the public chain, and a bond market may gradually develop around the interest rate.

Even if a crypto-native bond market with a scale similar to the current traditional bond market does not develop rapidly on-chain in the future, the emergence of “on-chain risk-free rate” LSD still has significant implications for investors: investors using public chain tokens (such as ETH) as the unit of account can still obtain low-risk returns in terms of coin base even in a bear market. From this perspective, some investment strategies in traditional markets can be more smoothly migrated to the crypto-native industry, such as the stock-bond balanced strategy.

Just like LSD, once the risk-free interest rate of the traditional financial market can be introduced into the on-chain world through government bond RWA, U-unit investors can use traditional allocation strategies. There are several benefits to this:

  1. U-unit investors still have a relatively safe and stable place to generate income even after the market turns bearish. Taking the stablecoin market as an example, after the market gradually turned bearish in the middle of 2021, the overall market size of stablecoins decreased from $188 billion to less than $130 billion. The decrease in the size of stablecoins also affects the overall market liquidity;
  2. Mixed-type wealth management products that combine stocks and bonds are easier to launch and be accepted by the market. Mixed-type wealth management products are also familiar to most investors in traditional markets. This will also promote innovation in the DeFi asset management field.

Source: https://defillama.com/stablecoins

The most typical example at present is MakerDAO. After the market turned bearish and US bond yields increased significantly, MakerDAO included US bonds in its investment scope, and its profitability has improved significantly after entering 2023.

Source: https://dune.com/SebVentures/maker—accounting_1

Therefore, it is reasonable to believe that other DeFi projects, after seeing the “demonstration” of MakerDAO, will also hope to improve project profitability through more diversified strategies such as RWA. Especially in a bear market, RWA can provide stable and sufficient sources of income for the stable operation of the project.

2. Business Models for Sovereign Bond RWAs

Currently, there are 5 main business models for sovereign bond RWAs: distribution models, platform models, infrastructure models, self-operated models, and hybrid models.

The distribution model does not directly participate in the packaging of underlying assets or provide KYC services to users. It mainly acquires customers through encryption and focuses on business marketing, fundraising, and the expansion of the ecosystem and application scenarios. Representative projects include TProtocol. These projects are not fundamentally different from infrastructure such as Aave and Compound that are used in daily life. They often obtain liquidity by establishing a fund pool, aggregate user funds, and then lend the funds to a single borrower to purchase underlying assets such as US Treasury bonds.

The platform model means that the project only provides a series of services such as on-chain, sales, KYC, etc., but does not directly participate in the asset packaging process. Representative projects include Desmo Labs. This type of project generally provides three types of services: (1) asset/equity tokenization services, (2) on-chain verifiable information services, and (3) user KYC services, etc. In terms of business, these projects theoretically can assist in packaging any type of asset/equity from traditional markets, not limited to sovereign bond RWAs, and are more similar to Internet platform models. To stand out in this race, the usability of the project’s one-stop solution and the project’s ability to acquire customers need to be considered.

The infrastructure model provides services such as on-chain deployment of RWAs, asset acquisition, and asset management, but does not directly interact with users who purchase government bonds on the C/B side. Representative projects include Centrifuge and Monetalis Group.

The self-operated model means that the project itself seeks corresponding assets, collaborates with external partners to establish a business structure, isolates asset risks, and tokenizes assets/equities. Currently, there are many projects of this type, such as MakerDAO, Franklin OnChain U.S. Government Money Fund, and Frax Finance. This type of model is relatively more complex in terms of off-chain business compared to the first two models, and requires investment in legal affairs, corporate business structure establishment, and asset and partner selection. However, an important advantage of these types of projects also stems from this: the underlying assets are relatively controllable, and the project team has the ability to proactively manage risks.

