How Oracles Act a Catalyst in Bridging Real World Assets On-Chain

In the presentation below, Niklas Kunkel, Oracle Core Unit Facilitator at MakerDAO, talks about the role that oracles play in bridging real world assets on-chain.

Below are further explanations of key points highlighted during his talk.

Introduction to MakerDAO & Stablecoins

MakerDAO is a decentralized autonomous organization (DAO) that guides the development of the Maker protocol. The Maker protocol is built on Ethereum and makes use of smart contracts to generate and maintain their stablecoin, Dai. Stablecoins are cryptocurrencies that maintain a stable value by being pegged to other stable assets or by using algorithms. Stablecoins generally fall into the following categories;

• Fiat-backed: Stablecoins that are backed 1:1 by one or more currencies such as the US dollar and Euro. Oneexample of a fiat-backed stablecoin is USDT.
• Crypto-backed: Stablecoins that are backed by other cryptocurrencies like Ether (ETH). Since cryptocurrencies are more volatile than fiat currency, crypto-backed stablecoins are usually overcollateralized. This means that instead of being backed 1:1, the amount in reserves would be higher than the value of the stablecoins in circulation. Crypto-backed stablecoins are issued on-chain using smart contracts. Dai is an example of a crypto-backed stablecoin.
• Commodity-backed: Stablecoins that are backed 1:1 by physical commodities such as gold. Paxos Gold is an example of a commodity-backed stablecoin.
• Algorithmic: Stablecoins that make use of algorithms to manage the circulating supply based on market prices. Ampleforth is one example of an algorithmic stablecoin.

According to Niklas, the Maker team developed one of the first oracles on Ethereum. Back in 2014 when they were developing the protocol, there were no oracle solutions available that suited their needs. The team decided to build their own oracle with the intention of switching to another service later on. However, nothing suitable was ever developed and MakerDAO still uses their own oracle today. Niklas is currently responsible for leading the oracle unit of the Maker protocol.

DeFi, DEXs & CEXs

Decentralized Finance (DeFi) has faced unprecedented growth over the last 2 years. As a result, Decentralized Exchanges (DEXs) have also seen a surge in the amount of usage, with volumes now competing with centralized exchanges (CEXs) like Coinbase.

DEXs are peer-to-peer marketplaces built on chain that enable the permissionless trading of assets. This is done by creating liquidity pools and incentivizing users to deposit assets to these pools through a process called yield farming. Yield farming refers to the process where users deposit cryptocurrency assets into liquidity pools in exchange for trading fees. Assets are automatically swapped between traders and liquidity pools using smart contracts. While CEXs have Order Books that match bids to asks, Automated Market Makers, AMMs, are essential to  DEXs like Uniswap or Curve, acting as the mechanism that sets the price of tokens in a liquidity pool.

Hyperreflexivity of DeFi

In his presentation, Niklas describes DeFi as being “hyperreflexive” in nature. He illustrates this point by describing the following scenario;

During bull markets, as the price of popular cryptocurrency tokens like Bitcoin and Ethereum go up, the demand for leverage also increases. As a result, the yield that can be earned for lending also goes up in order to incentivize users to provide liquidity for this leverage. This leads to a large amount of capital flowing into DeFi protocols.

As more and more users start yield farming, the Total Value Locked (TVL) on AMMs like Uniswap and Curve go up. This ends up serving as a positive feedback loop – a higher TVL attracts more and more users to put their capital into the protocol. The inherent problem with this hyperreflexivity is that when asset prices drop, all the feedback loops explained previously that help DeFi thrive go in reverse, and capital flows out just as quickly as it flowed in.

Connecting DeFi to the Real World

According to Niklas, in order for DeFi to grow beyond this hyperreflexive bubble, it must be connected to the real world. There are over 100 trillion dollars worth of assets in the traditional financial (TradFi) system versus approximately 100 billion dollars worth in DeFi. Even in a bear market, there is a chance that DeFi can continue to grow by absorbing these Real World Assets (RWAs). The growth from that can outscale any negative macroeconomic pressures. Absorbing RWAs into the DeFi ecosystem would also lower overhead costs in traditional markets by minimizing the need for middlemen typically required in traditional finance. According to Niklas, DAI could be a benefactor of this as the most time and stress tested decentralized stablecoin.

One problem with connecting RWAs to DeFi is that the majority of these assets are highly illiquid, meaning they are not actively traded on markets. It is also difficult to derive fair market values for these assets. Financial information pertaining to these assets are heavily censored, with limited information available about the relevant counterparties. If the asset originators are the only source of the data, there is a moral hazard involved as they would be incentivized to report market data that benefits themselves.

Implementing RWA oracles

In the framework prescribed by Niklas, in order to implement RWA oracles, 3 main players are required – The asset originator, an auditor and the data consumer, who is the ultimate end user consuming the oracle data.

Asset originators should submit underlying data on the asset, and not the price. They should not be setting the price of an asset themselves. Rather, they should be submitting data that can be utilized to derive a fair price.  Asset originators are incentivized to provide valid data because an auditor is going to check that this data is correct. If the auditor concludes otherwise, the asset originator can get their credit ratings slashed. Nevertheless, asset originators are assumed to be adversarial and will try to obtain an edge where possible.

The role of an auditor is to validate that the data supplied by the asset originator is legitimate. The data consumer will define a data model for how prices should be derived. Auditors then validate the data inputs provided by the asset originator, and plug these inputs into the aforementioned data model.

In this model, it is important to note that it is the data consumer who is paying the auditor for their services. The auditor and the asset originator cannot be morally aligned, or aligned in any business sense. A good counterexample would be this scene from ‘The Big Short’, where the ‘asset originator’ is the one giving business to the ‘auditor’, incentivizing the auditor to fake the validity of the data inputs.

MakerDAO & RWA

Maker has begun the absorption of RWAs into the DeFi ecosystem through a series of partnerships stated below:

New silver – MakerDAO is helping to provide short term mortgages for people who want to buy and sell homes quickly for a profit.

6S Capital – Credit tenant lease financing. MakerDAO provides capital, so 6S Capital can finance the construction of buildings when they have guaranteed tenants.

Monetalis – A financier which allows MakerDAO to divert USDC on their balance sheet into US treasuries. US treasuries are extremely liquid, resulting in higher yields with lower risks involved.

Societe Generale (Forge) – Covered bonds backed by home loans. Forge wants to finance 40 million Euros worth of bonds, proposing a 30 million DAI debt facility.

In the current crypto market, there are many who believe that there is a lot of value to be extracted from traditional markets which could help offset some of the revenue lost from crypto. While embracing RWAs could help protocols like Maker maintain its position as a leading DeFi protocol despite market conditions, there is still some concern over the centralized aspect of traditional assets.

In his interview with Blockworks, manager of Real World Assets at MakerDAO, TJ Ragsdale, explained that “the goal is really to take advantage of all the value that lives out there in the real world, and as Maker — with our unique position in the market, build in transparency and determinism that we all love about crypto into those traditional systems.”

The Blockchain Oracle Summit was the world’s first conference to fully focus on the importance of oracles and the potential value they bring to DeFi and beyond. Leading oracle experts from around the world gathered in Berlin to take deep-dives into their work.

Find out more about MakerDAO:

MakerDAO Documentation
MakerDAO Twitter
MakerDAO Discord
MakerDAO Youtube
Niklas Kunkel Twitter
Niklas Kunkel Github