It’s a shots-fired moment for decentralized finance, or DeFi. MakerDAO, a decentralized bank and one of the cornerstones of DeFi, made its first “real world” loan last month. It is lending to Americans who want to fix and flip residential real estate.
If old-school bankers weren’t aware of decentralized banks before, Maker‘s new foray changes that. Maker is now treading the same hunting grounds as not only banking behemoths such as Wells Fargo, but also A+ Federal Credit Union of Austin and thousands of other credit unions.
J.P. Koning, a CoinDesk columnist, worked as an equity researcher at a Canadian brokerage firm and a financial writer at a large Canadian bank. He runs the popular Moneyness blog.
No business is more regulated than banking. As long as MakerDAO confined itself to the blockchain sector, bank regulators such as the Federal Reserve could stay unaware. They can’t now.
Decentralized banking = centralized banking
Wells Fargo, A+ Federal Credit Union and MakerDAO are all engaged in the magical business of banking. That is, they each create deposits out of nothing and lend them out.
In Wells Fargo and A+’s case, dollar-denominated deposits are instantiated on centralized ledgers and then lent out to customers. MakerDAO does things a bit differently. It spins up dollar-denominated deposits, known as dai, on a decentralized ledger, the Ethereum blockchain, and then lends them using smart contracts.
But apart from the little details of how the deposits get stored and managed, all three institutions are in the exact same basic business – banking. Create a dollar, lend it, repeat.
Since its inception, Maker has provided banking services to a particular set of clients: pseudonymous cryptocurrency speculators. A typical MakerDAO borrower is a gung-ho crypto fan who, already heavily invested in ether, wants even more exposure. No credit checks or personal references required by Maker. The borrower need only submit their ether tokens to the Maker protocol as collateral, upon which a loan of fresh dai is automatically issued. The speculator uses borrowed dai to buy additional ether.
Like any bank, MakerDAO manages credit risk by controlling the amount of collateral that clients must submit. If a loan is about to go bad, Maker can protect itself by seizing the collateral, whether that be ether or wrapped bitcoin, or any other crypto asset on its permissible list.
Neither Wells Fargo nor A+FCU would ever dream of lending to pseudonymous coin speculators. And so Maker has never landed on those traditional banks’ competitive radar screens. U.S. banking regulators have been mostly oblivious, too. No need to supervise some strange blockchain-y thing that lends to an invisible and amorphous online client base.
But shots have been fired. And now traditional banking is going to have to devote some brain-power to figuring out what decentralized banks such as MakerDAO are up to. Here’s a quick explanation.
Anatomy of decentralized loan to meatspace
Last month, MakerDAO created and lent around $500,000 dai to fund “fix and flip” U.S. residential properties. A homeowner applies for a mortgage, uses the borrowed funds to improve the house, sells it and pays the loan back.
New Silver, an originator of real estate loans, set up a special purpose vehicle, or SPV, which holds title to the fix and flip loans. Technology from Centrifuge, a fintech, dices the loans into senior and junior tranches and encodes the securities as non-fungible tokens (NFTs) on Ethereum. New Silver keeps the junior, riskier tranche for itself and submits the senior tranche to Maker as collateral in return for fresh dai financing. (The fix and flip loans can be monitored here.)
Shorter story: We made some loans to house-flippers and our banker, MakerDAO, is financing them.
Read more: You’re a Lemon if You Buy a Tesla With BitcoinIt’s hard to miss the irony. Cryptocurrencies such as bitcoin and ethereum emerged in response to the 2008 residential mortgage implosion. Mortgages had been sliced and diced into conduits, SPVs, collateralized debt obligations (CDOs) and CDO-squareds, graded by credit rating agencies, and sold to witless buyers. And now, 13 years later, MakerDAO is tinkering with the senior tranche of an SPV-securitized residential mortgage portfolio.
Wells Fargo, A+FCU and other traditional banks will be furious (when they find out). They have invested significant amounts of money into chartering and compliance. With no regulatory costs, MakerDAO can probably undercut them by offering fix-and-flip financing at a lower interest rate.
MakerDAO isn’t standing still. It is targeting $300 million in real-world loans by the end of this year. There is talk of freight invoice lending, financing of U.S. farm properties and loans to solar facilities. Expect more blockchain-based banks to start copying Maker.
With all this growth, decentralized banks are destined to collide with real-world bank regulators. What will this collision look like?