Author: long_solitude

Translated by: Daisy, Mars Finance

Will cryptocurrency tokenize traditional finance, or will traditional finance traditionalize cryptocurrency?

The financial industry has been undergoing a transformation in its business model. For decades, we have seen the rise of alternative investments such as private equity, venture capital, and especially private credit. Private credit has become one of the fastest growing sectors in the financial sector.

M&A star Ken Moelis recently lamented the decline of the M&A banker. Today, alternative hybrid financing structures are more profitable than buying and selling companies.

For crypto-focused investors like us, alternative financing could well include on-chain structured products and tokenized elements of the capital structure. But it would be a shame if this opportunity ended up being snatched up by unemployed M&A bankers rather than profitable crypto project founders.

So far, the only cryptocurrencies that have been truly accepted by the traditional financial system are stablecoins and Bitcoin. DeFi (decentralized finance) has not really taken off outside the crypto space, and its performance is still highly tied to trading volume.

One of the future development directions is to build a fully on-chain capital structure (debt, equity, and tokenized assets in between) from the bottom up. Traditional finance loves income and structured products. Although many of us have received thousands of times the return from hype concepts in the past, the future development of institutional on-chain finance will require us to adapt to new challenges.

We used to disdain this

For a long time, we have been uninterested in real-world assets (RWA). In the past, we regarded it as an outdated "skeuomorphic" thinking - nothing more than a digital shell for existing assets off-chain, which are still subject to the traditional legal system that is completely different from "code is law". But now, we are re-examining this seemingly unimaginative but highly practical opportunity.

The limitations of on-chain private credit

Tokenizing private credit on a blockchain essentially just opens up new financing channels for borrowers. Platforms such as Maple Finance have indeed promoted this process. However, in the event of capital impairment or default, lenders can only rely entirely on the existing judicial system (and platform teams such as Maple) to recover funds. To make matters more difficult, this type of debt is often issued in emerging or frontier markets where the rule of law is weak. Therefore, it is by no means the perfect solution advocates advocate (see our earlier analysis for more background).

Adverse selection dilemma

What is more worthy of vigilance is the problem of adverse selection. The asset quality of on-chain private credit for retail crypto investors is often worrying. Those opportunities with the best risk-adjusted returns will always be monopolized by giants such as Apollo and Blackstone, and will never flow into the blockchain market.

Unique advantages of on-chain native businesses

Fortunately, there are indeed a number of on-chain native businesses that traditional institutions have not yet entered (but have achieved profitability). These projects now need to boldly innovate in their financing methods based on their on-chain revenue-generating characteristics.

As for the tokenization of U.S. debt? It is just a trick to add profit to DeFi strategies, or a shortcut for crypto-native users to circumvent fiat currency deposit and withdrawal restrictions to achieve asset diversification. Its actual significance is quite limited.

The exploration and dilemma of on-chain native debt

There have been several attempts to issue pure on-chain debt (such as Bond Protocol and Debt DAO), which is secured by project tokens or future cash flows. However, they all failed in the end, and we have not yet fully clarified the specific reasons. There are currently several explanations:

1. Capital and user exhaustion in a bear market

At that time, very few projects could generate substantial income, and market liquidity was severely insufficient.

2. The capital-light nature of DeFi

One of the most attractive qualities of this industry is the ability to run multi-billion dollar agreements with a lean team, with near-zero marginal expansion costs.

3. The alternative advantages of token OTC

Selling tokens to specific investors over the counter not only raises funds, but also gains social credit and status endorsement - these resources can then be converted into TVL (total locked volume) growth and coin price increase

4. The overwhelming advantage of the incentive mechanism

Compared with various incentives such as liquidity mining and point rewards, bond products are not competitive in terms of yield.

5. Regulatory fog on debt instruments

The relevant laws and regulations have not yet given a clear definition

It is for the above reasons that DeFi founders have always lacked the motivation to explore alternative financing channels.

Programmable Income and Embedded Finance

We firmly believe that on-chain enterprises should enjoy lower capital costs than traditional enterprises. The "enterprise" here refers specifically to DeFi-related projects - after all, this is the only sector in the crypto space that actually generates revenue. The basis for this capital cost advantage is that all revenue is generated on-chain and is fully programmable. These projects can directly link future revenue to credit obligations.

The debt dilemma of traditional finance

In the traditional financial system, debt instruments usually have covenants that constrain a company's specific leverage level. Once the default clause is triggered, the creditor has the right to initiate procedures to take over the company's assets. But the problem is that creditors not only have to estimate the company's revenue performance, but also need to monitor cost expenditures at all times - because it is precisely the two variables of revenue and cost that affect the clause indicators.

Structural breakthrough of on-chain credit

Based on programmable revenue, on-chain credit investors can completely bypass the cost structure of the enterprise and lend directly against revenue. This means that enterprises can obtain funds at a much lower rate than equity financing (based on PNL statements). Projects like Phantom, Jito or Jupiter should be able to obtain hundreds of millions of dollars in financing from large institutional investors using their on-chain revenue as collateral.

