Connecting DeFi with TradFi

Transcript

[applause] >> Thank you for coming to see this talk. I hope you guys are all recovered from yesterday's next game. My name is Sonia Kim, one of the co-founders of 3F. 3F is a new leverage vault protocol built on Morpho, and we allow leverage exposures in an automated customized way to our LPs on RWA yields. So today I want to talk to you a little bit about connecting DeFi with TradFi. As way of introduction, my background is actually TradFi. As young as I look, I have had 10 years of experience as an equity portfolio manager before hopping

in with two feet into DeFi. I started out at a at a small advisory company called Steakhouse Financial back in 2023, and in January 2024, we launched the first ever Morpho vault. Today you may know Steakhouse Financial as one of the largest risk creators on Morpho. So I'd say I have some qualification to speak on behalf of both TradFi and DeFi. So if we look at some of the strengths and struggles in both TradFi and DeFi, I think that we come to the consensus that the two are actually really

complementary. TradFi, you know, over the number of years that it's had time to mold, it's established diversified cash flows from real-world economic activities that are packaged into funds, into securities, different instruments. And over time the industry has grown to specialize around different sectors and subsectors. So, we've got underwriting rigor from, you know, the CFAs, the fund managers, uh market experts that really hone in on, you know, one subsegment of the industry.

And of course, over time, there's legal recourse that's been established. But this is actually what DeFi struggles with. Um as you may be familiar with, uh we don't have many sources of on-chain revenue streams. Um what we've seen over the last few years is bootstrapped startups trying to incentivize our early users through token incentives. But of course, token incentives are not real, per se, um and APY fluctuates based on the prices of these tokens.

There's also been many instances of shaky underwriting. Um I don't know if you in the audience have been wrecked or, you know, been impacted negatively at some point from offset hacks and from smart contract hacks. But the last few, you know, months have really felt like quite painful for a DeFi user, um as we've seen with the likes of Stream Finance, which was, you know, which had kind of shaky underwriting uh belaying the the stablecoin, and the likes of Resolve, which uh unfortunately was, you know, impacted by the infinite mint hack.

So, as you can see in this slide, what TradFi brings can really benefit what DeFi lacks. But TradFi is not all, you know, song and dance. Um it's a very competitive space. There's lots of different options, and particularly for asset managers who are active, meaning they're actively underwriting um the the underlying investments, they've been met with great challenges uh from the growth of passive or ETF products. Often times, they'll experience fee pressure. And, uh their priority, as a result, is to try and find new distribution channels and new

incremental buyers. Also, leverage or access to leverage and financing is often gated to institutions. As a retail uh holder of assets, imagine going to your everyday commercial bank, like Chase or Bank of America, and saying, "Hey, I've got some collateral here. Will you give me a loan against it?" They'll probably laugh at you and say, "No, we can't do that." Um [snorts] and lastly, it's very opaque. Um DeFi's really been going since 2019 at scale, but we've solved all of these problems already. We have a global user base, thanks to uh Ethereum, who's been able to bootstrap capital through its

permissionless decentralized applications. We have composability, you know, scaled um DeFi primitives, such as lending, and congratulations to Morpho, for instance, who announced today that they raised $175 million in the latest fund raise. So, we keep expanding these primitives who are being used by global user base. And most importantly, it's transparent. Anyone can access these primitives in a transparent way.

So, TradFi, in short, wants to come into DeFi because there's a real commercial distribution opportunity that does not exist in the real world. So, RWA is one of the bright spots, I'd say, in DeFi right graph tells it all. Uh we started from basically nothing in 2023, and you can see this hockey stick growth in the overall issuance of RWAs. Um most are US Treasuries, but there is a diversifying uh set of asset classes that are now being brought on chain. There's also huge number of tokenization agents who've

worked tirelessly to iron out little details such as what oracles do we use? What NAV reporting do we do? How do we make sure that there's legal recourse? And is there enough liquidity on chain to support all of these assets? These are nitty-gritty details that have been figured out over a number of years by people who are nerding out on this. But issuance, I'd say, is pretty much solved now. It's not the concern. Once you have on-chain presence, what do you do with it? What is this on-chain presence? A lot of early innovative asset managers who've come on chain, who have assets issued on chain,

are now asking themselves, how do we scale it? What is its purpose? Maybe we can get some answers or inspiration from the TradFi world itself. If you look at the simplest uh instrument, US Treasuries, and look at what it's being used for, we have quickly realized that it's not just issued and held in the in the bank accounts of people's uh in the uh in people's bank accounts. It does a lot more.

