How RWAs Address DeFi’s Boom-Bust Cycles
By Niklas Kunkel, Founder - Chronicle
Since its inception, DeFi has been prone to drastic boom-bust cycles. It’s this volatility that has earned the industry its fair share of criticism, often from incumbents in the broader financial services space.
However, as DeFi continues to mature, we have witnessed not only greater convergence between crypto and traditional financial markets, but also stronger calls towards bringing stability to the crypto market in order to drive mainstream adoption.
The past few years have seen great progress on this front, and real-world assets (RWAs) have emerged as a tool that could potentially smoothen DeFi’s hyper reflexive curves.
Diversifying Revenue Streams with RWAs
Volatility can be destabilizing for both individuals and organizations. To protect from volatility, every effort should be made to diversify revenue streams with assets that are uncorrelated - or best case scenario, inversely correlated. Typically in DeFi, we have seen hyper correlated ebbs and flows. When yields are up, trade and lending volume also increase. Unfortunately, the same hyper correlation exists in downward swings as well.
Given crypto’s proclivity towards hyper correlation, the introduction of RWAs presents an opportunity for diversification with less correlated assets.
Below is a chart showing MakerDAO’s revenue distribution. Prior to diversifying with RWAs, MakerDAO had experienced a series of boom-bust cycles. In 2022, amid favorable monetary policy, MakerDAO began heavily diversifying with treasury bills (T-Bills) and other RWAs. Within two years, about a third of MakerDAO’s revenue was driven by RWAs. While time will tell the degree to which this diversification will smooth out boom-bust curves, there has been unprecedented stability since diversification into RWAs.
Benefits of RWAs
Diversification is the primary benefit of including RWAs in a revenue portfolio for onchain investors. As mentioned above, MakerDAO’s diversification into RWAs represented an opportunity for healthy returns amid favorable monetary conditions as T-Bills are a safe asset with reliable returns.
Second, RWA-enabled diversification addresses the issue of having a portfolio composed of only highly correlated and reflexive crypto-native assets. The introduction of less correlated assets thus has the potential to moderate the fluctuations brought about by crypto-native assets. Maker’s balance sheet would have looked very different during 2023 had they not diversified from crypto-native assets.
How to Integrate RWAs
While integrating RWAs presents a variety of opportunities, it does not come without its challenges. By nature, RWAs are not crypto-native. They require metadata that is not necessary for crypto-native assets, whose properties are recorded and readily available onchain.
While each RWA is unique in terms of what information needs to be brought onchain, there are properties that must be considered to emulate the behavior of crypto-native tokens. While this list is not exhaustive, it provides a framework of important properties to consider.
Custody - RWAs are in the custody of institutions such as banks or trusts. It is imperative to have a verifiable mechanism that can validate in real time how much of an asset is in custody. Without attestation that a sufficient amount of an RWA is in custody, the tokenized representation of that asset is at risk of becoming worthless.
Liquidity - With crypto-native assets, when prices fluctuate, liquidation can occur onchain. This is not the case for RWAs. RWAs may or may not have liquid markets, and even when an RWA does have a liquid market, such as T-Bills, the liquidity is not onchain. This requires a way to communicate with offchain entities about when and how liquidations should occur.
Yield - In order to maximize returns on investments, there must be a way to obtain live data on changing yields. RWA Oracles can be used to report yields on real-world assets and protocols can then use smart automation to allocate resources in the highest-yielding assets.
Counterparty Risk - In order to establish trust, data must be collected from every party involved in offchain RWA transactions. Only when data from each of the parties is in alignment can there be confidence in the tokenized RWA.
While incorporating RWAs is not an easy solution, they present good opportunities to help bring stability to DeFi and wider the crypto ecosystem. As we have seen with the recent market sell off, when TradFi and DeFi markets saw downswings, investors ran to RWAs like T-bills - showing that they are an ideal inversely correlated asset. Revenue portfolios that included RWAs were therefore hedged against some of the sell off losses. However, DeFi protocols that are considering diversifying with RWAs should understand that these assets are more complex than crypto-native assets and should be approached with healthy due diligence.
Author Biography
Niklas is the Founder of Chronicle Labs, the developers of Chronicle Protocol. In 2016, Niklas became part of the founding team of MakerDAO with the goal of developing the DAI stablecoin. With a need for a reliable data source to track the value of DAI collateral, Niklas developed the Chronicle Oracle Protocol. This was the first Oracle built on Ethereum, which has secured up to $22B in assets for MakerDAO, Spark Protocol, and others. He was also involved in other MakerDAO innovations, including OasisDEX, the first decentralized exchange on Ethereum and DSProxy, an industry-standard account abstraction engine.
Niklas began his crypto journey at IBM Research, where he worked on the Hyperledger blockchain and early supply chain finance applications.