Centrifugal Transparency for Tokenized Assets

One reason for the financial crisis of 2008 was the lack of transparency into the quality of the loans packaged for resale. Mortgages were bundled off-chain, tranched off-chain, marketed off-chain, and painstakingly pieced back together off-chain when the financial system collapsed.

Founded in 2018, Centrifuge’s vision is to enable a DeFi structured money market where transparency exists right down to the individual asset (e.g., title to a piece of commercial real-estate) contained in a pool of collateral. Different participants will work together to bring the relevant data on-chain: asset originators, financial auditors, fraud scoring specialists, and valuation experts. When Centrifuge’s vision becomes a reality, financial services will be provided more transparently and efficiently by crypto native innovators. Similar to how Web2 brought massive efficiencies and economies of scale to commerce, Web3 bridged to real-world assets will eliminate rent-seeking behavior from intermediaries such as banks, lawyers, notaries, assessors, and underwriters.

Centrifuge wants to increase transparency, but not at the cost of revealing private data for everyone to see on the blockchain. The Centrifuge protocol has native support for managing these privacy requirements. For example, only parties with a need to know the borrower’s identity have access to it.

Centrifuge aims to prove that tokenizing and financing real-world assets on-chain is more efficient and more transparent than the existing solutions in traditional finance. The first dozen asset pools have been live since 2021, with more to come.

Real-World Assets

Real-world assets are different from other crypto assets. Crypto assets often derive their value from other crypto assets. Real-world assets (RWA) are very tangible (e.g., a title to a house), somewhat tangible (e.g., an invoice for 1,000 tires due in 60 days), or less tangible (e.g., future streaming royalties of a collection of songs by a particular artist).

To securely finance real-world assets on-chain, there needs to be a legal and commercial framework in place for ensuring that the process of providing the title to the asset as collateral is sound and that someone lending against the collateral can be assured legal recourse in the case of a non-performing loan. In mature markets, such as the US, well-established frameworks exist for repossessing an asset in such a case, and Centrifuge - at least initially - builds on these frameworks. Appropriately, it will take time before Centrifuge becomes available to borrowers in countries with less developed legal frameworks.

Centrifuge’s main achievement has been developing a technology and a framework for bridging RWAs and DeFi. Centrifuge is not a lender; it is a platform providing the right primitives for lending based on real-world collateral.

The Centrifuge Chain and the Centrifuge Token

Source: Centrifuge

The Centrifuge stack has a peer-to-peer messaging protocol to store and exchange business documents in a private, secure way, at the lowest layer.

The middle layer comprises the Centrifuge nominated proof-of-stake chain and the artifacts required to run real-world use cases as decentralized applications: NFTs linked by Anchors to privately shared documents off-chain. The first application is called “Tinlake” soon to evolve into the “Centrifuge App.” Other projects could build their own apps on top of the Centrifuge protocol, which is starting to happen: FinTech issuers are working on integrating automatic tokenization into their own technology platforms, one issuer is building a new UI specific to their asset class, and more.

The top layer connects Centrifuge to Decentralized Finance (DeFi) apps, such as Maker and Aave, where DeFi users have access to RWA lending.

Centrifuge uses its own native token - the Centrifuge (CFG) token. It incentivizes validators and nominators to participate through a block reward. Similar to other chains, the token is used to pay fees for transactions and services, including storing business data for the long term and participating in governance. Users of Centrifuge can obtain rewards paid in CFG. These rewards are paid for through inflation. A balancing burning mechanism, where a portion of the fees are burnt, could help to stabilize token supply in the long term.

As Centrifuge grows in transaction volume, the CFG token is poised to accrue value from increased fees, governance, and burning mechanisms.

Bridging Real-World Assets

Centrifuge is the platform allowing the exchange of value as shown:

Source: Centrifuge

• Final borrowers: e.g., entrepreneurs needing working capital to buy a property to “fix and flip” (example taken from New Silver, one of the first asset originators on Tinlake).
• Asset originators (AO): takes care of tokenizing (into NFTs) the assets (e.g., houses) and provides borrowers with fiat currency.
• Special Purpose Vehicle (SPV): an entity set up by the AO in a cookie-cutter way (framework provided by Centrifuge) to facilitate the legal agreements. It legally holds the tokenized assets and theoretically can be sued in real life (IRL) by the lenders or sue the final borrowers on default.
• Lenders: individual investors or Maker vaults accepting Centrifuge-issued ERC-20 tokens in exchange for DAI.

DROP and TIN are ERC-20 tokens specific for each lending pool (e.g., New Silver 2), representing the senior and junior tranches, respectively. The senior tranche gets stable and predictable interest and is the first to be paid back. The junior tranche takes on default risk by being the last party to be paid back and taking first loss, and in return, collects the difference between the (higher) interest paid by the borrowers and the (lower) interest paid out to senior tranche holders.

Asset originators invest a portion of their working capital in the junior tranche to signal to the market that they have skin in the game. This portion is visible in the Centrifuge app under “Junior provided by Issuer.”

