How Ondo Finance Creates an Institutional-Level DeFi Protocol

Key Takeaways

• With the approval of the Bitcoin ETF and the resulting increase in demand from traditional financial institutions for Bitcoin and blockchain technology, the need for DeFi protocols suitable for them is also becoming highlighted.

• Aware of this need, Ondo Finance is launching products focused on institutional DeFi products. USDY, OUSG, and OMMF are such products.

• Ondo Finance has made thorough preparations so that traditional financial institutions can use DeFi without worries. This attempt by Ondo is very meaningful in that it sets a standard for builders who are preparing institution-oriented products in the future.

Although 2024 has just begun, it will be remembered as a year of great significance for the crypto asset and, more broadly, the blockchain industry. This is primarily due to the approval of a Bitcoin ETF in January 2024. Over the past decade, Bitcoin has been categorized by many, especially in the financial sector, as a 'high-risk asset.' This perception has created significant challenges for the integration of Bitcoin and blockchain technology into the mainstream financial system. However, through numerous trials and errors over the last decade, blockchain and Bitcoin have sought to prove their worth. The approval of the Bitcoin ETF marks the beginning of official recognition from the established financial institutions. Although the Bitcoin ETF is specifically for Bitcoin, its approval signals a positive shift in how traditional institutions view Bitcoin and blockchain technology.

In fact, even before the ETF approval, there was already a growing trend of traditional financial institutions exploring blockchain. According to an article titled "Can Blockchain Revolutionize the Wealth Management Industry? - A Case Study of J.P. Morgan and Apollo" by 100y, major financial companies like UBS, KKO, Franklin Templeton, Hamilton Lane, and Citi have been experimenting and utilizing blockchain technology, both directly and indirectly. Now, 'institutions' are truly starting to enter the blockchain market. Amidst this trend, there is a product that aims to bridge traditional finance and decentralized financial services. This is where the story of Ondo Finance comes in. I believe that the products proposed by Ondo Finance will set a standard for the many institutional-oriented DeFi protocols that will emerge in the future. The question remains, how exactly did Ondo Finance design and launch its institutional-oriented DeFi products?

1. Introduction to Ondo Finance

Before delving into the products of Ondo Finance, it's essential to understand what Ondo Finance itself is about. Ondo Finance is a Real-World Asset (RWA) project that facilitates the trading of real-world assets on the blockchain infrastructure by tokenizing them. The term 'real-world assets' here refers to products like U.S. Treasuries, bonds, and funds. In a way, Ondo Finance's direction could be seen as opposite to that of a Bitcoin ETF. While a Bitcoin ETF enables traditional financial capital to flow into Bitcoin and the blockchain industry, Ondo Finance allows capital on the blockchain (or traditional capital through blockchain) to flow into the traditional financial market.

This raises some questions. A Bitcoin ETF is significant because it enables traditional finance institutions to invest in Bitcoin, which they couldn't do without an ETF. But what significance does Ondo Finance hold? Couldn't people with crypto assets already invest in real-world assets like U.S. Treasuries? To answer these questions, it's crucial to understand the vision and approach of Ondo Finance.

1.1 Overview of Ondo’s vision and approach to financial products and services.

1.1.1 Ondo’s Vision

Ondo Finance envisions that within the next decade, there will no longer be a distinction between traditional and decentralized finance. This belief is based on the idea that various assets will seamlessly transition between on-chain and off-chain environments, forming a larger market. The fusion of these two financial systems is expected to create substantial value. Teams that develop trustworthy products for institutions will likely benefit the most when this era arrives. To create such products, Ondo Finance believes it's essential to 1) enhance security and transparency, 2) comply with legal and regulatory requirements, 3) design protocols that are efficient and protect investors, and 4) ensure a global standard in UI/UX. Ondo's goal and vision are to introduce products that embody these values to the market, contributing to the integration of traditional and decentralized finance, and to address existing inefficiencies in the current market.

