Thought Leadership | 2020
The Melding of CeFi and DeFi: ArCoin’s Path to Becoming MKR Collateral
I’m always astounded by the myriad of use cases our team envisions for ArCoin, Arca’s digital security backed by a portfolio of short-duration U.S. Treasuries. It seems even more incredible when our team takes an idea and begins to create new use cases for ArCoin that have the potential to reframe and strengthen the digital asset ecosystem.
The Fund, and ArCoin, the digital security linked to a share of the Fund, is the first closed end interval fund registered under the 40 act. We believe that the Fund’s registration under the ‘40 Act is one of the greatest benefits it offers. This regulatory standing means ArCoin holders receive the following digital security attributes:
- Benefits associated with ‘40 act products
- Mandated daily reporting of the Fund’s Net Asset Value (NAV)
Upon the creation of the Fund and ArCoin, we knew that applying to be a collateral option for MakerDAO was one of the first use cases we wanted to pursue.
For those not familiar with MakerDAO, it is a decentralized organization built on the Ethereum blockchain. Just recently, Arca Labs submitted a Collateral Onboarding Application (MIP6) with the aim of receiving approval for ArCoin to be used as collateral when creating DAI in the MakerDAO ecosystem. DAI, issued by MakerDAO, is a decentralized, crypto-collateralized stablecoin that aims to maintain a dollar peg to USD. Maker’s smart contract manages the borrowing and lending of DAI. A user of Maker will deposit an approved digital asset to borrow DAI, which aims to keep a peg of approximately one dollar. A user can then use this DAI as a medium of exchange within the larger digital asset ecosystem. Under our proposal, a user would deposit ArCoin to borrow DAI, which would be held by MKR’s smart contract until the borrowed DAI was repaid and ArCoin returned to its holder.
Given the relatively historical low volatility of U.S. Treasuries, we believe that ArCoin could be a lending tool offering less volatility when compared to most digital assets. The potential for yield from the Fund means that using ArCoin as collateral for DAI could be more attractive than using stablecoins, which have no potential for yield when locked in the Maker system. Further, the benefits outlined above differentiate ArCoin from stablecoins and other DAI collateral types.
MKR APPLICATION PROCESS
With our application submitted, the Arca team prepared for Maker’s Collateral Onboarding Meeting, where we would present our proposal to the community and respond to any questions. While preparing for the call, we soon found ourselves exploring uncharted territory for our digital security: what is the value of adding a relatively centralized digital asset into a decentralized protocol?
ArCoin’s underlying assets, U.S. Treasuries, are referred to as “real-world assets,” making ArCoin a more familiar financial instrument. However, in creating ArCoin through the use of blockchain technology, our digital security has capabilities that traditional securities do not. ArCoin can be transferred peer-to-peer, offering the potential of reduced costs due to the removal of intermediaries. Through our Fund structure, the underlying U.S. Treasuries remain much the same, but ArCoin (digital securities) and their wrapper (the ‘40 Act Fund) have changed the attributes of these securities. This structure allows for personal ownership (in a wallet of the tokenholder’s choice) and peer-to-peer transfer of an asset previously restricted by the norms of the United States’ financial system. These features, enabled by blockchain, work to expand the capabilities and ownership rights of individual investors over their assets. This transfer of power from established institutions to single investors is a key element in decentralization.
The graph below is a great way to visualize this concept. U.S. Treasuries stand as the most centralized of assets, as they are issued by the U.S. Government. Additionally, the tradable market for U.S. Treasuries is massive, recording roughly $2,600B in notional value traded during the week of August 14th. On the other end of the spectrum, we have MakerDAO and its currency, DAI. Maker, being a decentralized autonomous organization, is not controlled by a single entity, but is instead managed by its tokenholders. DAI’s value fluctuates in accordance with DAI supply, which follows the actions of tokenholders (hold, buy, sell, redeem or liquidate DAI). ArCoin straddles these two opposites. Unlike DAI, ArCoin’s value is determined by the value of the portfolio of its underlying assets, U.S. Treasuries. One ArCoin is equal to one share of the Fund. The Value of the Fund, and hence the value of ArCoin, is based on the value of the portfolio of U.S. Treasuries as well as the income payments received from the Treasuries. However, very similar to DAI, Arca does not determine the floating supply of ArCoin. Though underlying assets that make up the portfolio of investments for ArCoin are centralized, ArCoin’s structure allows for a relatively more decentralized and continuous economy for U.S. Treasuries.
We believe that decentralizing real-world assets requires a bridge, and that ArCoin acts as the bridge of real financial assets to DAI. This is why our team believes ArCoin is a good fit for a decentralized organization such as Maker. The goal of creating an alternative financial system is to innovate. Without a bridge, we believe that digital assets will never achieve mainstream status, as institutional investors will lack the confidence necessary to invest in this new asset class. If our goal is to promote healthy growth in the digital ecosystem, then assets that are deemed to have real world value must be used to encourage growth in this ecosystem.
In my next blog post, I will further discuss the details of our proposal to be included as collateral for MCD.
The Journey to Launching the Arca U.S. Treasury Fund and ArCoin
Today may be a day that changes financial services forever. Arca team members have been lucky enough to launch two regulated futures exchanges, many derivatives contracts and an ETF company, just to name a few. While each of these initiatives forever impacted the landscape of finance, our current launch of the Arca U.S. Treasury Fund (“Fund”) and ArCoin may be more transformative. It is not often that you get to work on a project with the potential to change the way we do business, but we believe we are launching such a product today.
