Centrifuge: Bloccelerate VC Investment Memo
I. Investment Summary
Centrifuge is the first of its kind on-chain credit fund that bridges real-world assets such as goods, invoices, real estate, and royalties to Decentralized Finance (DeFi). Centrifuge enables asset originators to efficiently secure the lowest cost of capital, while helping investors access new yield-generating assets, while optimizing their risk and return, without the need for an intermediary.
Since its inception in 2018, this project has seen significant growth and signs of adoption: after going live in Q4 of 2020, Centrifuge has successfully originated and financed close to $100M worth of loans. It currently has $31M+ worth of funds locked in their smart contracts across 10 investment pools, ranging from real estate bridge loans to trade receivables - each yielding anywhere betweeb 3%-10% to senior tranche investors.
Centrifuge is the only RWAs (Real World Assets) platform fully integrated with the market-leading DeFi protocols - MakerDao and Aave. If successful, these integrations could lead to at least a 10x+ increase in the total value locked (TVL) for Centrifuge by the end of this year.
Roughly $90B of crypto assets are currently locked in the DeFi ecosystem. While this is a meaningful and growing number, to put things in perspective, JP Morgan alone manages $25T worth of assets under custody. Therefore, opening up RWAs (real world assets) to the DeFi ecosystem is a multi-trillion dollar opportunity.
II. Product Overview
Centrifuge project is an on-chain credit fund built by a team of experienced enterprise software engineers and entrepreneurs, Lucas Vogelsang and Martin Quensel. The project was born with a mission to create an open financial system without any barriers to entry for global trade, unlocking access to capital and liquidity to all borrowers - previously underserved by large banks. By doing so, Centrifuge is bringing real world assets (RWAs) into the DeFi ecosystem, and thereby offering additional yield products uncorrelated with volatile crypto markets for DeFi investors.
Centrifuge Chain is a proof-of-stake blockchain built on top of Substrate - an application framework for building distributed systems offering byzantine fault tolerant consensus mechanism and compatibility with the Polkadot ecosystem. Centrifuge chain enables asset originators to tokenize contracts and thereby bring most any cash assets on-chain in a form of NFTs (non-fungible tokens). An asset originator (AO) could originate a diversified collateral pool, with a minimum pool size being $250,000. Once these real world assets (e.g. trade receivables, mortgages, streaming royalties, revenue-based financing, real estate bridge loans, etc) are tokenized, they are listed on the Tinlake application.
Tinlake is the first application built on top of the Centrifuge chain. It is a smart-contracts based marketplace for asset originators and investors to list and access tokenized real world asset pools. Once the loan contracts have been tokenized as NFTs, asset originators are able to lock these NFTs as collateral on the Tinlake application in order to access liquidity. See the chart below for the visual explanation of this workflow.
Graph 2. Overview of Transaction Flow in the context of the senior and junior tranche investors
For every pool listed on the Tinlake application, investors are able to choose either one of two tranches based on their risk/reward appetite: the Senior Tranche or the Junior Tranche. The latter tranche offers the highest risk and highest reward option, as investors in this pool are the first to take on the losses of the defaulted assets. Typically, the first 8-20% of defaults are weathered by the Junior Tranche investors, before Senior Tranche investors take on the default risk. Therefore, the Senior Tranche, on the other hand, represents a more stable yield offering, since it is protected against the defaults by the Junior Tranche investors. In exchange for taking on less risk, the Senior Tranche usually yields a lower return.
Each tranche is represented by a respective token: DROP token (also known as “the yield token”) for the Senior Tranche and TIN token (“the risk token”) for the Junior Tranche. In order to participate in either one of the tranches, investors are required to purchase either TIN or DROP token. In order to do so, investors have to be whitelisted through the Tinlake platform by verifying their accreditation status (via Securitize integration). Once approved, investors are able to lock DAI in exchange for either TIN or DROP tokens, which in turn starts accruing respective interest rate, as well as CFG rewards. In order to align incentives and ensure the quality of assets placed on Tinlake marketplace, asset originators are required to stake somewhere between 25%-50% of capital in the TIN pool - though, for established AOs, this requirement is sometimes waived.
Each Tinlake pool is set up as an open-ended vehicle. That means that investors are able to redeem their capital as they wish. In order to redeem, investors lock their respective TIN/DROP tokens into the Tinlake app and collect DAI corresponding to the current price of TIN/DROP token, once the transaction is executed. See graph 3 below for more details.