1.1.2 Ondo’s Approach: Why Do We Need On-Chain Treasuries and Bonds?

While U.S. Treasuries can be purchased in countries like South Korea through ETFs, and even more easily in the U.S., there's still a question of why Ondo is focused on bringing these treasuries (both short and long-term) onto the blockchain. Although it might be relatively easy in some countries, numerous others face significant barriers. Even with advancements in traditional finance, issues with geographical and socio-economic accessibility persist. For example, people who cannot open bank accounts would likely be unable to invest in government bonds. Furthermore, even with a bank account, the infrastructure to buy U.S. bonds may not exist in certain countries. Thus, there are clear gaps in the opportunity to invest in such assets, and blockchain technology, with its global reach via the internet, makes the implementation of bonds on the blockchain a valuable endeavor.

Additionally, even if investors worldwide could access financial assets, the fragmentation of assets and liquidity among different countries is a problem. Each country has different methods and standards for handling assets, making interoperability challenging. Ondo believes that blockchain and decentralized finance can address these issues.

However, decentralized finance isn't without its challenges. Since its inception, DeFi services have had limited connectivity with the real economy. Assets created on the blockchain and physical assets have operated independently. To achieve Ondo's vision, it's necessary to bring real-world assets onto the blockchain, merging their liquidity with the advantages of blockchain technology (such as faster settlement, transparency, and programmability). Essentially, this integration is what Ondo Finance aims to achieve. The next question is what products Ondo Finance is currently offering and preparing.

1.2 Overview of Ondo’s Products

Ondo Finance's products can broadly be classified into two categories based on accessibility: some products are accessible to the general public, while others are designed exclusively for qualified entities, such as institutions. This section will explore the various products offered by Ondo and compare their characteristics.

1.3 Exploring General-Access Products like the USDY Token

Firstly, a product accessible to general retail is a token called USDY. Those who frequently trade in crypto assets will recognize that when an alphabet follows 'USD', it usually signifies a 'stablecoin'. However, USDY in the context of 'Ondo' is slightly different. USDY stands for US Dollar Yield Token, and it represents an asset tokenized from short-term US treasuries and deposits. The key feature of USDY is that it is accessible and ownable by individuals (though not all individuals) and institutional investors, and except for certain regions which will be mentioned below, its accessibility is not restricted. Currently, the only General-Access Product available from Ondo is USDY. Detailed information about USDY will be discussed later.

1.4 Understanding Qualified-Access Products and Their Distinct Features

In contrast to the previously mentioned USDY, tokens like OUSG and OMMF (whose characteristics will be discussed later) are not available for purchase by just anyone through Ondo. The criteria for being 'Qualified' include being an Accredited Investor and a Qualified Purchaser. There are several criteria to meet these qualifications, and a few key ones are outlined below.

1.4.1 Criteria for Being an Accredited Investor (At least one of the following conditions must be met)

For Individuals:

1. A person whose net worth, alone or combined with a spouse or equivalent, exceeds $1,000,000 at the time of purchase, excluding the value of the primary residence.

2. An individual with an income exceeding $200,000, or a combined income with a spouse or equivalent exceeding $300,000 in the last two years, and expects the same for the current year.

3. Persons holding certain professional certifications, designations, or credentials issued by accredited educational institutions recognized by the SEC.

4. "Knowledgeable employees" of the fund as defined in the Investment Company Act regulation 3c-5(a)(4).

5. Directors, executive officers, or general partners of the issuer of the securities being offered or sold, or any director, executive officer, or general partner of a general partner of that issuer.

