On-Chain Debt Portfolio Construction

On-chain finance is democratizing access to investment opportunities, allowing regular investors to participate in deals that were previously inaccessible. Credora believes that this theme will extend to on-chain asset management, where participants are empowered to effectively construct and diversify portfolios in a transparent manner, absent the guidance of industry experts. On-chain asset management isn’t new; Index Coop, founded in 2020, focuses on offering streamlined exposure to a diversified or thematic set of crypto assets. Considering Credora’s focus on debt markets, the remainder of this post explores the history and future of on-chain debt portfolio construction.

Debt is a major component of all balanced portfolios. Furthermore, debt portfolios generally benefit from diversification, ranging from sovereign debt exposure, to overcollateralized lending, to a broad range of private credit opportunities. A number of historically significant financial theories point to the benefit of diversification in the context of debt portfolio construction, including Modern Portfolio Theory, Capital Asset Pricing Model, and Arbitrage Pricing Theory. Fundamentally, diversification of a debt portfolio helps spread risk across different durations, issuers, sectors, and geographies.

In on-chain credit markets, diversification has historically been the responsibility of the capital allocator, or in certain instances a delegate. Various protocols curated a set of thematic investment opportunities, and allowed allocators to diversify according to their discretion and experience. In the early stages of on-chain credit markets, these protocols included Centrifuge, Credix, Clearpool, and Goldfinch. Where diversification was a responsibility of the delegate, the scope was typically limited to multiple loans in a specific market segment. Maple pools were a good example, where the delegate’s role was to balance diversification and determine an effective capital allocation strategy. In these scenarios, although lending operations were visible on-chain and it was a successful way to diversify risk within a sector, there were discretionary decisions impacting portfolio construction.

Recently, protocols including Morpho have experienced traction for enabling access to curated and active debt portfolio management strategies. Morpho allows a curator to develop and deploy a specific strategy through non-custodial vaults. These strategies are currently limited to overcollateralized lending. In comparison to their early credit market peers, the strategies more transparently balance diversification and actively rebalance to optimize risk-reward. Generally, overcollateralized markets have fewer considerations versus credit markets in terms of quantifying risk. As a result, the portfolio construction process can be more transparent. Ultimately, this programmatic portfolio construction is effective in accomplishing a degree of diversification, but again limited to a particular segment of lending.

While protocols’ offerings continue to grow, the possibility of purely programmatic and actively managed debt portfolio construction is limited by the absence of a standardized approach to quantifying risk across multiple lending strategies (e.g T-Bills, overcollateralized lending, SME lending etc.). Credora exists to help solve this problem for the market, combining traditional practices used by the world’s largest credit rating agencies with new technologies to standardize the risk into a probability of default and ratings agency equivalent output.

A standardized approach to risk segmentation is a critical piece of infrastructure that will enable the next generation of debt asset management protocols. To address the challenges in on-chain debt portfolio management, we envision the emergence of applications that leverage Credora’s credit metrics to enable automated and efficient portfolio construction, as well as active management. Applying standardized credit scoring methods across a spectrum of opportunities means being able to compare credit ratings across T-Bills like Ondo’s OUSG or Superstate’s USTB, curated vaults on Morpho, SME lending opportunities on Obligate, and basis trade strategies on Ethena. This allows for apples-to-apples comparison across a broad spectrum of yield opportunities, meaning users can set their risk-to-reward preferences and programmatically create a truly diversified portfolio.

Effective portfolio construction is always initially anchored to risk tolerance and objectives. For a fund manager, this may be outperforming a specific benchmark on key metrics. For an individual, it typically is anchored to preferences across portfolio growth and income.

The below describes the general steps of an effective portfolio construction process for an individual, enabled by the availability of standardized risk metrics.

Key Features:

• Secure Registration and Onboarding: A user-friendly interface for collecting data and assessing user risk profiles.
• Intelligent Portfolio Construction: Automated asset allocation and investment selection driven by AI and smart contracts, utilizing on-chain credit metrics to assess and diversify credit risk effectively.
• Seamless Trade Execution and Monitoring: On-chain execution of loans, ensuring transparency and real-time monitoring without the need for a centralized manager.
• Automated Rebalancing and Reporting: Continuous portfolio rebalancing and detailed performance reporting, all managed programmatically.

Advantages:

• Seamless Customization: Applications can guide users through a process which fits their risk profile and market views.
• Enhanced Transparency: All transactions and portfolio adjustments are executed on-chain, providing investors with full visibility into how their assets are managed.
• Cost Efficiency: Eliminating the need for traditional fund managers reduces management fees, allowing investors to retain more of their returns.
• Proactive Rebalancing: Tokenization allows for effective active management across a diverse range of underlying assets, ensuring risk-reward is optimized for user preferences.
• Accessibility: This approach democratizes access to sophisticated debt portfolio management, enabling individuals to benefit from strategies traditionally reserved for institutional investors.

Although we recognize the work required to achieve this vision, Credora’s on-chain credit assessments lay the foundation for a more robust debt ecosystem, where programmatic and quantitative management of diversified debt portfolios becomes the norm. As the market continues to expand, with standardized credit assessments becoming more prevalent, this approach will drive greater capital efficiency and broader participation in on-chain credit markets.