Real Life Asset Pools

In February 2020, Centrifuge was preparing to launch with a handful of asset originators.

At the time of writing, there are 11 active pools on Tinlake, the decentralized app built on Centrifuge. The pools cover a range of real-world use cases, as shown:

Link to Pools: https://tinlake.centrifuge.io/

Protocol Performance

Centrifuge set out to prove to the world that its model works, and the protocol has seen steady growth in TVL since last summer. After initial experimentation and yield farming (CFG rewards), the number of investors has consolidated, but the average ticket size has increased.

As of mid-December, high net worth individuals had the most significant share of the value locked, with protocols (currently only Maker) following second.

Centrifuge Investor Onboarding

Centrifuge is not an RWA financing app. Centrifuge is an on-chain securitization platform that provides the architecture and financial primitives for RWA financing apps to be built on top of. Those apps will be open, decentralized, and permissionless.

- Jeroen Offerijns, CTO, 2021-12-11

Centrifuge and other involved parties need to “Know Your Customer” (KYC), something they have solved by using Securitize, which takes care of storing and validating a users' name, email, physical address, local tax ID, and a copy of the user’s passport.

Once KYC is passed, a contractual relationship with the Asset Originator (e.g., New Silver) is established. This is in the form of a contract on Docusign. The contract has 41 pages.

The contract stipulates arbitration in the state of Delaware and explicitly waives the right to a court trial. This seems to have become a common way of reducing risk for the company.

Another step in the process is the necessity to fill in a US tax form, known as W8BEN. The PDF form contains some helpful hints, as it may be difficult for some users to find the required information regarding specific clauses of tax treaties and percentages of tax withholding.

It remains to be seen how this process can evolve in the future and to what extent it is suitable for non-professional investors. Having to sign a 41-page-contract and submitting a US tax form may be a deterrent for some users and may seem miles away from the ease and playfulness of DeFi.

Aave Real-World Assets

Aave just launched the “Real World Assets Market.” The company (a Centrifuge spin-off, soon to be a DAO) behind it still requires KYC and a subscription agreement, but it is lighter than the current one. The DAO then plays the role of the Lender, which is relied upon for taking any recovery steps in case the loans become non-performing. Essentially, users invest in an Aave pool backed by different RWA collateral. The APY will be floating based on the utilization of the pool. Centrifuge is hoping for a TVL of $25-50M, representing about 50-100% of the current TVL.

Centrifuge’s strategy is to focus more on professional, institutional investors, who have more assets to invest, have a longer time frame than typical retail yield farmers, and are encouraged rather than deterred by the legal frameworks.

Roadmap

Moving Tinlake to Polkadot

Currently, Tinlake is a dApp on Centrifuge, which is interoperable with Ethereum, the blockchain with the largest available capital and liquidity but the highest transaction costs and the slowest transaction speeds. Interoperating with Polkadot removes these two barriers. There will still be a bridge to Ethereum so that the massive liquidity on Ethereum can still be tapped into, but most of the data will be managed on the Substrate chain.

Integrating Centrifuge with Polkadot

In December 2021, Centrifuge started participating in the crowdloan campaign for auction batches 6-11. At the time of writing, it appears Centrifuge will win slot #8 in January 2022. Obtaining a slot will enable the protocol to move its stand-alone chain to a parachain on Polkadot.

By taking advantage of Polkadot’s security model, the security of Centrifuge increases, and therefore the investor’s risk premium goes down. This should benefit the protocol.

By taking advantage of cross-chain bridges within the Polkadot ecosystem (XCMP), Centrifuge gets access to a larger group of investors (compared to a stand-alone chain).

Competition & Risks

Centrifuge is a first player in a very immature market. They expect the market to grow massively and mature over the next five years. This will invariably bring many competitors into the game. As first movers, Centrifuge is well-positioned if they continue to innovate, improve the user experience, and invest in increasing adoption for asset originators and investors.

Potential risk scenarios:

1. A major player in the real estate financing market adopts similar techniques and implements a similar platform. Through their marketing machinery and strong network of asset originators and investors, they acquire the lion’s share of the market, forcing Centrifuge into other asset classes.
2. A major player in the crypto lending space branches out into RWA and dilutes Centrifuge’s market share (less likely, since connections IRL are essential).
3. A major player in the metaverse real estate financing market branches out into RWA. Today it is uncertain who that could be, but anything seems possible in crypto.

Conclusion

Centrifuge is proving that bridging real-world assets to the blockchain is possible. The integration with Maker and Aave shows how Centrifuge is deeply integrated into the DeFi ecosystem.

Given the sheer size of the assets that could be tokenized and put on-chain, it appears there is a massive opportunity for Centrifuge. Seizing the opportunity relies on a combination of well-established legal frameworks in the jurisdictions Centrifuge operates in and a well-functioning technology stack ranging from P2P messaging to blockchain bridges and token economics.

However, many issues may still need to be solved, especially on the KYC user experience side, before RWA transactions are as seamless as today’s crypto-only DeFi transactions.

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