RWA as DeFi collateral: inheriting the underlying's risk

Graduate · enrolled learners

This lesson opens with The collapse of Bear Stearns, March 2008.

What happened

Bear Stearns, a major investment bank, funded much of its balance sheet in the short-term repo market, borrowing cash overnight and pledging assets as collateral, and a large part of that collateral was mortgage-backed securities, bundles of US home loans. Those securities were only as sound as the mortgages inside them, and through 2007 and into 2008 the underlying mortgages began defaulting, so the value and, crucially, the liquidity of the mortgage-backed collateral collapsed: buyers vanished and prices became unknowable. Bear's repo lenders, who had been comfortable lending against that collateral, lost confidence almost overnight and refused to keep rolling the funding or demanded far more collateral, and because Bear depended on rolling that short-term funding every day, it faced a liquidity run and collapsed within a week in March 2008, rescued only by a Federal Reserve-backed fire-sale purchase by JPMorgan, with the Fed taking on around 30 billion dollars of Bear's mortgage assets. The collateral had inherited the risk of its underlying: when the home loans went bad, the securities backed by them lost their value and their liquidity together, and the lenders who had relied on that collateral, and the borrower who had depended on it to fund itself, went down with it.

The decision point

Collateral is a promise made good by an asset, so it is only ever as strong as that asset, which means collateral inherits the value and liquidity risk of its underlying and fails precisely when the underlying does, exactly when it is being relied upon. Bear Stearns is the case: a bank funded on short-term borrowing secured by mortgage-backed collateral collapsed in a week when the underlying home loans defaulted, the collateral lost its value and liquidity together, and the lenders refused to keep funding against it. For tokenized real-world assets this is the central risk of using them as DeFi collateral, because a lending protocol that accepts a tokenized loan, invoice, property or bond as collateral inherits the credit and liquidity risk of that underlying in full: if the underlying deteriorates, the collateral is worth less and may become impossible to sell, so a loan that looked safely over-collateralized on-chain is suddenly under-collateralized against an asset that cannot be liquidated, and the protocol and its lenders bear the loss, just as Bear's did. The on-chain value of the collateral, its last stated price, is not its stressed value: an RWA token can show a clean number while the home loans, the borrower, the building behind it are already failing, exactly as the mortgage-backed securities did before the market admitted it. So the decision when accepting a tokenized real-world asset as collateral is to assess it by the real value and liquidity of the underlying under stress, not by its stated on-chain value, and to size the loan, the haircut and the liquidation assumptions to what the underlying can actually be sold for when it is needed, because RWA collateral inherits the underlying's risk completely, and Bear Stearns is what collateral that inherited a failing underlying did to everyone who leaned on it.

Recorded loss

$30,000,000,000

Orientation and Year One are open: anyone can read them without an account. From Year Two onward the lessons are for enrolled learners, because progress through the later years only means anything if it is tracked against a record.

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