Following on from our last post on Real World Assets (RWAs), its clear that liquidity is needed to bring many such projects to fruition. DeFi, with its ease of transaction and confidence in code, is an ideal candidate to bring grand vision of RWAs to life. This article lays out the bird's eye view of how this might begin to mechanically work.

Stratified Costs

Many RWA projects face internally stratified costs. In the case of commodity or precious metals; it can be more difficult to bring one component part of the same combined asset to fruition; ground gets hotter and ores get denser the deeper one digs. One can straightforwardly imagine a way to arbitrage excess demand into supply of such a component, the same way any crowdfunder goes to market and says:

'Hey, please give me money for x, you'll get y in response [ahead of time]' even if y is just feeling charitable.

But scaling this model, especially under CeFi, has limited flexibility. Transaction fees are sickening, high value transactions have to be individually approved by law, conversion into more advantageous currencies wherever you are is expensive; everything works worse, but is entrenched and so is defaulted to.

Moreover, CeFi, by its declaration and disclosure requirements, promotes the sorts of perverse incentives which set up oligopolies in exactly the sort of new markets we want to be competitive. How?

Well, remember those higher costs? Those are already raising barriers to entry, and, more importantly, promoting strong selection biases for those who can get past them to economise at scale. Combine this with the knowledge that you can only get as far as one disclosed jurisdiction plus its connections before competitors jump on you, and it doesn't make sense to run the completely honest go to market which these economic models are fundamentally predicated on, especially if I've reached the point where I don't need to do this. Too big to fail, too grandiose for candour. It instead makes sense to channel your inner Julius II, and Treaty of Tordesillas yourself and any competitors into strictly defined zones where there's less competition and the consumer ultimately loses.

DeFi can fix this both for the ambitious producer and, by extension, consumers, even if they never notice it. I'd almost go as far as to say the consumer not needing to focus on their financial system is a compliment.

Tokens As Rights

Imagine that some variation of the Green New Deal, mandatory ESG, so on so forth, actually becomes law. I own a Lithium mine, and demand goes stratospheric because now all those additional batteries which have to go in those electric cars need my commodity to work profitably. However, as above, parts of my deposit previously didn't make sense to exploit, and, even with this newfound sovereign backed demand, some smaller part still doesn't. We now have three tiers of stratified product going to the same ends. CeFi doesn't allow for easy arbitration on this, never mind elegant expression of how that cost is going to vary.

Now, imagine that I issue a token instead, which, upon certain requirements being met, entitles the holder to the produce, or profit equivalent of, this mine, corresponding to the volume of tokens they hold. The advantages for me are obvious; I'm not locked into long term instruments, I can market for liquidity much more widely, and I'm not subject to CeFi mission creep. I can also market all of these things as points to investors and consumers alike.

On top of that, I can treat the different strata of my product with bespoke tokens, or change the release order to simulate that difference, or do any one of a hundred other things. Importantly, I have an immediately flexible way to respond to demand, because demand can now be more directly signalled. If the globe gets hotter than expected and regulations tighten further, I can open up operations into that third strata with code in seconds, whereas a parallel operation in CeFi would involve vis maior clauses in the innumerable contracts I've signed, which go to any number of arbitrators, so on and so forth. Much more costly for everyone involved; far more distorting on the actual price consumers end up paying, especially where demand inelastic goods are concerned.

Less obvious, and far more powerful, are the additional benefits to investors. Like me, they aren't locked into long term financial contracts. They can trust the code, rather than eleven different bankers and all their incentives. There's now, just as in any other DeFi space, a market on those tokens. You don't have to care about Lithium to get involved in my venture now - you can directly speculate strictly on the financial returns without any CeFi restrictions getting in the way.

This then allows all manner of interested and specialist parties to get involved in their own way; yield farming, options, ETF's; we can directly plug high fixed costs projects into the liquidity markets they need to get prices down and wealth in real terms up. Human deception and error can be eliminated because, code is the law here. Tying back to the above, the lack of disclosure requirements reduces what my competitors know about my capabilities and ambitions. It's now decision theory, rather than general game theory. They're forced back into behaving like exactly that, competitors; I'm forced into actually carving out what I want based on product quality and customer service, rather than cornering the supply ahead of time and maximising for my own surplus.

I can feel Hayek smiling from here.

Come One, Come All

All of the above is true in the case of one commodity with a specific range of use cases and a variable cost. However, mines aren't pure. Going back to my example, Magnesium is often found alongside Lithium. Like Lithium, Magnesium has a range of commercial use cases. If its lightweight and electric, or needs to maintain internal stability at high speed, it probably has Magnesium in it, but notice that these use cases are subtly different from Lithium. Having enjoyed my runaway success tokenising Lithium, and noticing the low XED in my products, I want to tokenise Magnesium too.

And now comes the cherry on top; liquidity pools. DeFi, can, by setting up a pool of tokens representing my Lithium supply compared against tokens representing my Magnesium supply, do more than eliminate extortionate CeFi currency arbitrage.

It can directly democratise demand for any comparably pooled asset.

