Fintech loan tokenization
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July 28th, 2022

Summary

Tokenization represents the conversion of an asset into a digitally native representation that exists on blockchains. From a capital markets perspective, tokenization carries a number of key benefits that are not dissimilar to securitizations, making it suitable for bridging institutional capital to fragmented markets. Not all assets are suitable for tokenization. The write-up proposes that emerging market fintech loans are compelling candidates for tokenization based on the following criteria: creditworthy Borrowers with capital intensive businesses, a large total addressable market with capital markets deficiencies, and a capacity to deliver real stakeholder value. Lastly, the write-up concludes by providing key considerations on whether to buy, build, or partner with respect to implementing a plan to expand into fintech loan tokenization.

Organization

The write-up is organized into the following sections:

  1. Tokenization overview: Key benefits and challenges associated with tokenization.
  2. Unsuitable opportunities: Examples of assets that are not suitable for tokenization.
  3. Fintech loans: Context on why emerging market fintech loans may be suitable for tokenization.
  4. Implementation strategies: Evaluation of strategic alternatives for a fintech loan tokenization program.

1) Tokenization overview

Tokenization is the conversion of an asset into a digital representation that can be incepted, managed, and retired on-chain (i.e., on blockchains) and is interoperable with the various products, services, and applications that exist throughout the web3 ecosystem. From a capital markets perspective, tokenization supercharges the principles of securitization by both streamlining (i.e., digitizing) the issuance, management, and exchange processes of the asset and reducing the impact of off-chain frictions associated with the supply and demand of capital. Outlined below are key benefits and challenges associated with tokenization from the perspective of a regulated crypto platform (“Platform”) seeking to develop solutions that bridge the gap between counterparties in need of capital (“Borrowers”) and institutions that provide capital (“Lenders”).

Benefits

  1. Composability: Tokenizing capital markets products, such as loans, unlocks composability with the broader web3 ecosystem allowing synergies with other products, services, and capital (e.g., staking, cross chain exchanges, derivatives, etc.)
  2. Capital efficiency: Digitization enables smaller individual assets to be underwritten and/or pooled into portfolios, unlocking financing for fragmented or hard-to-access markets (e.g., residential solar securitization, credit card receivables, etc.).
  3. Liquidity: Tokens provide a more efficient means of liquidity and borderless access to capital, which supports access to a more diverse set of prospective Lenders and more efficient asset-liability duration matching for Borrowers.
  4. On-chain mechanisms: Creating financing products (i.e., smart contracts) that exist natively on-chain can improve transaction efficiencies, incorporating embedded features including governance, covenants, loan repayments, etc.
  5. Transparency: Selectively provided on-chain data can improve disclosure, mitigating capital market inefficiencies through transparency and availability of information.

Challenges

  1. Off-chain legal recourse: Digital loans and fixed income assets that require Borrower covenants need to be paired with corresponding legal agreements, providing Lenders with off-chain recourse if Borrowers enter into a default.
  2. Scalability: The pipeline of assets (or size of a market) to be tokenized needs to be sufficiently large to justify the time, cost, and effort required to stand-up an asset origination and tokenization program.
  3. web3 infrastructure: Regulatory compliant infrastructure necessary to facilitate end-to-end access to tokenized financial products is nascent. For example, DeFi platforms can face difficulties scaling due to regulatory uncertainty.
  4. Sustainable yields: A sustainable tokenization program necessitates underwriting assets tethered to real economic value. Successful financing products and programs are built on long-dated sustainable cash flows from value generating assets (e.g., mortgages, renewable energy, consumer loans, etc.)
  5. Regulatory compliance: Cryptocurrencies face a heightened regulatory focus. Any tokenization program needs to demonstrate real value delivered to Borrowers, Lenders, and the broader community in a regulatory compliant manner.

