European blockchain startup Defactor Labs is marketing a $100 million bond offer to accredited investors in Asia in a bid to bring them into the world of decentralized finance (DeFi).
In some ways, this is another fintech platform connecting borrowers who need working capital to investors looking for yield and diversification. There are plenty of companies in Asia doing the same thing, from Validus in Singapore to Velotrade in Hong Kong.
In this conventional fintech model, the borrowers are businesses that want the certainty of cash in hand, which is often a challenge for smaller businesses involved in supply chains.
They will bring their various short-term debentures to the platform, including invoices, receivables, and financing on inventory – money owed to these businesses but slow to arrive. The SMEs sell the rights to these claims to the platform operator in return for a haircut, say 10 percent.
The platform operator then packages this hodgepodge of short-term debt into an investible format, such as a fund, tranches, or individual debts that it markets to investors. The platform is constantly sourcing more borrowers (SMEs), in order to sustain a viable income stream for investors. These investors might be banks looking to deploy their balance sheet, but it could also be hedge funds, family offices, or anyone else seeking a return.
Now do it with DeFi
The similarities end there. Defactor’s idea is to take this fintech platform and structure it as a tokenization vehicle, based on smart contracts, and backed by real-world assets.
In order to attract institutional investors, Defactor is adapting the process to a compliance-heavy, regulated environment. It has partnered with a a broker-dealer licensed under German financial regulator BaFin, and it is issuing a bond to investors domiciled in Luxembourg (a common jurisdiction for financial products that can be marketed across the European Union).
“We want to resolve the problems of accessing traditional finance and bring that money on-chain,” said Maurice Tracey, Dublin-based chief commercial officer at Defactor Labs.
But why?
Why bother with trying to shoehorn fintech-trade finance into DeFi? DeFi means regulatory uncertainty, and it means poor liquidity: the entire DeFi space is only about $50 billion, measured in total locked value of money in protocols such as Lido, Aave and Uniswap. DeFi experienced a bubble last year, reaching about $250 billion of TVL, but it crashed in line with the general bust in the wake of the FTX wipeout.
For SMEs hungry to secure liquidity and for investors looking for a reliable yield on a credible asset class, the crypto angle seems like difficult terrain.
However, Defactor’s team believes that by creating a compliant, regulated mechanism, it can bring money into DeFi – which means creating a new channel for capital to reach SMEs. Traditional lenders such as banks have pulled back from the sector, due to increased compliance and capital-reserve requirements. DeFi, therefore, is not a substitute for traditional SME working capital but a complement.
A blockchain-based structure also brings benefits to investors. Because the bond is a tokenized instrument, the investors can trade their units into a secondary market. The Defactor team views this first bond as part of a movement to tokenize real-world assets, which can be expanded beyond trade receivables.
Sourcing real-world assets
The equation begins with borrowers, or in Defactor’s terminology, asset originators. It has an initial pool of six fintechs from around the world that are looking for a combined financing of about $100 million. Some are blockchain companies but not all, but they do share a fintechy mentality that is eager to try innovative solutions to their financing challenges, says Tracey.
They all have ordinary working-capital arrangements – invoices, receivables, trade financing – that they conduct as a matter of course. They have agreed to sell these to Defactor to the extent that Defactor can raise the investor capital to meet that demand.
Defactor is now arranging The Alpha Bond, a $100 million one-year note that yields 10 percent, paid out every six months, based on the collective paper. The bond is designed to roll over, in effect creating permanent capital for the asset originators.
One of Defactor’s jobs is to vet the asset originators, onboard them with AML and KYC checks, and judge that the fintechs have balance sheets capable of meeting their obligations.
But that isn’t the only risk that investors are taking. Smart contracts remain an untested mechanism in the event of a default. However, the bond is regulated under Luxembourg law, so there is a known legal system to manage any disputes.
“The yield is the equivalent of a high-yield bond in the U.S.,” Tracey said. “But it’s low risk. The underlier is 60-day paper, and the cashflows are visible.” The discrepancy is a premium to ensure Defactor finds the investors it needs to jumpstart its business.
Added incentive: DAO tokens
That’s not the only enticement. Before there was Defactor Labs, there was Defactor DAO (decentralized autonomous organization). This DAO was launched two years ago and issued governance tokens as a means of financing its business. It built the tech underpinning Defactor Labs’s business, including writing the smart contracts.
The minimum investment for the Alpha Bond is $100,000, but the team prefers investors write checks of at least $1 million. To encourage this, they are gifting larger investors with Defactor DAO governance tokens.
The team regards these tokens as ‘utility’ tokens. They do not confer ownership or claims on Defactor revenues. However, they do trade in crypto markets, with their value determined by the success of the DAO’s businesses, of which Defactor Labs is the first (and for now, only one). If Defactor Labs is a hit, the value of those tokens should rise. Therefore bond holders get both an attractive yield as well as potential, equity-like upside.
(In the US, the Securities and Exchange Commission does not recognize utility tokens, and would regard these as securities. Although there are US-based fintechs serving as asset originators, Defactor Labs is not marketing the Alpha Bond to US investors.)
Unconventionally conventional
The bond has a conventional structure but it is tokenized, issued on blockchain rails and denominated in USDC (Circle’s US dollar stablecoin). Investors can ignore this aspect, paying in dollars for units in a traditional bond.
Or, if they wish to trade their holdings as tokens, Defactor Labs has its brokerage partner (Black Manta Capital Partners) to facilitate those. Investors can also opt to purchase units in the bond with crypto.
In the long run, Defactor’s team hopes retail investors will also be able to participate, but for now it is only marketing the bond to accredited investors.
It also hopes to bring this model to other asset classes. It has been involved in proofs of concept involving fine wines and art collections. “Any asset can be tokenized,” Tracey said. “DeFi releases the value of assets that are not tradeable in the TradFi world.”