2.1. Centrifuge and MakerDao Integration
On April 22nd, 2021 the Tinlake integration with MakerDAO officially passed the Maker Governance Council vote and has now been live on mainnet for close to five months. Centrifuge is the only RWAs platform whose assets are offered as collateral on the MakerDAO platform at this time, though MakerDAO is aggressively pursuing the RWA vision by adding one new real world asset per month. Specifically, MakerDAO announced its plans to onboard $300M worth of RWAs in the next 12 months.
At this stage, MakerDAO supports five Centrifuge pools. For example, New Silver - real estate-backed financing pool, has a $20M debt ceiling with the current utilization ratio of 38%(~$7M currently locked as collateral). This means that MakerDAO offers a credit line of up to $20M to New Silver asset originator at a fixed rate of 3.5% - highly competitive in the current market.
Graph 4: Centrifuge and MakerDAO: how the Maker Adaptor Works
Centrifuge is co-founded by Lucas Vogelsang and Martin Quensel, both experienced enterprise software execs. Lucas has previously held senior engineering roles at companies, Taulia, Close.io and others. Martin is the co-founder and former Managing Director of Taulia. Taulia is now a leading supply chain financing provider for SMEs, having transacted with over 1.5 million suppliers from 164 countries and provided over $100 billion of liquidity and early payments to SMBs.
Other key team members of the leadership team include Cassidy Daly (Token Design and Research), Michael Ruzic-Gauthier (Capital Markets & Institutional Capital), Colin Cunningham (Head of BD), Michel Hervas (Senior Software Engineer). Krishna Visvanathan serves as a board observer for Centrifuge. He also runs a Crane Venture Partners - an enterprise software and deep tech venture capital firm out of London.
The team brings a good diversity of experiences from capital markets, like BMO Advisors, to crypto networks, like Stellar Development foundation, to engineering experience from places like Puppet, SatoshiPay, Taulia, etc. As the team grows, it would be helpful to see more team members come from traditional real assets lending backgrounds, as well as traditional institutional backgrounds.
Team token allocation is 27%. At the current value of Centrifuge’s market capitalization, this represents roughly $27.54M - rather large for a team of 36 people, but not uncommon in the crypto token space. Lock-up for the team is 48 months with a 12 month cliff. The core contributors have a shorter lock-up period of 12 months and the release schedule started in July of 2021.
IV. Token Economics
Centrifuge’s native token is called CFG. It is used to pay transaction fees, functions as a governance mechanism for the network, as well as used to incentivize both asset originators and investors on the platform.
CFG’s current total supply is 425,000,000 tokens, of which 400M tokens were minted at genesis and 25M additional tokens were minted as additional rewards for adoption. The protocol is set to increase the total token supply by 3% each year.
The inflationary mechanism of minting is counterbalanced by the deflationary mechanism of burning of a portion of the transaction fees. Transaction fees are accrued for various services performed on the centrifuge chain, such as NFT minting, anchors, Tinlake financing transaction, etc.
Graph 5: Distribution of total CGF token supply
As most token projects, Centrifuge incurs a number of expenses related to engineering and product development work. Specifically. Centrifuge contracts with Centrifuge GMbH entity for outsourcing engineering talent, which results in a recurring monthly expense. There are also expenses paid out to validators and network security, as well as grants to the community.
Another expense is CFG rewards issued by the network to investors and asset originators. Early adopters get compensated in CGF tokens for locking their DAI and assets for at least 30 days. Specifically, the current reward for investors is 0.0042 CFG/DAI locked/day and for asset originators is 0.0017 CFG/DAI originated/day.
In other words, investors receive ~0.125 CFGs for staking 1 DAI for 1 month. Concurrently, asset originators get ~0.05 CFGs for each 1 DAI worth of assets originated per month. According to the Centrifuge website, total CFG rewards paid out to date equal 10.5M CFGs, which at the current price equals roughly $11.5M over the last 9 months. These rewards will diminish over time, as adoption of the network grows.
4.2 Revenue Projections
One source of revenues are accrued fees (30 bps) on new loans issued and successfully financed on the platform. The fees are charged in DAI and subsequently converted into CFG on the open market. A portion of these fees goes to Centrifuge treasury, while the remaining portion. As the outstanding value of all loans grows, the revenues grow accordingly.