For Institutions:

1. Banks, savings and loan associations, and other institutions as defined in the Securities Act.

2. Brokers or dealers registered under the Securities Exchange Act.

3. Investment advisers registered under the Investment Advisers Act or state law.

4. Insurance companies as defined in the Securities Act.

5. Investment companies registered under the Investment Company Act or Business Development Companies.

6. Rural business investment companies.

7. Small business investment companies licensed by the Small Business Administration.

1.4.2 Criteria for Being a Qualified Purchaser (At least one of the following conditions must be met)

1. Individuals who own $5,000,000 or more in investments, either solely or jointly.

2. Companies owned by a close group of family members with at least $5,000,000 in investments.

3. Trusts formed not specifically for the purpose of purchasing the fund, where the trustee or settlor meets certain criteria.

4. Individuals or companies discretely owning and investing a minimum of $25,000,000.

Tokens like OMMF and OUSG require meeting one of these criteria, and there are many more conditions than those listed here (for more details, refer to Ondo Finance’s website). It's important to note that fulfilling just one of these conditions qualifies an individual or entity for these products.

2. USDY Token: A Deep Dive

Previously, I mentioned that in Ondo Finance's offerings, USDY is an investment product permitted for both institutions and retail(although restricted in some areas). Therefore, in this article, I intend to focus on USDY, comparing and analyzing it against other products. Before we compare USDY with other products, let's take a closer look at the USDY token.

2.1 Basics of the USDY Token

As mentioned earlier, USDY is an asset based on short-term U.S. Treasuries and demand deposit accounts (where depositors can withdraw a portion or all of their deposits on demand). Being a Real-World Asset (RWA), it is not a synthetic asset but rather a tokenized version of actual traded treasuries, making it easier to trade. The minimum investment amount is $500, which is expected to decrease over time.

Due to its focus on institutional-grade DeFi products, Ondo must adhere to stringent regulations and guidelines. Therefore, transferable USDY can only be minted approximately 40 to 50 days after the customer's deposit. So, how exactly is USDY minted, how is its price determined, and where is investment in USDY restricted?

2.1.1 The Process of Investing in USDY

1. The first step is, of course, Know-Your-Customer (KYC). Once KYC is complete, you can deposit USDC at any time (for amounts over $100,000, bank transfers in U.S. dollars are also possible).

2. When you purchase USDY with your deposit, you're issued a cohort based on the time you start investing. The cohort is a form of grouping for accounting and legal reasons.

3. After the cohort is issued and funds are processed, you receive a Token Certificate. The reason it's a certificate and not the token itself is that transferable USDY is only available about 40 to 50 days after the deposit, as mentioned earlier.

4. After 40 to 50 days, customers finally receive the token and can freely transfer or use it.

2.1.2 USDY Price Mechanism

Interest on USDY accumulates daily and is reinvested, continually increasing the token's value. For instance, if an investor invests $1,000 at 3.75% APY on January 1st, by January 3rd, the value of their USDY would be $1000.2017.

2.1.3 Regions Where Investment in USDY is Restricted

As USDY complies with U.S. investment laws, residents of the U.S., U.S. territories, the U.K., Canada, Crimea, Cuba, Iran, North Korea, Syria, Albania, Barbados, Belarus, Cambodia, Colombia, Haiti, Jamaica, Japan, Russia, South Korea, Ukraine, Venezuela, and Yemen cannot invest in, redeem, or trade USDY.

2.2 Comparing USDY to Stablecoins and Other Ondo Products

2.2.1 Differences Between USDY and Stablecoins

While USDY is denominated in dollars and has stable value like stablecoins, it differs significantly in the following aspects:

1. Bankruptcy-Remoteness: Unlike stablecoins, which can become insolvent if the issuing foundation goes bankrupt, USDY is bankruptcy-remote due to its trust structure.

2. Revenue Generation: While stablecoins require other lending protocols or third parties to generate returns, USDY inherently earns interest as it's tokenized from short-term U.S. Treasuries.

3. Compliance: USDY adheres to federal and state laws, while stablecoins often exist in regulatory gray areas.

4. Third-Party Audit: Most stablecoins aren't obligated to publicly report the assets backing them and can arbitrarily change these assets. In contrast, Ankura Trust Company protects the rights and obligations of USDY holders.