Over the course of the past 24 months, we took an 80-year old financial product structure and integrated it with emerging technology—blockchain. The result is the first fund that is registered under the Investment Company Act of 1940 ('40 Act) that offers digital shares.
The Arca U.S. Treasury Fund employs a well-understood structure from the traditional fund world as its foundation. It is a closed-end fund regulated by the U.S. Securities and Exchange Commission (SEC) under the '40 Act that is invested in a portfolio of short-duration U.S. Treasuries. Where it gets interesting is how we use blockchain technology to streamline the backend mechanics to create a digital security. In other words, instead of issuing traditional shares, the Fund will issue ArCoin, which are digital securities. Put another way, by purchasing ArCoin, a person will be investing in the Arca U.S. Treasury Fund.
Blockchain technology allows for the facilitation of peer-to-peer transfer of ArCoin, which aims to offer greater transparency, traceability, speed and a reduction in costs. Through peer-to-peer transfers, investors in the Arca U.S. Treasury Fund can send ArCoin from their wallet directly to any other ‘whitelisted’ wallet, eliminating the need for brokers and other financial intermediaries. We’ll provide the option to create a wallet for those who do not have an Ethereum wallet. This is a real world example of a new technology being used to create efficiencies in the way we conduct financial transactions.
When designing the Fund, we deliberately selected U.S. Treasuries for the portfolio. We wanted ArCoin to be backed by a portfolio of instruments that are interest-bearing, historically considered less volatile, and with the potential to provide varying degrees of yield. U.S.Treasuries are backed by the full faith and credit of the U.S. Government, are widely used and offer varying degrees of yield, which made them the obvious choice for us.
Some of the innovations that the Arca U.S.Treasury Fund offers include:
- Issuance of ArCoin, which are digital shares of the Arca U.S. Treasury Fund
- Use of blockchain technology in connection with the ‘40 Act structure, allowing for peer-to-peer transferability
- Transfer of ArCoin peer-to-peer on the blockchain
- Investment in U.S. Treasuries, offering investors interest-bearing securities with a quarterly yield
- Transparency and bankruptcy protection
Why should anyone care about this? By using blockchain technology, we believe that ArCoin's peer-to-peer transferability can enable a fund registered under ‘40-Act to have greater utility than previous financial instruments. No longer are investment products defined by their investment goals, but what is able to be done with the structure. Working in conjunction with 18 leading companies within the digital assets space, we identified five potential use cases in which ArCoin could address enterprise challenges currently present in the industry. These include:
- Clearing and settlement
- Treasury management
How would this work? Let's examine the "treasury management" use case as an example. Corporate treasurers currently use low-risk financial instruments (e.g. municipal bonds, money market funds, treasuries, etc.) to manage their corporate reserves and the flow of funds between their different international corporate entities. Often this is a tedious process, requiring treasurers to work with a bank or financial institution to invest on the behalf of the company. Additionally, there are important timing considerations (such as standard banking hours) and costs (using FedWire), which result in delays.
Using ArCoin instead offers two advantages to the Treasurer:
- Elimination of the financial intermediary due to direct access to ArCoin
- Ability to use the blockchain to transfer ArCoin to subsidiaries and other corporate entities with a keystroke
When we were creating this financial product, we knew that the digital assets ecosystem had a volatility and trust problem. Because of the nascent state of the ecosystem, we’ve seen wild swings in the prices of digital assets. In response, “stablecoins” were created as a potential safe haven to crypto volatility—often pegged 1:1 to a fiat currency. However, many of these tokens are not subject to regulatory oversight, making it impossible for regulated entities to hold them, and they do not offer the type of investor protections (regulated custodians, regular and transparent audits, an independent fund board, etc.) that funds registered under the ‘40-Act typically include.
ArCoin was conceived in an effort to solve these problems. Although ArCoin is not a stablecoin, it does offer holders certain advantages:
- A fund invested in a managed portfolio of short-duration U.S. Treasuries, which have historically been considered less volatile and are backed by the full faith and credit of the U.S. Government
- The potential for the Fund to earn and distribute income to investors
- Registered under the Investment Company Act of 1940
- Fund assets held in custody by a bank custodian, as required by the Investment Company Act of 1940
- Peer-to-peer transfer
We cannot express enough gratitude to the visionaries that believed in Arca when this project was in its infancy. While this product was initially conceived by Arca Chief Legal Officer and Co-Founder Phil Liu, many have contributed to its genesis along the way—this includes law firm Morrison & Foerster LLP and our partners Ultimus Solutions, TokenSoft, DTAC, LLC, Ceros Financial Services Inc., Member FINRA/SIPC, UMB, RSM and Arca capital Management. Working with a completely new type of product and technology required a heavy lift by our entire team and partners. It was not an easy task to understand the essence of the product we were trying to build and to integrate it into the incumbent financial system. Thank you all for your incredible hard work and dedication. We could not have launched this product without each and every one of our team members and service providers.
Every member of the Arca Labs team looks forward to what lies ahead. As we enter into this new phase of our business, we are invigorated to work with industry leaders to incorporate ArCoin into your workflows and take one step toward creating a stronger, faster and more efficient global financial system.