COUGAR PAW N’ SHOP
PART 1 - THE EXPOSITION
The year is 2023, two furries dressed as Cougars, or Cougars dressed as humans (you never can tell) walk into a pawnshop and demand they take their farm as collateral for a pawn loan. The pawnshop owner is frazzled. “I can’t do that, '' he says with a thick Eastern European drawl. I only take physical things, jewelry and power tools, bicycles and shit. Things I can sell in the store if you don’t come back for your redemption of the loan. What should the Cougars do?
Decentralized finance, also known as "DeFi," is a rapidly growing ecosystem in the cryptocurrency space that aims to create a more decentralized and open financial system using blockchain technology. One way that DeFi can be compared to a traditional financial model is through the concept of a pawnshop.
A pawnshop is a non-bank financial institution that provides loans to individuals by accepting collateral in the form of valuable assets such as jewelry, electronics, or vehicles. These assets are then held by the pawnshop as collateral until the borrower repays the loan, at which point the asset is returned to the borrower.
Similarly, DeFi platforms allow individuals to collateralize their assets, such as cryptocurrency, to secure a loan in a decentralized manner. The collateral as virtual tokens are held in smart contracts on the blockchain, and the loans are disbursed in the form of other tokens, usually pegged stablecoins, which are pegged to the value of a currency. These loans can be used for a variety of purposes, such as buying a home or starting a business, or more leverage.
Just like a pawnshop, DeFi platforms also have a mechanism to liquidate the collateral if the borrower is unable or unwilling to repay the loan. This is known as a liquidation, where the borrower is given an opportunity to add more collateral to their loan to avoid liquidation. In DeFi, liquidation happens automatically often through incentive mechanisms, called keepers, and the collateral is sold to the highest bidder in the keeper market. These markets use oracles to determine the price of the asset to interact with the blockchain and usually keeper bots, to orderly (hopefully) liquidate the collateral and repay the loan to keep the DeFi pawnshop solvent. These collateralized arrangements are typically perpetual (without a maturity date), so long as the collateralization ratio is maintained. From the borrowers’ perspective their is no note obligation to repay. They actually never have to redeem the position. This is similar to a pawn shop loan where there is not a personal obligation to repay the loan.
In conclusion, DeFi can be seen as a decentralized and more transparent version of a pawnshop, where individuals can collateralize their assets in order to secure a loan without either party really needing to know each other, or sign loan papers, direct intermediaries, custody agreements, etc. These parameters are often programmed into the smart contract platforms. DeFi platforms allow for greater accessibility and inclusion. The use of blockchain technology and smart contracts ensures the process is secure and transparent. Liquidations are geared to happen rapidly over a small timeframe to minimize the risk of the overcollateralization margin vanishing and bad debt accruing.
What is a Mortgage Really?
Traditional secured loans on commercial and residential real estate are a laborious and tedious undertaking. Secured transactions, financings that include security interests in collateral, require significant underwriting both of the collateral, the repayment capacity of the borrower and the character of the underlined signatories to the obligation. Normally they require a mortgage (a property interest granted in realty), a note (an obligation to pay) that is secured by the collateral (property) encumbered by the mortgage. In this world, recordings of notarized signatures, signed papers, original ‘wet signature’ notes, recordings of the mortgage are all necessary in order to foreclose or alternatively sue the signatories on the note.
People often talk about “tokenizing” a mortgage, and it is unclear how exactly that can be accomplished. It is probably not really possible in the sense of how mortgages and notes work. Can they be originated and assigned? Yes. But that obviously treats each as a unique instrument (similar to a NFT) and then the loan (the mortgage, note, loan agreement, etc.) are then assigned to a new mortgagor and a new holder of the note. Loans and mortgages are often “securitized”. Which basically means the loans are pooled and bundled with an entity that holds all the obligations and then this entity is registered as a security and ownership interests are then granted as shares and ownership interests in the pool. To collect on a note obligation requires presentment of the original note. In other words, for the bearer instrument to be effective requires the original instrument which doesn’t naturally follow around a digital instrument.
Securities and corporate shares by their nature require custodial intermediaries and are very difficult to tokenize with the tokens retaining any bearer properties as they likely require;
SEC Registration: The issuing company must be registered with the Securities and Exchange Commission (SEC) and comply with all relevant regulations and laws.
Prospectus: A detailed prospectus must be provided to potential investors, outlining the terms and conditions of the offering, including the number of shares available, the price per share, and the company's financials.
Audited Financial Statements: The issuing company must provide audited financial statements, including balance sheets, income statements, and cash flow statements, to demonstrate its financial health and viability.
Disclosures: The issuing company must disclose any material information that could impact the value of the stock, such as litigation or regulatory issues, to potential investors.
Escrow Account: The issuing company must establish an escrow account to hold the funds raised from the offering until all regulatory requirements have been met.
Compliance with State Laws: The issuing company must comply with any additional requirements or regulations specific to the state in which the offering is taking place.
Stock Transfer Agent: The issuing company must have a stock transfer agent in place to handle the transfer of ownership of the stock certificates.
There are many that are moving this direction, which makes sense as it is a huge market and flows from how these securitizations are conducted today. But the securitization will be gated behind compliance walls, AML/KYC accredited investor, reg A, reg D, reg S, maybe a touch of Reg CF? Which they probably should be. There is an issuer, with information asymmetry that is offering complex financial instruments. These probably shouldn’t be offered to Ma and Pa McGensler.
Not all finance routes through Wall Street. There is a world of peer to peer finance that exists today, in small towns where people make loans to each other (both secured and unsecured). That area is ripe for exploration. Just as Bitcoin is peer to peer cash, there is an individual and sovereign right of people to contract with each other, to make peer to peer agreements without intermediaries. It is actually the majority of commerce. Obviously there is a web of local, state and federal laws that seek to regulate commerce and set licensing models, and legal and regulatory guard rails, but the right to contract is still generally respected and foundational to individual rights and liberty and respected under the law.
How to take RWA’s such as a farm and use a pawnshop DeFi model?
That is the question we will be exploring in future updates to the Pawnshop series as this is just a high level overview of secured lending transactions.
Among many of the concepts we’re exploring with real property rights on the Blockchain, another thesis we are exploring: is it technically and legally possible to conduct the equivalent of a pawnshop loan on real property, using blockchain and digital orgs (LLC’s), and existing laws? Should we try to finance or sell our farm we bought using DeFi rails?
Will there be a booger in the soup bowl? Perhaps, but watch us fall flat. Either way, we aim to educate and entertain. We are also exploring the use of other tools, such as machine learning AI such as Midjourney and OpenChat AI used to help draft portions of this article. Want to see the details on the farm, check out the TATR NFT for the farm.