The hybrid model can be a combination of the above 4 models. Projects of this type can provide services such as on-chain deployment, KYC, etc., and also actively seek assets to directly provide investment opportunities to users. A representative project of this type is Fortunafi. Taking Fortunafi as an example, it provides 4 types of services: (1) Access Capital, which provides a way for financing parties to obtain funds; (2) Earn Yield, which refers to pre-packaged assets that users can directly invest in after completing KYC; (3) Protocol Services, which provides governance, treasury management, and other services to other protocols; (4) whitelabeled products, which provide full-process on-chain services for RWAs. Of course, the RWA services of these types of projects are not limited to government bonds and can also provide on-chain packaging services for other assets.

Of course, in addition to the above five modes, there are also more pure trading infrastructure such as DEX serving RWA, such as DigiFT. However, these types of projects do not participate in the selection, on-chain, and sale of underlying assets, so they will not be discussed in detail here.

3. Asset Side: Underlying Assets and Asset Side Architecture

3.1 Underlying Assets

Currently, there are several types of underlying assets in the market:

  1. US Treasury ETF. Projects that use such underlying assets include Backed Finance, Swarm, MakerDAO, and ARKS Labs. The advantage of using this type of underlying assets is simplicity: the management of underlying assets is handed over to the ETF issuer and manager. Issues such as liquidity and rolling over bonds do not need to be managed by the project team. US Treasury ETFs have not encountered major risk issues so far, so project teams do not need to worry about operational risks in asset management. They only need to include the largest and most liquid assets on the market.
  2. US Treasury Bonds. Projects that use such underlying assets include OpenEden, TrueFi, Matrixdock, etc. These projects often choose short-term US Treasury bonds, which are as liquid as cash. However, since the project directly seeks cooperative trustees, the project itself needs to bear the risks related to asset management. It is important to select suitable trustees.
  3. A combination of US Treasury Debt, US Government Agency Debt, and Cash/Repurchase Agreements. Projects that use such underlying assets include Franklin OnChain U.S. Government Money Fund, Superstate Trust, TProtocol, Arca Labs, Maple Finance, etc. Similarly, these projects entrust the management of underlying assets to professional managers. The rolling over and liquidity issues of underlying assets will be directly related to the project team. At the operational level, if the project team fails to select high-quality managers, problems may occur.

3.2 Fee Structure

The fee structure resulting from the above three types of underlying assets is also different. Without considering the gas fees caused by on-chain transactions, the main fee structure is as shown in the following figure:

Since the management of US Treasury ETFs is entrusted to ETF managers, the main fee issue comes from the minting and redemption process, with a fee rate of around 0.05%-0.5%. The latter two types involve asset management and transaction fees, with management costs of approximately 0.3%-0.5% and transaction fees such as bank transfer fees at around 0.2%.

3.3 Asset Business Architecture

Different underlying assets will also affect the overall business logic architecture. Currently, there are several types in the market:

  • Trust Structure: Projects currently using this approach include MakerDAO, etc.

Source: https://forum.makerdao.com/t/mip65-clydesdale-governance-framework-setup/16565

The trust operation mechanism involves the transfer of assets by the initiator to establish a trust relationship with the SPV, the initiator obtains the trust income rights, and then the initiator transfers the trust beneficiary rights to ordinary investors. Taking MakerDAO’s US Treasury RWA architecture as an example, it includes various roles such as managers and auditors, but part of the off-chain business architecture is built by Monetalis Group. The corresponding asset purchase, regular reporting, and on-chain operations are all completed by Monetalis Group. In this architecture, MakerDAO influences the scale, underlying asset purchases, and other details through governance.

  • Limited Partnership SPV Business Architecture: Projects such as Maple Finance, Matrixdock, etc., have adopted this type of business architecture. The project will participate in the process of asset searching and liquidity acquisition.