2) Unsuitable opportunities

The challenge of standing-up a tokenization program is finding an asset that delivers a sufficiently strong value proposition to overcome the inertia of bootstrapping Product-Market fit. Over the past few years, tokenization has been tested on many different types of assets but has yet to achieve significant institutional adoption. The following are examples of assets that are unsuitable for tokenization:

  1. Efficient Capital Markets: Narrow spreads between the borrow and lend rates make it difficult to bootstrap new financing products. Borrowers with reasonably efficient access to capital providers (e.g., institutional credit markets) are more suitable for private blockchain initiatives such as the World Bank’s 2018 Blockchain-Based Bonds.
  2. Niche assets: Tokenization of assets that are too esoteric may not be worthwhile due to a limited number of prospective Borrowers and limited interest from a niche market of Lenders. For example, AspenCoin was a one time tokenization of equity interests in the St. Regis Aspen.
  3. Low (or infrequent) capital needs: Tokenizing equities (as opposed to fixed income) limits scale since equity is expensive for Borrowers and offers limited opportunities for ongoing repeat capital issuances. It’s common for companies to issue loans on an ongoing basis for all sorts of capital needs whereas equities are mostly limited to primary and follow-on issuances. For example, Securitize Markets has been tokenizing equities since 2018 but has not achieved significant issuance volumes.
  4. Delegated asset origination: Access to a robust pipeline of quality assets that are attractive to prospective Lenders is essential in bootstrapping any tokenization program. Given the nascency of this market, assets that require delegated underwriting may not be suitable for tokenization as it may lead to scaling issues such as in the case of Maple Finance.

3) Fintech loans

DeFi projects such as Goldfinch and TrueFi have achieved notable momentum originating more than ~$1 billion of tokenized loans. These projects underwrite tokenized loans, providing Borrowers with USD denominated financing and Lenders an opportunity to invest their stablecoins to earn risk attractive returns. Further investigation into these platforms reveal that fintech loans in emerging markets may be a compelling asset class for tokenization based on the following characteristics:

  1. Creditworthy Borrowers with capital intensive businesses
  2. Large total addressable market with capital market inefficiencies
  3. Capacity to deliver real stakeholder value

Creditworthy Borrowers

Fintechs are attractive to institutional Lenders because their businesses require a consistent flow of reasonably priced third-party debt, supporting the origination of loans to individuals and/or small-to-medium businesses. Fintechs receive financing in the form of structured facilities, since it allows them to raise capital based on the quality of their assets (e.g., loan receivables) as opposed to solely relying on their corporate balance sheet. These types of financings are well suited to tokenization since these Borrowers need capital on an ongoing basis and greatly benefit from digitization as it enables a more granular and detailed evaluation of their assets.

In the United States, fintechs have an established playbook raising third-party debt to grow their businesses in an asset-light manner. Pioneers such as Lending Club, which was started in 2006, were instrumental in getting institutions comfortable with the creditworthiness of loan receivables originated and underwritten by a venture backed start-up (as opposed to a bank or large financial institution). Fintechs in emerging markets is a more recent phenomenon and companies in these regions (e.g., Latin America, Africa, and Asia) do not yet have access to the same types of credit products despite the rapid growth of companies in these markets.

Large addressable market

Based on the International Finance Corporation, individuals and small-to-medium businesses in developing countries have an unmet financing need of over ~$5.2 trillion annually. Local banks and large financial institutions have difficulties meeting this credit gap due to stricter liquidity and capital requirements in addition to a lack of sophistication in underwriting. Furthermore, the growth of the digital economy in emerging markets (e.g., mobile commerce, e-commerce, digital payments, etc.) has made it easier for local or regional tech companies to create financial products for underserved segments in their respective regions.

These factors have given rise to alternative lenders and fintech aggregators. For example, in Southeast Asia and India there are an estimated 45,000 players underwriting loans to address a ~$500 billion credit gap. However, unlike fintechs in the United States, most of these non-bank financial companies are capitalized with expensive equity capital making it difficult for them to scale. Due to deficiencies in local capital markets and a limited access to sophisticated credit investors, many regional fintechs are forced to obtain dilutive financing from venture capital or other equity investors. In other words, there is an opportunity to address an unmet need in these markets by providing credit products similar to what fintechs in the United States are accustomed to.

