When exploring the product offerings of Strip finance, one thing became quite clear. Strip is building both a decentralized & centralized bank, in a sense.
The pooling of user capital, connecting lenders with borrowers, while Strip holds the collateral on its balance sheet (escrow) is in essence, creating a digital bank. If this is true, than the quality of collateral Strip will hold on its balance sheet is of paramount importance!
From exploring white-papers/pitch decks of other lending platforms (similar to Strip), it’s evident that they do not understand what exactly they are building. This has resulted in sub-par classes of collateral they are willing to underwrite loans against on their platforms (which is why most projects are illiquid, such as rocket NFT etc., with no one lending/borrowing).
We will divide the product offerings into two categories:
Centralized/Commercial Banking (Pooling) & Decentralized Banking (P2P)
Centralized Banking — “Loan To Own Model”
The health and vitality of a bank is built upon its foundation of collateral. Ever wonder why most commercial banks will give you a loan/mortgage for a house up to 10x your annual income, but would be hesitant to provide a personal loan?
The reason is quite simple, in case of default, the bank can liquidate homes and suffer a minor loss (in most cases). This is still not a desirable case for banks.
The other side of banking, which does not get mentioned much, is the “loan to own” model, where banks lend out against collateral they would eventually like to own and turn a profit on (hoping for the borrower to default).
Although such a practice is unethical and considered “predatory lending”, the key takeaway is morally agnostic. A bank should ideally loan out capital on collateral which would be desirable to own, should a default happen. The regular interest payments assuming no default should be the base case however.
We do not recommend Strip Finance to practice predatory lending in any shape or form! The capital raised from lenders (pool contributors) should not be used to underwrite predatory loans. Loans should only be underwritten to parties who can afford the interest payments, and have a reasonable ability to pay back the principal and retrieve their collateral.
With that being said, we would also recommend Strip to only loan out capital against collateral which can be sold for a profit (for centralized pooling) in case of default. The same philosophy of “loan to own” should be the guiding principal behind loans underwritten.
To demonstrate how this would look like in practice, we have created two products (proposals) to be offered on the Strip platform.
1. Debt Financing Product for Projects/Teams
2. VC/Pre-Sale Investor Vested Token Liquidity Product (In next article)
Debt Financing Product for Project/Teams
In traditional finance, companies can lower their cost of capital via debt & equity financing. In other words, to raise funds for development and capital investments, a company can either sell equity (stock), or finance through debt (bond/note issuance). The optimal mix of both (calculated via WACC, weighted average cost of capital), produces a lower cost of capital (fundraising cost).
When we took a step back and analyzed the entire crypto ecosystem, we realized that Debt financing does not exist, only equity financing does (via selling tokens raised under development/ecosystem funds at IDO/ICO)!
This is such a vital piece of financial infrastructure, and it is surprising how it has not been thought of/created already. This presents a massive opportunity for Strip!
How would this look like in practice? The idea is quite simple. By creating a liquid debt market (pool)for new/existing projects to take out a loan against their locked development funds, they will not need to sell the tokens on the market to raise capital (at least not in the short term, diluting the supply and lowering the price). If they can fund their development via debt (just paying interest), they can then sell a smaller amount of tokens in the future as the price rises, assuming it is a decent project with a growth trajectory.
Here is a very, very basic illustration describing what we mean.
As depicted above, the idea is straightforward. Assuming we are underwriting a loan for a great project, as time progress, the token value will increase. What we are doing is providing teams (of the project) to access capital now, rather than having to sell off a large portion of their dev funds to grow the project.
As shown above, if the price today is $1, and the team needs $10M, then they would have to sell $10M worth of tokens (not a realistic case, just illustrative). If they can access capital today (via debt), then in the future, they can sell a significantly lower amount of tokens (1M @ $10), paying back the principal with exponentially fewer tokens (and drastically lowering their development cost).
Additionally, this would significantly benefit communities, as there is no dilution/extra circ supply added (in the short term). The teams could also burn the remaining 9M tokens, causing a significant price increase/deflation. Strip will need to layout the value proposition for both teams and communities when marketing this product (we can explore this later).