As of the time of this writing (September 2021), Centrifuge chain successfully launched and finananced close to $100M worth of loans since launch in October of 2020. As a result, total revenues that would have been generated from processing and financing the total loans on the platform is roughly ~$300,000 (the function to charge 30 bps is not going to be officially turned on until early 2022, at which point the revenue accrual will begin).
While this number is still relatively small, as the platform grows and gains adoption by more asset originators and investors alike, we can see how Centrifuge could issue $5B+ worth of assets each year. If that were to happen, Centrifuge would accrue fees upwards of $15M. It is important to note that a portion of the fees are burned and the remaining portion is retained by the Centrifuge Treasury to help pay for the expenses.
For context, just in the real estate bridge loan space, one of the leading originators, Arbor, originated $1.1B worth of bridge loans per quarter in 2017. That is over $4.4B a year in origination just from one company and one type of fixed income security.
Graph: The growth of the TVL on Centrifuge since inception in October of 2020
Just over the past 9 months, the total value locked (TVL) is 73% CMGR (Compounded Monthly Growth Rate). While the current TVL ($31M) is relatively small, it is important to note that while the TVL of most DeFi applications had a sharp drop in the past few months of the market pullback, the growth TVL of Centrifuge remained intact. That speaks to lack of correlation between Centrifuge collateral and typical crypto collateral. That also means that while Centrifuge’s platform will take longer to obtain the initial TVL traction, the value will likely remain more resistant to short-term market swings.
Additional sources of revenue are being considered by the team. They include repayment fees ($.40 per transaction), underwriter fees ($0.75 per transaction), investment and redemption fees ($0.20 per transaction). However, none of these fees are currently charged by the platform yet.
V. Use Cases
The platform in its current version already covers a number of highly lucrative use cases actively trading on the platform. At the time of this writing, there are nine active asset pools available on the platform, with 31,740,096 DAI locked, ranging from music streaming invoices pool (with just 44K DAI total pool value) to real estate bridge loans pool (with 14,182,216 DAI pool value). See the graph below with a snapshot of all asset pools and respective interest rates offered.
Graph 7: Asset pools offered via Tinlake platform
In the following section, we will cover one of the use cases actively deployed on Centrifuge - real estate bridge loans, offered by one of the asset originators, New Silver.
New SIlver asset pool currently offers a diversified set of 60+ real estate bridge loans at 4.5% APY, with an average financing fee of 6.8% and an average loan size of $238,000. Total value of the successfully financed loans on Tinlake platform is $14.3M DAI. Pool has been open and operating since December of 2020. New Silver specialized in short term “fix and flip” loans which are typically repaid within 12 months or sooner.
Given recent integration with MakerDAO and Aave, investors in the New Silver asset pool are able to obtain immediate liquidity. MakerDAO has a 20M DAI debt ceiling available to borrow against DROP tokens at 3.5% stability fee (interest rate). Of the 20M DAI debt ceiling available on MakerDAO, roughly 8M DAI has been borrowed against since April of 2021.
Real estate bridge loans represent a relatively safe asset class with 96.32% of loans typically paid off without foreclosure. Of the remaining 3.68% of foreclosed loans, 85%+ are paid off prior to REO sale. Hence, the default rate on this asset class is less than ~0.5%, at least in the current market conditions. This makes this asset class highly attractive for investors looking for stable risk-adjusted return.
Graph 8: Total mortgage originators in the US from 2000 through 2021
VI. Market Opportunity
The most immediate market that Centrifuge is aiming to disrupt is the CLO (Collateralized Loan Obligations) market. The CLO market is approaching $1T in 2021, in terms of total amount of bonds outstanding. $360B of issuances is forecasted by Bank of America for 2021, of which $140B are new issuances and remaining $220B are refinancings. See the graph below for historical and projected CLO issuance data. The reason this asset class is attractive to institutional investors is its low default rate. As of 2019, the average rate of defaults was 1.39%.
Graph 9: Historical and projected CLO issuances in the US
- Oxford Lane Capital (
- Eagle Point Credit Company (
- OFS Credit (
While the CLO market is an immediate opportunity, the broader market of asset backed securities is ultimately ripe for disruption as well. The broader structured finance sees new issuance exceeding $1T/ year globally.
