The private credit market is growing briskly, reaching $2.1 trillion in assets and committed capital globally at a CAGR of 17% p.a. Private credit helps small and medium-sized enterprises to whom traditional lenders shy away from granting loans.
Private credit markets bridge the gap and lend to enterprises that are non-investment grade.
However, private credit markets need more regulations and have their own share of challenges. Tokenization can alleviate most of these issues. We will discuss how, but first, let’s understand what private credit is and how its market functions.
What is Private Credit?
Any lending or borrowing that happens outside the realm of traditional banking is private credit. The lender here is not a bank or a financial institution. It can be an entity like a non-banking financial institution (NBFC) or an investment fund that negotiates loans with borrowers, who can be small and medium-sized enterprises.
Private credit loans are not traded in public markets. Interest rates are often floating, i.e., they can change over time. The lenders are creditors and not equity holders in the company to whom they are granting loans. Investors find private credit a good way to diversify their investment portfolio as they carry less risk, ensure predictable returns, and can collect high interest rates. Also, private credit is not correlated with equity markets to a high degree.
Private credit managers and lenders offer a variety of funds and investment vehicles to a wide borrower base. The market has seen great expansion and growth and has consistently delivered higher returns and lower volatility than the S&P 500 and the MSCI (Morgan Stanley Capital International) World Total Return indices.
Challenges in Private Credit Markets
Despite the rapid growth, private markets suffer from multiple challenges. Liquidity is a big barrier in private credit markets. Due to the lack of active trading, there is a lack of liquidity and accessibility.
The market is opaque for investors, as asset valuations are often based on assumptions by asset managers. Funds report infrequent performance and use metrics that hide the actual risks involved.
The metrics, such as IRR (Internal Rate of Return), focus on returns but do not indicate the risk or volatility involved. Since reporting occurs quarterly, investors who only use quarterly reports as a source of information may remain misguided and face challenges in assessing the risks involved in the investment in a timely fashion.
The opacity, illiquidity, and lack of efficiency involved in managing private credit markets require a solution.
Tokenization as a Panacea
As we know, tokenization involves representing assets, credit, or even data as tokens over a blockchain. Blockchains like Ethereum are based on smart contracts, which are self-executing agreements that execute automatically as soon as a set of predetermined conditions are met.
These smart contracts can be embedded with information, terms, conditions, and rules related to any asset, asset right, or agreement involving such assets. In the case of private credit, private credit managers can assume the asset’s fair value and fractionalize the value into a smaller number of units. Each of these units is represented as a unique token on the blockchain.
The blockchain records any buying, selling, or trading of such tokens, and the transactions become part of the immutable blockchain history. Blockchain provides a transparent and distributed record of all the tokens, allowing private credit investments to benefit from its transparency, efficiency, and open nature.
How Does Private Credit Benefit From Tokenization?
By representing tokens over a blockchain, tokenization eases the buying process and trading of private credit funds. Retail traders from all over the world can participate in trade and transactions, and the market can achieve greater liquidity and accessibility. The accessibility factor works both ways. Investors and private credit borrowers now have greater visibility of the investors available, introducing better and more competitive rates in the market.
Since most of the operations related to private credit lending, borrowing, and trading happen in an automated manner, a considerable amount of costs associated with managing these funds can be saved. As the asset manager achieves better visibility and reduces the number of middlemen, indirect cost benefits bring better efficiency.
As transactions get recorded on-chain and are visible to all stakeholders, the added layer of transparency helps to ward off the opacity so prevalent in the private credit markets. Real-time settlements and the use of shared databases ensure data is always available for scrutiny.
Real-time settlement and analytics are a blessing in disguise for investors. They can now make educated decisions about where to put their money and how their investments are performing in real-time. They don’t need to depend on quarterly reports to assess an investment’s worth. Tokenizing private credit leaves little to no room for manipulation.
Fractionalization of private credit ensures investors from all walks of life and geographies participate, opening up the gated walls of the private credit markets and setting up the pathway for better regulations.
Tokenization can also help ensure regulations are in place by encoding them within the smart contract. Though tokenization can help mitigate liquidity and transparency barriers, it’s still unclear whether efficiency would go beyond token issuance and whether complete disintermediation would be possible.
Tokenization will help expand the private credit market in the long term, alleviating and transforming many issues. It will also highlight never-before-seen issues and be a major force in solving them.
TokenFi is working towards Larry Fink’s vision of tokenizing every asset.
Our soon-to-be-launched RWA Tokenization Module can help you tokenize any asset, except securities, in a few simple steps.
TokenFi’s Token Launcher can help users create fully-audited tokens (ERC-20, ERC-721, and ERC-1155) on most EVM-compatible blockchains in little to no time without writing a single line of code.