Flexible settings through smart contracts:

  • When project revenue shrinks, the proportion allocated to creditors automatically increases (reducing the risk of default)
  • When income grows rapidly, the corresponding ratio is dynamically adjusted downward (maintaining the agreed credit period)

This embedded financial architecture is redefining the way capital and value flow.

Practical Exploration of On-chain Income Financialization

Take pump.fun as an example. If it raises $1 billion from a pension fund, when the coin binding rate drops (as in the recent situation), the pension fund can take over the smart contract until the debt is repaid. Although the feasibility of such radical measures is still controversial, this direction is worth exploring.

Advanced Applications of On-Chain Income

On-chain income can not only fulfill basic credit obligations, but also achieve:

  • Automatic liquidation of claims of different priorities in the capital structure (subordinate and senior debt)
  • Condition-triggered repayment mechanism
  • Debt auctions and refinancing
  • Tranche and securitization of revenue by business type

Limitations of Token Financing

This revenue securitization should be a more economical financing solution than selling tokens at a discount to hedge funds (which often hedge or sell at the right time). The project revenue is sustainable, but the token supply is limited. Token sales are convenient, but they are not sustainable for long-term development projects. We encourage bold teams to open up new funding paradigms, not stick to the old ones.

Reference system of traditional e-commerce

The above model is called "merchant cash advance" or "factor interest rate loan" in traditional e-commerce. Payment processors such as Stripe and Shopify provide operating funds to the merchants they serve through their own investment tools. The actual interest rate of such loans is usually as high as 50-100% or even higher, and there is a lack of price discovery mechanism - merchants, as price takers, are firmly bound to the payment system.

Breakthrough in On-chain Embedded Finance

This embedded (in-app) funding model will shine on-chain:

  1. Programmable payments support conditional payments and real-time fund flows
  2. Enable more sophisticated payment strategies (such as targeted customer discounts)
  3. Stripe is taking the lead in practicing this algorithm-first model through merchant coverage and Bridge acquisitions.
  4. Promote the application of stablecoins between merchants and consumers

But the key question is: Can this model be opened up to permissionless capital and promote competition? Payment companies are unlikely to give up their moats and allow outside institutions to lend to their merchants. This may be the entrepreneurial opportunity for on-chain native crypto commerce and permissionless capital solutions.

Different Rights for the Same Shares

If the company's equity value comes entirely from on-chain revenue (i.e. no other sources of income), then equity tokenization is an inevitable choice. In the early stage, it is not necessary to adopt the standard equity form, and a hybrid structure between debt and equity can be adopted.

Recently, Backed.fi launched tokenized Coinbase shares, which has attracted attention. The scheme holds the underlying shares through a Swiss custodian and can provide cash redemption for users who have completed KYC. The token itself is ERC-20 standard and enjoys the composability advantage of DeFi. However, this type of design is only beneficial to secondary market participants, and Coinbase, as the issuer, has not gained any substantial benefits - it can neither conduct on-chain financing through this tool nor realize innovative applications of equity instruments.

While tokenization of equity (and other assets) has become a hot concept recently, truly exciting use cases have yet to emerge. We expect this type of innovation to be driven by platforms that have broad distribution channels and can benefit from blockchain settlement, such as Robinhood.

Another development direction of equity tokenization is to create on-chain giants that can obtain almost unlimited financing at extremely low costs through on-chain income, and prove to the traditional market that half-baked solutions do not work - either all income is chained to become a fully on-chain organization, or continue to stay on Nasdaq.

In any case, equity tokenization must achieve new functions or change the risk characteristics of equity: Can a fully tokenized company reduce its capital cost due to its real-time on-chain profit and loss statement? Can conditional equity issuance be triggered by on-chain oracle verification events, changing the current market offering (ATM) mechanism? Can employee equity incentives be unlocked based on on-chain milestones rather than time? Can a company collect all the fees generated by its own stock transactions instead of giving them to brokers?

in conclusion

There are always two paths of development we face: top-down and bottom-up. As investors, we always pursue the latter, but more and more things in crypto are being achieved through the former.

Whether it is equity tokenization, credit instruments, or income-based structured products, the core questions remain the same: Can new ways of capital formation be enabled? Can incremental functionality be created for financial instruments? Can these innovations reduce the cost of capital for companies?

Just as the traditional venture capital sector arbitrages between private and public markets (the trend is to stay private rather than go public), we predict that the binary opposition between on-chain and off-chain capital will eventually disappear - there will only be better and worse financial solutions in the future. It is very likely that we are wrong, and on-chain credit linked to income may not necessarily reduce the cost of capital (it may even be higher), but in any case, the real price discovery mechanism has not yet been formed. To achieve this goal, we need to go through the maturity process of the on-chain capital market, large-scale financing practices, and the participation of new market participants.