Due to the scale of these transactions, the needs of most SMEs (small and medium enterprises) are not being met by the large banks. While the largest corporations, like Google and Apple, are able to access capital at highly attractive rates (2%-4%), most small midsize businesses have to pay a premium of up to 20% to take out a loan.
Centrifuge is removing this barrier to access capital, opening up new asset classes - not previously used as collateral (e.g. music streaming royalties or invoices, etc), while offering a highly attractive risk-adjusted return to investors. If the total market of CLO issuances is poised to grow by a concervative rate of 5% over the next four years and Centrifuge team is able to capture 5%-10% of the market, we are looking at $21B-$42B of new yearly issuances on Centrifuge platform.
Just like any early stage company, Centrifuge has a number of risks that are worth considering as we make this investment. However, before jumping into the details, it is worth highlighting a few areas where this project has already “de-risked” itself.
- First, close relationship and integration with DeFi protocols like MakerDao and Aave give Centrifuge a chance to establish itself as the first mover in bridging real assets into the DeFi space.
- Secondly, though TVL is still very low ($31M) compared to other crypto-native platforms, the TVL on Centrifuge chain has already proven to be more resilient and not as correlated with the rest of the market during the market pullback earlier this year. That means that if we were to experience another “crypto winter,” Centrifuge’s assets are likely to be more resistant to market fluctuations, hence making it appealing as a way to hedge other yield-generating products in the DeFi ecosystem.
- Lastly, Centrifuge also has proven its ability to successfully attract both asset originators, as well as individual investors onto its platform. There are tem asset pools already up and running on the TinLake app, of which two asset pools have been oversubscribed. This demonstrates that the platform is offering a compelling value proposition to both sides of the equation (asset originators and individual investors looking for alternative sources of yield).
Now, let’s discuss a few important risks to consider.
- “Chicken and Egg” Problem
Ultimately, Centrifuge faces the same “chicken and egg” problem that most marketplaces do: rapidly acquiring both the sell side (asset originators with sufficient loan origination capacity) and the buy side (investors interested in the asset and yield offered on the platform) of the market.
Since Centrifuge is subject to regulatory compliance requirements, it has to follow stringent rules for onboarding and completing the KYC for both the investors and the asset originators on the platform. Inevitably, this process slows down the acquisition of their customers. However, once customers are onboarded, they are likely to use the platform on an ongoing basis. For example, New Silver AO has already launched 60+ loans as a part of the NS Pool on the platform since April of 2020. That is roughly adding 10 new loans each month, with little friction.
What currently helps to overcome this risk on the liquidity provision side is the active and growing partnership and integration with players like MakerDao and Aave. These platforms are already fulfilling a large portion of the lending demand from the originated pools and are likely to continue increasing their debt ceiling in the future. On the flip side, the CFG reward program is incentivizing the asset originators to come onto the platform. It has already paid out $10M in rewards since launch as a way to attract new AOs (asset originators).
2. Technology Risks
Like most blockchain projects in the DeFI space, Centrifuge has a high degree of technology risk. Specifically, this includes the smart contract risk, which can lead to the assets locked on the platform being lost or stolen. This risk has been partially mitigated by audits from Trail of Bits and Least Authority, the former being one of the leading smart contract audit firms in the space. Since there is a close relationship with other crypto-native projects like MakerDao and Aave, inevitably, Centrifuge security is also intertwined with the security and risks of these protocols.
In addition to the smart contract risk, there is another facet of the technology risk that Centrifuge is facing - the interoperability risk. Centrifuge is built using the Substrate framework, while the vast majority of the DeFi ecosystem resides on Ethereum. While the Centrifuge chain does support a bridge that allows users to securely move assets between Centrifuge Chain and Ethereum, there is a risk of another Ethereum-based platform taking market share away from Centrifuge simply due to lack of this interoperability friction.
Centrifuge has also opted to “mint” both the NFT tokens, as well as DROP / TIN tokens in the ERC 721 and ERC 20 standards respectively. This has allowed for the portability of these assets across the Ethereum ecosystem and frictionless integration with Ethereum-based platforms, like MakerDao and Aave. With that said, it is possible that some developers will choose not to build new applications (such as TinLake) on top of Centrifuge chain because of lack of Ethereum EVM compatibility and/or Solidity language (Substrate is built on Rust programming language and encourages the use of WebAssembly virtual machine)
3. Governance Risk
The Centrifuge chain is governed by CFG token holders, as well as the Centrifuge Governance Council. The latter has 7 elected members. Members are elected by CFG token holders in order to represent interests of the CFG community and have a higher weight in governance votes. In order to make any changes to the Centrifuge network, the network requires a scale-weighted majority.
