Regenerative Finance and a Stable Asset backed by Nature

Thanks to Roman Croessmann and Sandra Kumhofer for their feedback and review.

This is the second article of a four-part series describing how I think about the future of money. The first article was about money backed by nature. In this second part, I am going to explain the concepts of Regenerative Finance and Digital Environmental Assets. Then I am going to introduce one specific approach to Regenerative Finance - a new type of stable asset in development at Mento Labs. A stable asset backed by nature.

The key concept to learn in this article is that economic and financial mechanisms can be designed in a more nature-friendly way, an area called Regenerative Finance. One project in that area is the Mento Labs ReFi Stable Asset - a stable asset backed by digital environmental and other regenerative financial assets.

Digital Environmental Assets

What are digital environmental assets (DEAs)? DEAs are digital representations of assets that encompass everything from carbon to biodiversity to clean water. These assets are usually tokens or NFTs on a blockchain for transparency and market infrastructure. They can make the value of pieces of nature priceable and tradable. For a deeper dive into DEAs I recommend this article from our partners in the Climate Collective.

Regenerative Finance

DEAs are part of a larger movement - Regenerative Finance (ReFi). ReFi describes a movement toward economic and financial models that encourage regeneration, not exploitation, of communities and our environment. It relies on regenerative economies, putting a price on negative externalities which is often missing in our current economic system. Those who create negative externalities like carbon emissions are charged, while those with positive externalities like untouched forests are rewarded.

“ReFi is a beautiful idea – a re-imagining of the financial system using the tools humanity now has at its disposal to better account for the needs of all stakeholders, current and future.” writes Packy McCormick in his article about Celo, a climate-positive Layer-1 blockchain.

State of ReFi Markets

The digitization of ReFi assets is in its beginnings. ReFi markets on blockchains are facing challenges that are typical to developing markets. There are not many people participating in these markets and trading these assets yet. The financial term for that is illiquidity. In other words, it’s hard to buy and sell large quantities of these assets without substantial loss in value. This leads to volatility, which can be understood as an instability in market prices over time. Like with many new technologies in regulated industries, it takes time for user adoption and until government rules are developed. This legal insecurity makes it hard for big institutional money to enter the space and drive the technology forward. From a business perspective, this is a chicken-and-egg problem. Buyers are only joining a market when there are enough products and services available, while sellers only join when there are enough buyers.

The ReFi market is in need of a jumpstart. But how can you jump-start a market?

Let us step back from ReFi for a moment and think back to the beginnings of the broader blockchain and crypto space. One critical piece in their market development was the introduction of stablecoins, stable assets that are pegged to a fiat currency. They gave users a stable store of value as well as a unit of account in return, which are important functions for everyday use and trading. Coming back to ReFi, a green stable asset might be part of the chicken-and-egg problem solution. Creating a green stable asset might help to solve the market jumpstart problem for ReFi by creating a use case for volatile ReFi assets and building an asset that has more utility for users, like stablecoins compared to regular crypto assets. Let us therefore take a look at how stable assets are usually created.

Stable Assets

Stable assets are crypto assets that remain stable in value over time. There are different approaches to creating a stable asset, which I won’t explain here, but a good overview can be found in this article on the Celo blog by Asa Oines.

What most stable assets have in common is that they are usually created by something called Collateral Debt Positions (CDPs). CDPs are a widely used traditional financial mechanism for creating loans, where some debt position is borrowed against a collateral position. In the traditional world, every loan seems to be some sort of CDP. A mortgage is for example collateralized by the value of the property and future income. In Decentralized Finance (DeFi), a loan can be borrowed against a crypto asset, which created a whole industry of lending and borrowing protocols. Maker DAO pioneered that approach for stable assets, where DAI can be borrowed against an over-collateralized position of for example, Ether or USDC. For a more detailed explanation of the creation of stablecoins with CDPs, I recommend Dankrad Feist’s superb article on the supply and demand for stablecoins.

All stable assets, except algorithmic ones which proved to often fail, are usually backed by one or more collateral assets. To a large degree, the quality of the collateral determines the stability of the stable asset. Also, fiat-backed stablecoins like USDC or Mento’s stable asset can be seen as a special case of the CDP mechanism. USDC is backed one-to-one by Fiat US Dollars, for example, while Mento’s or Maker's stable assets are backed by a diversified crypto reserve. In Mento’s mechanism, there is one large CDP for all stablecoins, and the whole collateral reserve, while for Maker there are many smaller CDPs.

If the collateral assets are volatile in value, the stable asset needs to be backed by more than one-to-one to reduce the risk of under-collateralization and with it a possible bank run and loss in value. The more volatile the collateral, the more safety buffer it generally takes.

Recapping from my first article, our goal is to back money by something with a climate-positive and regenerative impact. Exactly this stable asset mechanism can be used to actually do that. Here comes the ReFi stable asset.

ReFi Stable Asset

The ReFi stable asset is a new type of stable asset. Instead of being created and backed by regular cryptocurrencies or fiat money, it will rely on DEAs and other ReFi assets.

The ReFi stable asset protocol enables users to create CDPs - borrowing a stable asset debt against a basket of DEAs equity position. These assets will be locked in a managed pool - a technology developed by Balancer Labs. A managed pool is a portfolio of assets with different weights. The weights and asset allocation can be changed over time and a LP-Token digitally represents the share of ownership of that liquidity pool. This LP-token represents a basket of DEAs and can be used as collateral to create and back the ReFi stable asset.

The ReFi stable asset therefore enables users to hold a diversified and lower volatility version of a basket of digital environmental assets and they will be able to support a new form of climate-positive money. The protocol can be used as a source of liquidity, leverage, and yield. Several benefits for both borrowers and lenders arise. Borrowers are in this case the stable asset suppliers, while lenders are the stable asset users.

Borrowers will be able to get liquidity, leverage, and yield on their often illiquid digital environmental assets. With that protocol, multiple smaller illiquid ReFi assets are pooled and can become more liquid with the LP-token of that pool.

Users will be able to use a new form of money with a positive impact on the environment and participate in a diversified, lower-volatility token of digital environmental assets. The stable asset can also be used in the protocol to earn rewards.

The impact on ReFi market can mostly be in two areas. Firstly, larger ReFi asset positions can become more liquid and usable by borrowing against them. Secondly, if the ReFi stable asset gains traction, demand for ReFi assets will automatically increase.

I can also imagine several use cases in the Celo and Mento ReFi ecosystems. The Mento Reserve is looking for a liquid and solid ReFi asset for several years now without finding one. The ReFi stable asset could be a good candidate for future addition to the diversified crypto reserve. In the Celo ecosystem, while the Celo Dollar seems to be the base currency now, the ReFi stable asset can be an even greener and more mission-aligned alternative in the future.

This new type of stable asset can help solve the challenges that ReFi markets currently face. But one critical piece is still missing: How does the value of the stable asset remain stable? This will be the topic of the next parts of this blog post series. It will be about stability and monetary policy, and how stable assets remain stable over time.

If you want to keep up to date with these topics, you can follow Mento Labs on Twitter or join the Mento community on Discord.