SPV, that is, “Special Purpose Vehicle” – a special-purpose carrier. The main function of an SPV is to provide financing to investors in the process of asset securitization/asset purchase. The original design purpose was to achieve bankruptcy risk isolation. Strictly speaking, the first trust structure mentioned above can also be considered as an SPV structure. The development of SPVs has become more mature, and in addition to bankruptcy risk isolation, there are several advantages: (1) simplifying financial management processes and getting rid of the problems of too many departments involved in traditional company business architectures and unclear business flows; (2) convenient transparent management, in general, a single SPV corresponds to a single project/asset, which may avoid management issues. For example, in a commercial bank, it is difficult for investors to have a thorough understanding of the status of underlying assets because the bank will not disclose too many details. Such information may only be disclosed at the management accounting level within the bank. In the case of personal mortgage loans, the financial statements and annual reports disclosed to the public will not reveal the characteristics of such loans, let alone specific information about individual debtors. However, if personal mortgage loans are packaged in an SPV, more detailed information about the loans, such as term, interest rate, collateral, loan amount, may be disclosed. In this way, the information provided by the SPV becomes much richer; (3) reducing taxes and fees, for certain underlying assets, the tax and fee standards of SPVs are lower.

Source: https://downloads.eth.maple.finance/docs/legal/abe08ded-5d07-42cf-b435-a0d8d8156ca5/Cash_Mngt_T&C.pdf

In this business architecture, there are two layers:

First layer, users and SPV: Users actually receive the debt rights of SPV. The premise for users to guarantee their income is that SPV can fulfill its obligations on time;

Second layer, SPV and commercial banks: SPV will participate in the government bond market and also participate in the interbank market for reverse repurchase operations. In this process, if there is a default in the reverse repurchase between banks, there may be greater risk than holding US government bonds directly.

In addition, users in this architecture face an additional layer of risk: that is, SPV itself may have some risks.

ARKS Labs has expanded the above business architecture: nesting small SPVs in a large business architecture, which can achieve scalability of business scale and facilitate operations when adding new underlying assets in the future. This is very similar to the architecture mentioned earlier in “RWA Discussion: Underlying Assets, Business Structure, and Development Path” by MakerDAO.

Source: ARKS Labs
  • Lending Platform + SPV Architecture: Currently, TProtocol adopts this type of business architecture. The difference from the second type of SPV business architecture mentioned above is that in the second type of SPV business architecture, one of the relevant parties of SPV is the project party, which will participate in the asset search and packaging process. In TProtocol, SPV is not related to TProtocol, but the initiator of RWA assets.

Take the following figure as an example, the initiator of SPV can be different institutions, and subsequent on-chain service providers and asset brokers can also be different. TProtocol’s business architecture is more flexible, but it is not without cost: as the number of partners increases, the subsequent control of SPV, including the ability to check and manage service providers, may be reduced to a certain extent.

  • On-chain Tokenization of Fund Shares: Similar to the traditional fund purchase strategy, detailed information about the purchasers needs to be known and corresponded to the addresses one by one. Currently, Franklin OnChain U.S. Government Money Fund adopts this type of business architecture. This type of project is more like what was commonly referred to as “chain transformation” in the past, that is, the project party will put the off-chain assets and purchaser information on the chain, and future transfer information will also be recorded in a bookkeeping manner and recorded again on the blockchain.

Although the RWA track is still in its early stages, the requirements for business architecture are not high for users and fund scale. However, as the value of government bond RWAs is gradually recognized by investors, the “scalability” of the architecture becomes very important. Whether it can timely package new assets and access more off-chain service providers may be the winning factor in the rapid development stage of the track.

4. User End: KYC and Other Requirements

Due to the differences in underlying assets and business architecture, there are differences in the requirements for the user end by different projects. Currently, there are three main differences:

Minimum investment threshold: Projects such as MakerDAO, ARKS Labs, and TProtocol do not set a minimum investment amount for users, but projects like Maple Finance, TrueFi, Arca Labs, and Backed Finance have set clear minimum investment limits. The “no minimum investment limit” is more in line with the habits of current DeFi users, while projects with minimum investments of over $100,000 mainly target high net worth users.

KYC requirements: Based on the difficulty of KYC, it can be divided into three categories: projects without KYC, such as Flux Finance, ARKS Labs, and TProtocol; lightweight KYC, such as Desmo Labs, only require the submission of passport and other information; heavy KYC, such as OpenEden, Ondo Finance, Maple Finance, and Matrixdock, require the submission of KYC information similar to traditional financial industry. The higher KYC threshold not only means a threshold in the traditional financial industry, but also makes it difficult for current DeFi users to accept.