While this system is designed against the “negative turnout bias,” whereby 3/4th of the council carries majority decision making power, it poses a centralization problem, if the members of the council collude. This specifically is dangerous in decisions regarding how and when revenues are being distributed and paid.
New asset originators coming onto the Tinlake marketplace have to be voted in by the Centrifuge governance committee. It is very important to allow for the Centrifuge governance to balance the quality of AOs coming onto the platform with the lack of a “bottlenecked” approval process, in order to bring more quality assets on board quickly.
In addition to the aforementioned risks, it is also worth considering regulatory and collateral risks. The former has to do with meeting the Reg 506 C when onboarding new investors onto the portal, as well as through integrations with partners like Aave. The latter (collateral risk) has to do with the quality of loans being on-boarded onto the platform. If the underwriting process incorrectly assesses risk of these loans, the investors will likely lose money and not use the platform again. Based on our conversation with one of the asset originators, New Silver, the process for underwriting these loans is quite robust and relies on other established third-party appraisal networks, like Mercury and others. To date, none of the loans issued by NS Pool have defaulted. However, it has only been a few months since the pool was launched and the real estate market has been relatively stable. This might change, if we face another market downturn or financial crisis (e.g. 2008).
VIII. Competitive Landscape
In its purest form of functioning as a decentralized credit fund on a blockchain, Centrifuge truly has the first mover advantage in the space. No other platform, to our knowledge, has built a similar product. The first mover advantage, however, is a double edged sword - on the one hand, Centrifuge has a chance to establish itself as the “go-to” RWA platform for DeFI and potentially serve as the foundation for trillions of dollars worth of assets flowing into the space. On the other hand, Centrifuge will have to pave their own path through trial and error.
It is clear that the broader tokenization trend is under way - whereby most real world assets from real estate to art are being tokenized as we speak. In that sense, it is foreseeable that these “tokenized assets” will make their way directly onto the lending DeFi platforms like MakerDao, Aave, Compound with or without relying on Centrifuge pools. If that were to take place, Centrifuge will have a hard time onboarding new asset originators. Instead, these AOs will go directly to the DeFi platforms for instant liquidity (without the need to put up their own capital into the Junior Tranche). As a result, “chicken and egg” problem is mentioned in the risk section of this paper.
Specifically, according to the Maker forums, the governance has already approved a liquidity offering to a platform for tokenized real estate loans, Reino.io. Reino is an asset originator offering loans collateralized by tokenized commercial real estate. While Reino.io is not directly competing with Centrifuge (in fact, it could become one of the asset originators on the Centrifuge platforms), Reino chose not to work with Centrifuge due to the requirement to put up capital into the Junior Tranche. With that said, if Centrifuge is able to develop a strong network of other liquidity providers outside of MakerDao and Aave, offering streamlined and cheap liquidity, it is likely other AOs will choose to work with Centrifuge.
There are other players interacting with real world assets (e.g. mortgages), such as Figure technologies. Figure offers a variety of lending solutions, from the home equity line, to mortgage, or a personal loan. According to the founder, Mike Cagney, Figure “has reportedly traded almost $3 billion in loans via the exchange platform.” While Figure originally launched as an asset originator, in its current form, Figure is mostly used to buy and sell loans to investors as securities, rather than an avenue to participate in the pooled loans as a yield-generating asset. Hence, Centrifuge and Figure are playing in slightly different markets. With that said, In May of 2021, Figure technologies raised $200M, valuing the company at $3.2B. With that capital, nothing stops Figure technologies from going after the credit fund market.
Lastly, there are also obvious “status quo” incumbents, including investment banks - from the likes of JP Morgan to small credit unions - lending money to SME (Small Midsize Enterprises). Though unlikely, it is possible that these players will embrace blockchain-based solutions and “disrupt” themselves to offer streamlined liquidity by tapping into established DeFi pools.
IX. Outcome Analysis
We have compiled our assumptions into a model that can be reviewed here. We will continue to monitor the market and update the assumptions, along with the model in order to determine the fair value of the project.
Do you have any questions or comments about this memo? Feel free to discuss them on Twitter @KMitselmakher @materionaut @bloccelerate