This rests on some assumptions, but not necessarily the ones you'd intuit. My ownership of the mine at this stage doesn't matter very much - once the tokens are out in the world for exchange, as long as the mine keeps mining, who owns it matters very little. The core assumption is that whatever rate of supply all this overlay infrastructure was posed on remains inside tolerance limits. This is, as with every other financial instrument, more true as you rack up risk. The heavier I bet on Lithium against Magnesium, or vice versa, if supply of one stops, I'm in trouble. But there's no reason for this risk to become existential to the given DeFi system; much less so than in CeFi because, again, code is law. There's no incentive for larger agents to conspire to push the leverage beyond what's sane, knowing that the taxpayer will backstop them - there's no taxpayer here.

This also allows consortiums of smaller retail investors access to profits reserved for institutional actors under CeFi. Say a well-performing retail investor gets news of incoming regulation; my Magnesium extraction operation goes so well that I've flooded some electronics manufacturing market somewhere, and the price is going to fall imminently, causing some other tokenised and pooled asset to rise in response (which need not be Lithium at this point). Well, they can take out a flash loan and arbitrage on the price hike on the other commodity - easy profit, directly to consumers.

C.F. Fiat Stables

Comparing against fiat stables provides further elucidation. Counterparty risk is (largely) ameliorated by using a commmodity - as long as there is liquid demand for the underlying commodity and confidence in the token, there'll be someone looking to purchase. This is not the case where underlying fiat positions are being abandoned or rolled back. Some others would have been in the worse position of factoring their structural inequalities into their distribution, but MiCA more or less kills any possibility of a competitive European stable.

A niche, but perhaps, dare I say, dull market in the underlying commodity is advisable; those in broader demand or with more dangerous applications are likely to have their movements around the globe regulated and tracked - all complications project directly onto any pegged token. This must in turn be reconciled with logistical constraints and liquidity concerns - the backer can be as confident as they like, but the stable is still limited by the total market of the underlying commodity. Perhaps some fractionation is in order - it's difficult for me to ship rare earth metals around the globe on a whim, but if I incorporate them into a larger order of more common deliverables, average prices start dropping. Similarly, if my token (and, chemistry allowing, physical currency to match) is based on a rarer commodity to the extent that a price is readily derivable, I can, up to my established risk appetite, build that into something more commonplace to ease liquidity concerns, and effectively optionise liquidity.

I mention physical coinage representing a token as another approach to liquidity problems, especially ones related to friction and uptake. If it becomes just the next kind of cash, the average person can use what is also a stable and a token from their physical wallet, as well as a chain one. All that is necessary is drumming up the underlying capital to match the token with parallel coinage, and convincing whichever central banks one intends to target that introducing this parallel coinage won't have disastrous effects. An awful lot certainly, but, a visible amount. This is perhaps the most heterodox ambition in this paper, but in a deglobalising world, I remain hopeful. Those who choose to break from the dollar over pride, prerogative or prudence could find a cooler political alternative in a decentralised, private option, set apart from centralised geopolitical intrigue and diorama. Especially in jurisdictions where cash substitution is a long running issue - none of the political friction of CBDC's (nor expenses incurred in building the necessary infrastructure on the public purse), easy integration into all extant markets, and direct tracking, assuming some mechanism to correspond a hybrid coin to its token (the most difficult part to build into a technology which would try to solve both these problems at once, but necessary lest double spending take hold everywhere). An ATM like dispensary connected to a wallet might be a good start.

But, drawing our metaphor to a close: if I don't like how separate my Lithium and Magnesium markets are, even if I can address them separately, and tokenise those efforts, how about I fuse the two with a token made of 50% Lithium, 50% Magnesium? Ok, don't put it in water, or heated air, or pure oxygen... but you get the point. Liquidity (or reactivity) concerns? Just dilute into a different ratio with a parallel refining product and resume the process.

Especially if favoured counterparties could be made ready, waiting to provide liquidity across the barrier until it dissolves, and then translate customers into the new paradigm once I decide to make rid of it. Instant market-wide efficiency improvements, and wider uptake appeal.

I'd have triangulated demand between, and thereby profit maximised the supply of, my individual products, derivatives thereof, and fusions therebetween, in one fell swoop. Oh, yeah, and created a parallel financial ecosystem, limited only by scale and adoption.

Aut Caesar, Aut Nihil.

Concluding Necessities

It's not obvious where such a system should be based or begin from. Stables would make a good place to start, and neither the EU nor US is a good home for them right now; this will be further commented on later.

Further, as you've likely surmised, it's likely to make CeFi, and all its institutional power, very, very angry, long before DeFi figures out its advertising and comprehensibility problems. In an uncertain, de-globalising world, only relatively insulated and uninvested jurisdictions make obvious homes, and the US isn't a good place to start as long as the SEC maintains its current course. Mexico, Canada and Australia might all be strong candidates with commodities connections and some kind of shock insulation from changes in trading markets.

However, for the ambitious, I can think of no better triple offensive to legitimate DeFi, establish a legacy which spans the transition from CeFi into DeFi, and which garners prestige to last generations. All remaining notes concern judicious deployment; far better handled by operatives than ideates.