This product does not exist yet, even though it would be a game changer for projects/business models. You cannot go to BlockFi (as a new project) or any of the other major DeFi projects, and post your new projects tokens as collateral and take out a loan (as far as we know). Currently, your only option is to sell your tokens on the market (equity financing), causing price decreases/dilution. Having a mix of debt & equity financing lowers the weighted average cost of capital.
We have illustrated below (in a basic sense), how this product would work on the Strip platform
As depicted above, the platform would work similar to any other lending protocol. The caveat here being, we are providing liquidity/loans to an area of the market which has yet to be served, early stage projects.
However, there are a few caveats. The first being, when providing loans to these projects, we must have a risk assessment management system.
The following basic points should be considered when determining the APR%, and subsequently the risk being underwritten :
- Debt Duration & Project age/availability of historical pricing data (older project, lower APR). Main predictor of APR%.
- Team, doxxed or not (no doxx, higher APR%)
- Quality of partnerships (VC’s, other projects)
- Exchanges listed on/liquidity (higher liq + better exchange = lower APR)
- Valuation of collateral
- Revenue (platform fees)
The following points would be important if Strip is underwriting the loans. If you wish to implement this product under “interest rate discovery”, then it would be up to the market to determine the APR%/Risk.
Realistically, we do not think interest rate discovery, and outsourcing the risk assessment to the market completely would be ideal. The Strip platform should at least determine a fundamental base rate APR%, with the market having a say in more minor role. If it is completely left to the market, we would assume their would be wide bid-ask spreads/illiquid.
Point #5 is very important. Strip should underwrite loans for lower tier projects at a very low LTV, and at a discounted collateral valuation, so we can sell the collateral at a profit! For example, if there is a new project seeking debt financing (lower tier project), we would value their collateral at 60 cents on the dollar (not exact, just for illustrative purposes), and provide a lower LTV ratio.
For bigger name projects with solid growth potentials, the LTV should be higher, and we would potentially have to value their collateral (tokens) at a premium. For example, when a top tier project is raising debt before mainnet/testnet, and it is obvious that their tokens will be worth significantly more post mainnet, we would value their collateral at a 30% premium (as we expect it to go 2–3x by the time of loan maturity).
In either case, the collateral should be valued such that Strip can liquidate it at a profit. This involves negotiating with projects on valuations of collateral.
This brings us to the option 2 in the illustration at the bottom of the picture shown above. If Strip believes that the value of the collateral that is liquidated because of default will be worth more in the future (lets say FUD caused momentary price drop), we can decide, either the Strip team, or via voting, whether or not to hodl the tokens on Strip’s balance sheet (pool), and sell it at a later date for a profit. Most likely, this would need to be voted on, as it is an extra layer of risk.
Providing a debt financing product for virtually all (great) projects in the crypto ecosystem will set Strip apart from the rest. This is a much needed piece of financial infrastructure, which if executed properly, can propel Strip to the top tier of DeFi projects, in terms of scope & liquidity.
In the next article, we will explore the 2nd centralized banking product, VC/pre-sale vested token liquidity, and also the P2P decentralized banking products for NFTs etc. We decided to focus on the Debt financing product first, as we think it can be Strip’s “killer app”, and a flagship offering for the platform.
This article is merely a rough draft, with initial thoughts abstracted to demonstrate concepts. The actual details will need to be ironed out later on when the products are being built. We did not want to make this article too long and dense, so if you have any questions, please feel free to ask us!
-Abe, Co-Founder & Co-Principal of The NewField Fund
As a new investment fund focused on the disruptive technology of tomorrow, we hope to share our world-view and mental frameworks in which we derive our theses. We welcome change and progress, but also strive to understand truths that remain constant and are timeless.
Disclaimer: Nothing written in this research article, or any article by The NewField Fund should be considered as financial, legal, or investment advice of any kind. Investing in crypto is highly risky, do your own research. #DYOR