I've tried to um you know, classify the types of use cases for Treasuries. So, of course, you store it to as a savings vehicle. Um it's around 30 trillion in total. But also, different fund managers have collated Treasuries in a new vehicle called money market funds for cash management purposes for a lot of corporations. Who then can post either treasuries or money market funds in the repo market or in collateral financing venues to release even more capital and do other economic activities with it.

And then finally, some of the most specialized hedge funds will then take this market structure and try and create more yield or sophisticated yielding strategies out of it such as leverage carry or basis trades. So, we've taken one instrument, one simple US treasuries instrument and created multiple different use cases out of it. Um and as a result, we get what we call higher asset velocity. This is really interesting because there's lots of now tokenized assets that are currently issued and just being held in the wallets of users.

Then the next question is, can we take this inspiration and create new use cases that will eventually create more economic activity out of these assets by creating higher asset velocity? So, 3F has decided to target one very specific use case. Um it's actually at the bottom here, the leverage carry trade which in TradFi is over a trillion dollars in notional. It represents the highest asset velocity type of use case.

So, if you guys are degens on chain, if you've lived through the plethora of yielding stable coins that have been issued, you may be familiar with the concept of looping. Looping for those who are not familiar is this trade. You deposit your money to buy an asset. You collateralize it on a lending market like Aave and Morpho. You draw a loan against that. And then you buy more of the asset. Collateralize borrow buy.

So on and so forth. Depending on how many turns of leverage or number of loops you've constructed, you have the opportunity to keep pumping up your returns. So the math goes, if you have an underlying asset that earns 6%, say you can borrow against this asset as collateral at 4%. You've got a spread, a positive carry of 2%. Let's put some leverage on it. Let's say you want to put 5x leverage. Then you can magically turn a 6% yielding asset into a 14% yielding asset.

All of the sudden, a boring asset now looks quite attractive to a Degen user or uh generally allocators on chain who are looking to get compensated for taking on several layers of risk. If we were to do this looping mechanism, though, RWAs which have settlement delays because the real-world infrastructure is much less efficient than the blockchain infrastructure, we run into issues.

Um I strongly recommend if people are interested to go into my Twitter profile later and have a look at the long form that I've written called RWA Looping Is Broken. But to get into the details, for DeFi native assets, uh crypto native assets, which settle instantly on the blockchain, looping is very easy and trivial through code. What you would do is you buy, and say 1 million of the underlying.

You can borrow instantly through a flash loan, say 4 million to top up your exposure to 5 million, still the 5x leverage. You buy the asset, collateralize it on Morpho or Aave, borrow against it, and pay back the flash loan all in one block. 12 seconds for mainnet. However, you can do the same thing to get leverage on RWAs. To go through the money flow, what would you would have to do is buy 1 million of the asset, wait until the asset settles, in which, you know, in treasuries or other fixed income products, it's T+1 typically.

Collateralize it on a lending market. Go again the next day, buy $800,000 worth of the RWA, wait until the asset issuer gives you the asset next day, and go again. So, if you were to get up to asymptotically 5x leverage, let's say you get into 20 loops, that takes you 20 days to get up to the 5x leverage position, and the same time on the way out, 20 days to wind down your position. That's very glitchy, and I don't know that many people would have the patience to keep doing the same thing over and over again for 20 days to get up to 5x leverage.

This has been historically one of the um the the bottlenecks for RWAs being integrated on DeFi protocols seamlessly to allow leverage. So, what do we do? 3F is trying to create a new primitive for allowing users to build one-click leverage on RWAs. We're solving this exact problem of settlement delays being compounded as soon as you try and put on leverage through DeFi rails.