Other requirements: Some projects also restrict their investors to certain regions, such as serving only non-U.S. users or non-U.S., non-Singapore, non-Hong Kong users. These restrictions are generally implemented by limiting IP addresses.

Some projects’ requirements for users, such as KYC and geographical limitations, are often verified by third-party KYC service providers, and the project team does not directly participate in the KYC verification process.

5. Distribution Strategy and Composability

5.1 Distribution Strategy

Currently, there are mainly two distribution strategies in the market:

The first and most common strategy is direct distribution through debt relationships. Whether users hold SPV debts or obtain national debts ETFs, national debts, etc. through other structures, users can receive the majority of the income generated by national debts. Apart from the income earned by minting and burning, as well as intermediaries, users can expect a net income of about 4%. This distribution strategy is very similar to LSD: most of the staking income is returned to the users, with only a portion deducted as fees.

The second strategy is currently only seen in the MakerDAO project, which is distribution through deposit rates. Since users’ funds do not directly correspond to underlying assets, MakerDAO uses a model similar to commercial banks’ interest rate spreads: on the asset side, funds are invested in relatively high-yield assets such as RWAs; on the liability side, users’ income is adjusted through DSR. Up to now, DSR has been adjusted four times: (1) from 1% to 3.49%; (2) from 3.49% to 3.19%; (3) from 3.19% to 8%; (4) from 8% to 5%.

This strategy gives the project team more flexibility, but the downside may also be obvious: users lack a clearer analytical framework for future yield. Originally, it was national debt RWAs, and users would understand that they should receive income levels similar to national debt yields. However, through monetary policies, such as MakerDAO recently giving excess income to deposit users, the rate soared to 8%. If the number of deposit users increases to a sufficient amount, the yield will drop back to near U.S. bond yields. This volatility is not friendly to investors who hope for a stable yield level.

For the yield of government bond RWA, clear “predictability” is very important, so the first distribution strategy may be better than the second strategy. However, once the project adopting the second strategy has established a clear anchor for government bond yield, there is no difference between the two in terms of yield.

5.2 Composability

Due to the requirements of KYC, there is also differentiation in the composability of government bond RWA tokens:

For projects with strict KYC qualifications, such as Ondo Finance, Matrixdock, Franklin OnChain U.S. Government Money Fund, etc., because there are whitelist restrictions on addresses, even if there is a corresponding token trading pool on the chain, it is impossible to achieve unrestricted trading for users. For these types of projects, unless the scale of the underlying assets is large enough, it is difficult to gain support from many DeFi projects and achieve greater composability.

Projects that do not require KYC currently do not have difficulty in composability. The only limitation on the composability of these projects is the project’s own business resources, BD capabilities, and the scale of the project itself.

6. Summary

By reviewing the above government bond RWA projects, we can vaguely see the potential winning business models for such projects in the short to medium term:

  • Underlying assets: Using government bond ETFs may be a relatively clever way, delegating liquidity management and other issues to giants in the traditional financial field. If directly purchasing U.S. bonds or mixed assets, it tests the project’s own ability to select partners;
  • Business architecture: There are already relatively mature models that can be applied, preferably with strong scalability, making it easier to expand scale quickly and include new asset classes in the future;
  • User end: In the short to medium term, projects with no KYC requirement and no fund threshold have a wider user base. In the future, if KYC is required due to regulatory enforcement, lightweight KYC projects may become more mainstream solutions;
  • Yield distribution: In order to make the yield expectation for government bond RWA investors more stable and reliable, the best solution is for the project to provide a consistent ratio between the yield offered to users and the government bond yield;
  • Composability: Before regulations restrict access to on-chain RWA assets, expanding the usage scenarios for user government bond RWA tokens as much as possible is an important factor for project parties to achieve greater business volume in the medium to long term.

In the medium to long term competition, certain lightweight KYC projects may have greater opportunities due to increasingly deep regulatory intervention.

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