Private credit’s lack of liquidity and transparency can be viewed as barriers to investment, even if some see them as being advantageous. A majority of wealth and asset managers say they would have allocated more to private credit investments
if it weren’t for liquidity risks and/or high manager fees, according to a year-end
2023 survey by Coalition Greenwich. A substantial share also cited concerns about transparency. Even so, 63% still expected to increase allocations to private credit in the year ahead.

While tokenization can potentially mitigate each of these three barriers, the extent to which benefits can be realized remains to be seen. For instance, efficiency gains could be limited as issuance would still require intermediaries, such as broker-dealers and transfer agents, to perform specific duties and meet legal requirements.

Furthermore, transparency benefits must be weighed against privacy considerations, which are of paramount importance to financial institutions. Portfolio managers want to keep positions private, so as not to show their hand to other traders. This desire will likely clash against digital markets’ use of public wallets, even if records are anonymous.

Both private credit and tokenization have a common goal of disintermediation. Where private credit is direct lending that bypasses banks, tokenization seeks to use smart contracts in place of some financial intermediaries. But as each grows in scale and scope, we would expect a need for new trusted intermediaries to emerge. These custodians would attest that a token is genuinely underpinned by the specific real world asset it purports to represent. 

The composition of active outstanding loans made on-chain has changed greatly since the market tumbled from a peak near $1.5 billion in 2022. In the run-up to the slump, from July 2021 through year-end 2022, borrowing was dominated by crypto-trading and market-making firms. This lending collapsed during the crypto winter of 2022 (see Crypto CeFi And DeFi Must Strike A Balance To Thrive). As the market has rebounded, it has changed.

New growth has predominantly come from real world lending financed through the Centrifuge protocol. The decentralized lending protocol had $289 million of active loans outstanding as of July 26, 2024, focused on consumer asset backed securities (ABS), real-estate bridging loans, and trade finance. Over 85% of loans originated through Centrifuge have been financed via the Sky protocol (previously called Maker), which is one of the most established decentralized finance protocols and the issuer of the USDS (previously DAI) stablecoin. 

In a simplified Centrifuge transaction, an originator will sell a pool of consumer loans to a special-purpose vehicle, which then issues two tranches of debt tokens through the Centrifuge protocol backed by the loans. The originator will hold onto the junior tranche tokens as a first loss position, and use the senior tranche as collateral in the Sky protocol to borrow USDS. Generally, the senior tranche has a balance no higher than 70% of the asset balance.

A secondary market has not yet been established for these tokens.

Greengage has taken a different route. The London-based digital finance company announced in July that it is collaborating with Coinbase to issue tokenized private credit to provide e-money account services to SMEs. Greengage said that SMEs are often under-served by traditional banks, and that tokenization can help them access credit in a more transparent and efficient manner. The company aims to let SMEs benefit from the efficiencies of commercial paper, which is normally the preserve of large corporations. It will source funding from providers including hedge funds, high net-worth individuals, and family offices. 

While some firms are taking incremental steps toward private credit tokenization, others have already pulled back, possibly due to concerns that the market environment and/or the blockchain technology are not quite ready.

Percent, for instance, encountered several specific problems that could represent broader challenges to the adoption of private credit tokenization.

The firm, then known as Cadence, issued its first tokenized private debt product in 2019, intending to cut back-office costs by standardizing and re-using smart contract templates for structured offerings.

It ran into three problems at the time:

1. Regulatory challenges. The company had to structure offerings in the real world within existing regulations and then create a mirrored contract on chain.
2. Lack of efficiencies. Creating mirror contracts and putting them on-chain was more expensive than expected. This often offset all of the revenue from smaller transactions.
3. Demand. There was insufficient demand for tokenized debt on-chain, probably due to the limited number of investors set up to invest meaningfully in tokens.

In another case, private credit lending through DeFi platform Goldfinch was curtailed after it encountered problem credits through its emerging market offerings. Even when tokenized, the quality of the credit matters. 

We believe the tokenization journey is not a straight path. Benefits for liquidity, efficiency, and transparency all come with trade-offs, and challenges remain.

Investor demand may come gradually, then suddenly. The evolution of on-chain assets could turn into a revolution once the pool of capital reaches a critical mass.
A meaningful pick-up in tokenized private credit can also probably only happen if investors are holding a broad array of tokenized assets and have embedded on-chain transactions into their operational processes.

Regardless of technological innovation, the quality of the credit remains of paramount importance. Whether on-chain or off, credit is credit. The quality of the borrower is what ultimately matters.