Delivering real value

Broadly speaking, fintechs provide financing to underserved communities such as individuals and/or small-to-medium businesses that do not have sufficient access to capital from traditional banking institutions. Tokenized loans for fintechs have the potential to deliver real world value to these underserved communities by reducing the cost and/or broadening the access to capital. The following provides detailed descriptions of how tokenized fintech loans improve on the status quo:

Borrowers: Tokenization provides creditworthy fintechs, as Borrowers, an option of accessing institutional capital in developed markets. Emerging market fintechs can raise and repay capital more efficiently such as through stablecoins (e.g., USDC), mitigating challenges dealing with local banking infrastructure. Furthermore, tokenized structured loans that exist natively on-chain can facilitate greater transparency improving disclosures and availability of information for prospective Lenders.

Lenders: Giving institutional Lenders access to tokenized fintech loans provides sustainable yields, access to impact investment opportunities, and an opportunity to earn attractive risk adjusted returns from real world assets. Tokenization reduces costs by improving capital efficiency and streamlining the issuance, management, and retirement of structured products. Blockchain infrastructure helps unlock liquidity allowing high quality loans to be more efficiently pooled together to meet minimum “bite size” or investment requirements. Accessing emerging market lending opportunities through blockchain technology is analogous to Lending Club pioneering the securitization model for fintech consumer loans in the early 2000s.

web3 ecosystem: Fintech loan tokenization directly facilitates the mass adoption of digital assets by enabling real world use cases for decentralized blockchains. Tokenized fintech loans create tangible utility, providing Borrowers with broader access to financing proceeds used to support underserved markets. Value is generated from mitigating local capital markets inefficiencies and access to sophisticated institutional investors, willing to underwrite quality opportunities. Bringing fintech loans on-chain in a regulatory compliant manner allows the broader web3 ecosystem to participate in supporting real world economic activity.

4) Implementation strategies

Implementing a plan to expand into fintech loan tokenization depends on the resources, constraints, and capabilities of a given organization. Since there is no one size fits all solution, the following section provides an overview of considerations as to whether a particular Platform should build, buy, or partner to access the fintech loan tokenization market.

Build

Building a fintech loan tokenization program from the ground up is the riskiest strategy that provides the highest reward. It would entail a relatively longer development cycle and tie up a firm’s financial and operational resources. Assuming a Platform is considering this approach key processes to be built include: creating the tooling required to issue, maintain, and retire a digital financial product; originating and developing prospective Borrower and Lender relationships; identifying and structuring the underlying loans that would be deployed onto the tokenization platform. The consideration as to whether or not to proceed with this path depends on the costs associated with standing up the program relative to the amount of tokenized loan issuances that the platform is expected to generate.

Buy

Buying entails lower risk and potentially a faster go-to-market process. However, given the specificity and nascency of tokenizing fintech loans for emerging markets, it’s unlikely that there are acquisition targets that provide a complete end-to-end solution for loan origination and tokenization. Over the past few years, a number of start-ups have explored the primary and secondary issuance of digital tokens (e.g., Securitize, tZERO, Templum, etc.). Acquiring one of these firms may not be suitable as their experience primarily consists of tokenized equity issuances and they do not have an “out of the box” solution for digitally native loans or structured products. Said differently, there is no standalone Buy strategy available for a Platform seeking to enter fintech loan tokenization as any acquisition would still entail a moderate amount of Building.

Partner

DeFi projects such as Goldfinch and TrueFi have achieved notable momentum in fintech loan tokenization originating more than ~$1 billion of structured loans to real world assets. Partnerships with one or several existing players is a worthwhile investigation. Existing players have built relationships with Borrowers in emerging markets and development teams experience in structuring, issuing, managing, and retiring tokenized loans. These projects would also greatly benefit from a partnership with qualified digital custodians as historically it has been more challenging to source institutional capital for these platforms. As two-sided marketplaces subject to network effects, higher availability of institutional capital on these DeFi platforms are likely to lead to more Borrower activity creating benefits for both the Platform and the DeFi project, respectively. A partnership could also increase the velocity of loan origination by augmenting underwriting capabilities as a lending partner, investment committee member, or other collaborations. A key item to address is ensuring that the partnership and its activities are established and performed in a regulatory compliant manner.

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