5. Immediate Redemption: While immediate redemption is challenging for stablecoins, USDY holders can receive a share of the collateral assets from Ankura Trust in case Ondo doesn't redeem them instantly.

In summary, USDY is like a stablecoin in dollar denomination and stability but is superior in terms of safety, reliability, and its inherent interest earnings. This level of compliance and security might be essential for institutional investors to engage in financial activities on the blockchain.

2.2.2 Differences Between USDY and Other Ondo Products (OMMF, OUSG)

Source: Ondo Finance

The most significant difference between USDY, OMMF, and OUSG is who can invest in them. USDY is open to retail investors, whereas OMMF and OUSG are accessible only to investors who meet specific criteria (as previously mentioned). Additionally, the scope for secondary trading differs: OMMF and OUSG can be traded in the secondary market but only among investors who have completed Ondo's onboarding process. In contrast, USDY can be traded by anyone in permitted regions (excluding those mentioned earlier).

OMMF (Upcoming Launch)

OMMF is backed by a Money Market Fund (MMF), unlike USDY, which is backed by short-term treasuries and bank deposits. An MMF is a type of investment trust that invests in short-term government securities, offering stability of principal and a stable interest rate. Although OMMF tokens, like USDY, are pegged at $1, the profits come from the interest generated by the underlying MMF. Unlike USDY and OUSG, where interest is automatically reinvested to increase the token's value, OMMF distributes interest in the form of OMMF tokens, keeping its value consistently at $1.00.

OUSG

OUSG is backed by the popular BlackRock's iShares Short Treasury Bond ETF, a short-term U.S. Treasury ETF. This backing is slightly different from USDY, which is backed by treasuries and bank deposits. Like USDY, interest in OUSG accumulates and is reinvested, leading to an increase in the value of OUSG tokens.

2.3 Economic Mechanism of USDY

We've looked at what USDY is and how it differs from other Ondo tokens. However, if someone invests in USDY, they are likely doing so to generate profits. So, how is profit made in USDY, how is it distributed, and what fees are involved?

2.3.1 Interest on USDY

As mentioned, it takes 40 to 50 days to receive transferable USDY. Does this mean no interest is earned during this period? The answer is no. Investors start earning interest as soon as they deposit USDC or USD. USDY's yield is determined on the first business day of each month based on the APY and is paid out daily. For example, if the APY is 3.75%, the daily interest rate would be (1+0.375)^1/365-1 = 0.0008729%.

2.3.2 Fee Structure of USDY

Ondo Finance does not charge management or performance fees. Instead, it earns a margin by collecting interest from the short-term treasuries and bank deposits it purchases, then passing slightly lower interest rates to USDY holders. This margin effectively acts as the concept of fees for Ondo Finance.

3. What is Flux Finance then?

Source: Flux Finance

We have explored various products of Ondo Finance so far. However, readers might wonder, "Where does the Ondo token fit into all this?" It's a valid question, as Ondo Finance, in itself, doesn't seem to have an apparent need for issuing its own token. So, why was the Ondo token issued, what is its purpose, and how does it relate to the products of Ondo Finance mentioned earlier?

To understand the Ondo token, it's important to know about Flux Finance, a lending protocol created by the Ondo team. Flux is a lending protocol forked from Compound V2. Like other lending protocols, it supports USDC, but uniquely, it also supports OUSG tokens, which are proprietary products of Ondo Finance.

Naturally, activities like borrowing USDC against OUSG collateral are permitted only for 'qualified' investors, as previously mentioned. This means institutions can use OUSG as collateral to borrow USDC.

Furthermore, the Ondo token serves as the governance token for Flux Finance. Flux Finance is controlled by the Ondo DAO (Decentralized Autonomous Organization), and in turn, the Ondo DAO is governed by holders of the Ondo token. Similar to other lending protocol governance tokens, it allows for changes in parameters and upgrades to smart contracts through governance mechanisms.

