Debt Tokens as Collateral

Debt as Collateral in Traditional Finance

In traditional finance, the use of debt as collateral underpins a vast array of financial activities, and plays a critical role in short-term financing. Outstanding global repo transactions typically exceed $10 trillion, where debt securities are the primary form of collateral. In the U.S. in 2021, government securities accounted for approximately 70% of collateral, while MBS accounted for 15% and corporates for 3%. Although more bespoke repo transactions do utilize non-investment grade debt as collateral, it is currently a small segment of the overall market. Central banks play a critical role in the repo market, managing the available cash in the banking system via open market operations.

The extensive use of debt securities as collateral in traditional finance highlights the enormous potential for DeFi markets, if debt tokens are correctly structured and accompanied by the necessary market infrastructure. From a technology perspective, major institutions are exploring the use of distributed ledgers for accelerating the settlement of repo transactions. From a market perspective, the DeFi market is quickly enabling short-term financing opportunities where yield bearing digital assets serve as eligible collateral. Reliable credit assessments are a piece of the puzzle, and can help the DeFi ecosystem grow to support a larger set of debt tokens serving as collateral, unlocking liquidity and efficiency in digital asset markets.

Current Market Activity

Debt tokens are increasingly serving as a form of collateral throughout the DeFi universe. Today, the fastest growing tokens are primarily investments in US government securities. Investments in tokenized treasuries recently surpassed $2 billion. Despite the impressive growth, these instruments are a fraction of the $170 billion of active stablecoins. Although tokenized treasuries may have relative distribution and therefore utility disadvantages versus the largest stablecoins, the underlying credit profile is similar. As an example, approximately 80% of USDC reserves are in short term treasuries.

The structure and mechanics of tokenized treasuries are relevant from a credit risk perspective. As an example, Moody’s assigned a rating to OpenEden’s tokenized treasury product which is 2 notches below the credit rating assigned to the underlying assets. However, as the underlying credit risk is minimal, these assets are justifiably growing in use as collateral throughout the ecosystem.

Ondo Finance was a pioneer in the space, allowing users to borrow USDC against eligible debt tokens via the Flux Markets protocol. In June, FalconX executed a transaction using Superstate’s USTB as collateral. More recently, RE7 announced a Morpho vault which allows multiple treasury tokens as collateral, including those offered by Centrifuge and Hashnote.

In the case of US Treasuries, where the credit risk is minimal, collateral requirements are similar despite expected deviations in the credit rating of a specific tokenized issuance. This dynamic changes as you cover a wider range of the risk spectrum, and adopt other debt assets as collateral. In traditional markets, credit ratings provided by agencies like Moody’s and S&P guide investors in understanding relevant risks, and enable the market to efficiently assign haircut requirements when accepting a specific form of debt as collateral.

Liquid staking tokens are another form of yield bearing assets which are increasingly serving as collateral. AAVE allows for wstETH as a collateral asset. Recently, Wintermute announced acceptance of Lido stETH as collateral in OTC transactions. Although short, leading liquid staking tokens have a demonstrated history of adequately protecting allocator capital. Liquid staking and restaking tokens frequently draw debt comparisons. Although available historical data is relatively limited across networks, in comparison to traditional debt markets, there are some fundamental similarities which allow for the comparison of risk profiles.

As a result of their risk profiles, tokenized treasury products and liquid staking tokens are a logical starting point for demonstrating the utility of debt tokens as collateral in DeFi. Credora anticipates that activity in this space will continue expanding rapidly.

The availability of credit ratings across stablecoins, various government debt backed tokens, liquid staking tokens, and crypto native structured products (e.g. basis trade tokens), can allow for more efficient parameterization of collateral requirements for these assets. Additionally, Credora expects the market to continue extending out the risk curve, allowing for different types of private credit debt issuance to serve as collateral. Credora’s experience in these sectors, along with the ability to make these assessments available natively on-chain, can help ensure the stability of lending against debt tokens in DeFi.

Expected Future Development

There are many projects which are actively pursuing the development of marketplaces, which facilitate liquidity against various forms of debt, or the creation of yield generating assets, which can subsequently achieve acceptance as collateral throughout the DeFi ecosystem. In Maple’s announcement of SYRUP, the team acknowledges their plans of partnering across the DeFi ecosystem to benefit from interoperability, targeting the use of the yield-bearing syrupUSDC as collateral on other protocols.

Where lending marketplaces allow for debt tokens as collateral, they require an analysis of the underlying risk. These protocols and their governance processes are typically responsible for answering the following questions:

• What should the collateral requirement be for each individual debt token?
• If a diversified portfolio of loans is pledged as collateral, how should the collateralization requirement vary?
• Where secondary market trading is limited entirely or for periods, how are debt tokens valued?

Standardization can unlock a great degree of friction in lending markets. As discussed in several pieces in the past (see a great blog post by Kevin Miao), standardization of risk can allow for an apples-to-apples comparison of differentiated products, and result in diversification of risk and greater liquidity. As a result, where there are assessments of the underlying debt that can be compared with other assets, there are simple, objective and formulaic methodologies which can guide collateral requirements.

Working alongside partners, Credora expects credit assessments to provide guidance for protocol parameters where the underlying asset quality is quantified, and the protocol or users can in turn target a specific probability of default for any overcollateralized loan.

These and many more challenges will arise as the market progresses towards the increasing availability of debt tokens, and their use as collateral. Throughout this journey, Credora’s aim is to provide reliable credit information on-chain, fostering market development and increasing efficiencies.

Just as traditional finance has evolved from simple loans to complex structured products, DeFi is on the cusp of a similar evolution. As loan tokens become more prevalent, the potential for creating diversified portfolios, backed by Credora’s rigorous credit assessments, will open up new possibilities for risk management and yield optimization. If you’re building something exciting in DeFi lending markets and you’d like to work together, reach out via DM or our website!