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Codefi

Achieving Real-Time Continuous Asset Financing with the Universal Token for Assets and Payments

by Matthieu BouchaudOctober 28, 2020
ramon salinero vEE00Hx5d0Q unsplash

This month, the Codefi Assets team introduced the Universal Token for Assets and Payments, a token standard designed to power a much wider range of use cases than existing standards.

Last week, the team walked through the features and benefits of the Universal Token, concluding that the token stands to bridge the worlds of centralized and decentralized finance with modular features that can be easily activated and customized for different use cases.

Today, we will discuss different use case examples for the Universal Token.


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Let’s start by defining Asset-Backed Securities (ABS) on the blockchain. ABS are security tokens that represent investment securities which are collateralized by a pool of assets, such as loans, leases, credit card debt, royalties, or receivables. Let’s call them ‘real world assets.’

On the left side, you have retailers or corporations looking to generate cash, and on the right side you have investors who want to participate in a wide variety of income-generating assets.Because the underlying real world assets are often illiquid and can’t be sold on their own, pooling assets together (a process called securitization)— allows the owner of the assets to make illiquid assets marketable to investors.

So the issuer will create a ‘special purpose vehicle’ (SPV) and sell real world assets into this vehicle. On the other side, investors will just purchase shares of this vehicle in a tokenized form. Usually these shares are grouped into different tranches with similar characteristics, such as maturity, interest rate etc. This is why we use a hybrid token standard to model these securities on the blockchain. Just about any cash-producing situation or asset can be securitized into an SPV. In the blockchain world, when we talk about security token issuances, the structure that is used in this process is often just like the one we outline in the diagram below.


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Ok, so let’s go a level deeper and see how this works.

  1. First, the issuer will buy real world assets and represent them on the Ethereum blockchain, creating a digital existence for the asset. Usually, as all real world assets are unique with different properties, we use non-fungible tokens to represent them.

  2. Then the issuer will work with lawyers to create an SPV, a company that will own the real world assets. That’s step 2 on the diagram above.

  3. Then because the idea here is to automate the process, all the rules that dictate how the SPV should behave are encoded into a smart-contract.

  4. It’s at this point that investors will show interest. To comply with securities law, investors will have to complete an onboarding questionnaire so that the issuer can verify their identity. The investor will also be invited to submit his Ethereum address, so that the issuer can check that the funds that he holds there are compliant with anti-money laundering regulations. Once the validation is successful, the investor’s Ethereum address will be allowed to receive security tokens following specific control mechanisms (either following the allowlist or Certificate methods).

  5. At this point, the investor gains access to the Codefi Assets platform and can browse and select the investment opportunity that suits him best.

  6. He can then create and submit his purchase order, specifying its characteristics.

  7. After the order is sent, the portion of the investor’s balance that corresponds to the amount of his order will be put “on hold”. This means that the investor cannot spend this portion elsewhere.

  8. Now it gets a bit more complex, but this is the killer feature of all financial blockchain applications, so please bare with us! The last step of the process, the corresponding amount of securities is created in the SPV smart-contract and also put “on hold”.

The only way for the issuer to receive the cash deposited by the investor (which entails releasing the cash from the “hold”), will be to send a message on the blockchain containing the key that will allow the investor to release the securities from the hold.

When this is complete, we have what we call ‘Delivery Vs Payment,’ (DvP) the payment of the securities against their delivery. This is done in a peer-to-peer fashion, without any third-party participation.

The magic of this feature is that it also works between private assets and/or between different blockchain networks.


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Now that the investor has purchased and received his assets, he has two choices: EITHER wait and receive interest as the real world assets distribute cash flows or reach their maturity, OR put these assets to work by lending them, a process we call asset-based lending, a fairly broad category that entails loaning money in an agreement that is secured by collateral.

In our example the collateral is the securities that were issued to the investor.

The process is quite simple this time: The investor can borrow money by depositing his securities into a smart-contract. The lending pool on the diagram below translates all the rules that can be found in any asset-based lending agreement into blockchain code. On the other side of this smart-contract are lenders, who deposit money to be lent to borrowers.

The key characteristic of asset-based lending is it’s security and certainty, as lenders can recoup most or all of their losses in the event that the borrower defaults. These rules are encoded in a smart-contract in such a way that they cannot be changed unilaterally.

The maximum loan amount an investor can get against his assets is defined by the loan-to-value ratio, in orange on the screen below. This ratio will depend on many characteristics that are linked to the type and value of the assets offered as collaterals.


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Now that the investor has purchased and received his assets, he has two choices: EITHER wait and receive interest as the real world assets distribute cash flows or reach their maturity, OR put these assets to work by lending them, a process we call asset-based lending, a fairly broad category that entails loaning money in an agreement that is secured by collateral.

In our example the collateral is the securities that were issued to the investor.

The process is quite simple this time: The investor can borrow money by depositing his securities into a smart-contract. The lending pool on the diagram below translates all the rules that can be found in any asset-based lending agreement into blockchain code. On the other side of this smart-contract are lenders, who deposit money to be lent to borrowers.

The key characteristic of asset-based lending is it’s security and certainty, as lenders can recoup most or all of their losses in the event that the borrower defaults. These rules are encoded in a smart-contract in such a way that they cannot be changed unilaterally.

The maximum loan amount an investor can get against his assets is defined by the loan-to-value ratio, in orange on the screen below. This ratio will depend on many characteristics that are linked to the type and value of the assets offered as collaterals.


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Ok, let’s go a level deeper into asset-based lending.

As we can see at the bottom we have lenders. This can be anyone that will lend money to borrowers at the top who will use their assets as collateral for these loans.

But the part that is the most important to focus on is the loan-to-value ratio.

Like in traditional finance, a risk management department is tasked to assess the risk of the assets that can be deposited as collateral in a pool.

What are the risks that these teams must monitor today?

  • Counter-party risk: How and by who the Asset is governed, as ultimately, even in blockchain form, these assets tie back to real world assets that are linked to real world events.

  • Market risks: The volatility of the collateral that needs to be carefully monitored to define the correct loan-to-value ratio

  • And some new risks that the technology brings: Smart contract risk. These risks can be mitigated by auditing contracts ahead of their deployment.

As more and more data is made available and secure on the blockchain with regards to these assets, the complexity of assessing the risks of the underlying asset, and by extension, the loan-to-value ratio, will decrease.This brings us to our last point.


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What will the future of asset financing look like?

If we connect these two use cases together we see an interesting picture with corporation or retail asset owners looking for financing on one side, and investors looking for lending opportunities on the other.

What if we could remove the middle section and allow borrowers on the right to sell real world assets directly into SPV smart-contracts. What if these contracts could issue different tranches of securities with standardized risk profiles that are seamlessly integrated in decentralized lending pools?

And what if this process could happen instantly?


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We could end up with what we call real-time continuous asset financing, a decentralized protocol where investors could sell assets to an SPV smart-contract and receive financing instantly.

At Codefi, we are convinced that there are great benefits in moving in this direction and are excited to help both large financial institutions and decentralized finance startups achieve this vision with our Codefi Assets APIs, platform and blockchain based tokens.