4. Team

Source: Ondo Finance

The team at Ondo Finance seems to have a well-distributed mix of personnel from both traditional finance and Web3 sectors. Firstly, the founder and CEO, Nathan Allman, is an alumnus of Goldman Sachs, one of the world's largest financial firms. The President and COO, Justin Schmidt, is also from Goldman Sachs. Katie Wheeler, another key member, comes from BlackRock, the world's largest asset management firm. Besides, the team includes developers from OpenSea, MakerDAO, and Boson Protocol. Ondo Finance, having a different vision and purpose compared to other protocols, seems to have a team composition that aligns well with its objectives.

4.1 Investors

In April 2022, Ondo Finance raised approximately $20 million in a Series A funding round. This investment attracted significant attention as it included participation from prominent investors such as Founders Fund, established by Peter Thiel, along with Tiger Global, Coinbase, Wintermute, and Flow Traders. This substantial funding round underscored the growing interest and confidence in Ondo Finance's approach to bridging traditional finance with the burgeoning field of decentralized finance (DeFi).

4.2 Partner

Indeed, the attention garnered by Ondo Finance can be partly attributed to the reputation of its partners with whom it collaborates. Notably, its asset management partners include BlackRock, the world's largest asset manager, and PIMCO, the world's largest bond fund manager. Additionally, Ondo Finance works with reputable firms like StoneX and Ankura, and receives auditing services from NAV. This approach to asset management, involving partnerships with well-established and trusted institutions in the financial world, likely plays a significant role in attracting interest and building trust in Ondo Finance's products. The involvement of these high-profile names in the finance industry provides a level of credibility and security that can be appealing to investors, especially in the relatively new and evolving field of decentralized finance (DeFi).

Ondo Finance, dealing primarily with Real-World Assets (RWA), recognizes the importance of partners who can manage and protect these tangible assets. However, equally vital are blockchain partners capable of trading and tokenizing RWA products. To date, Ondo Finance has collaborated with Polygon, Solana, Injective, and the Sui Network to distribute their products across a multi-chain ecosystem. According to the Ondo Finance team, their future focus will be on collaborating with various blockchains to transform Ondo's products from being single-chain based to becoming multi-chain products.

5. Looking Ahead

In researching Ondo Finance, I realized two critical points: 1) To attract institutional investors, products must be meticulously aligned with regulations and laws, and 2) To fully leverage the advantages of decentralized finance, regulations also need to adapt swiftly and appropriately.

Ondo Finance has diversified its products in line with regulatory requirements, distinguishing between institutional and retail offerings. These products are accessible through a stringent onboarding process, including KYC, making them suitable for traditional financial institutions. They have also considered accounting and tax issues in their product design, seemingly creating an environment conducive for use in traditional finance.

However, a notable limitation is the current regulatory framework's unpreparedness to fully realize Ondo's vision. Despite the goal of making U.S. bonds accessible to everyone, as mentioned earlier, there are still too many countries where Ondo Finance’s products are not accessible. Among these are countries that, in my view, need Ondo Finance’s services the most (for example, Venezuela, struggling with hyperinflation, or Ukraine, amid conflict). It is also regrettable that South Korea is among the countries unable to invest in Ondo Finance’s products.

Despite these challenges, I believe Ondo's efforts are incredibly valuable. Over time, just as the Bitcoin ETF was eventually approved, the number of countries able to use Ondo Finance's products will likely increase. Furthermore, Ondo's journey could serve as an excellent precedent for teams developing institutional blockchain products. Particularly for RWA products, traditional financial roles like trusts and fund managing will be significant. Therefore, I anticipate that Ondo's initiatives will encourage more collaboration between blockchain and traditional finance sectors.

Thanks to Kate for designing the graphics for this article.