The mechanism is quite simple. We actually try and mimic the flash loan mechanism. Except think the flash loan is not given to you in one block and settled in one block. But imagine if one block in the real world is actually one day. We call the givers a flash loan or IRL flash loan I'm calling it bridge facilitators or BFs. The gives us an upfront loan all transparently on the blockchain as soon as a user is ask for leverage position.

Then 3FB draws his bridge loan along with the user equity or deposit and put it into the RWA. We wait one day for it to settle. Collateralize it immediately on lending protocol in our case Morpho. And we finance the bridge facilitator by drawing an over collateralized loan against the asset. So in this case just to go through it again, you're the user, you want 5X leverage on a fixed income fund, you have 1 million capital. As soon as you instruct the 3FB protocol that you want to establish this leverage position the protocol asks the bridge facilitators on a best rates basis a $4 million bridge loan.

5 million gets subscribed, collateralized on Morpho. You can draw an over collateralized loan against 5 million of collateral. 4 million gets paid back to the bridge facilitators. The result of this is that you can now create leverage positions on RWAs in one settlement cycle rather than compounded settlement cycles over multiple loops. Here's an example of a new product that we launched in conjunction with FalconX, uh one of the tiered one market makers.

FalconX has a has put on chain a private credit instrument. This instrument is basically the underwriting that FalconX does to its institutional clients, a loan that they over collateralize loan that they extend to their institutional clients who post collateral with them in an SPV structure. And that SPV structure has been tokenized by tech provider called Pareto and brought on chain. 3F leverage vaults are taking this instrument and allowing users to customize their leverage on top of this asset. Currently, you can get up to 6.5 times leverage through 3F based on your

own risk appetite. Let's go through the math. The underlying clients of FalconX borrow in an over collateralized way at 7.5%. The native yield of this private credit vault, in another word, is 7.5%. You can collateralize this instrument and borrow against it on Morpho at 5.5%. There's a 2% spread, which through 3F you can amplify. Um if you go max leverage, right now you can earn more than 20% real yield.

So, we can do this alone. The beauty of DeFi is that we build small primitives globally on chain, and people can build on top of each other to make a greater, more robust, more powerful ecosystem. To give you an idea of the number of players that are required in our ecosystem to make this work. First of all, we have traditional asset managers, tokenization agents, bringing interesting assets on chain, the RWA shares we call them.

We want to focus on bringing quality assets on chain such that we limit the number of hacks and rugs that we've seen in DeFi time and time again. Then there are lenders on Morpho. They want to lend against also robust collateral that won't go to zero or be rugged or be found out overnight that there's 90 million missing from the fund. We've had enough of that and I think lenders are very cautious these days to lend against prime assets and we think that we have the ability to bring on quality RWA issuers to give Morpho

lenders a quality yield as well. As I mentioned, the bridge facilitators are BF's. are the new entities that allow this efficient looping to happen. They earn a yield for extending the short-term bridge acting as the connective tissue between blockchain speed and real-world speed. Finally, the the leverage LPs. They want to amplify returns. They want to do something different that you can't do in the real world using the same underwriting rigor and instruments that we already have over time honed in the real world.

And actually finally, liquidators. Liquidators are opportunistic yield uh a capital providers that want to earn counter-cyclical yield by when somebody is too levered seizing the collateral and making the lenders whole and getting a premium yield premium for it. So, these five players in the 3F ecosystem are really important for the whole thing to function and create a new primitive on chain using old assets.

Want to end with a a meme here. I feel like the energy is sagging a little bit. For RWAs to succeed on chain, I think that we really need to focus on new use cases that are not available in the real world. We're a bunch of very creative, ambitious, and smart people. I think that if we work together, we can create new instances of a new yield sources using the old assets that are currently not even possible in the real world. And leverage carry trade through 3F is one instance of this.

Thank you. If you're interested, please feel free to check out our Twitter, our website. Our app is now available for white-listed actors. So, reach out if you want to participate in private beta. And I'll also be in the back if you have any questions and want to chat afterwards. Thank you.