Real World Assets – How Tokenization Bridges Traditional and Digital Assets
Real World Assets – How Tokenization Bridges Traditional and Digital Assets
By Dominic Weibel (Decrypt D23E03)
Altering the rate environment into hawkish territory highly impacted the DeFi landscape. As the FED stuck to a high pace in raising interest rates in the prior months, the transition from legacy structures to the digital age via tokenizing Real World Assets just accelerated. Off-chain assets entered the main stage of our industry and we outline below why that is reason for excitement.
Key insights
- Tokenization of RWAs is the hot topic in crypto right now and comes with transformative potential. It gained substantial traction as key institutional players such as JP Morgan, BlackRock or Goldmann Sachs enter the space. The RWA narrative brings TradFi closer to decentralized structures and collaboration between both is at levels not seen before.
- RWA protocols bridge off-chain assets with DeFi. Compared to legacy financial structures, they offer increased efficiency, transparency, accessibility, and liquidity. They allow for tangible and intangible off-chain assets to be represented on-chain.
- The first killer use case were tokenized dollars and commodities such as gold. In a high interest environment, tokenized treasuries become the gravitational center as conservative DeFi yields drop below the Federal Funds Rate. An inflection point, as the total value lend to the U.S. government is on an upwards trajectory and already exceeds $600m with substantial headroom, all while offering an average yield to maturity of 5.25%.
- The recent expansion of around $1b in tokenized RWAs was mainly driven by fixed income and other yield bearing assets. These RWAs offer a new source of sustainable yield to on-chain citizens and protocols are quick to catch up to the narrative: MakerDAO and Frax Finance (watch out for FraxBonds in V3) forged RWAs into their business model, Centrifuge leads in RWA lending, while Franklin Templeton Benji Investments, Ondo Finance and Matrixdock dominate the field of tokenized U.S. Treasuries.
- While there are various obstacles to master, including regulatory uncertainty, the area is primed for parabolic growth and is estimated to become a $16t market by 2030, a mere 2% of the overall global asset value. The potential TAM is mind bending and blockchains serving as the rails will need to grow in value alongside to provide sufficient economic bandwidth.
The digitalization of real-world assets (RWAs) will be a momentum-shifting theme for institutional crypto in the year ahead, with stablecoin technology at its heart.
Timo Lehes, co-founder of Swarm
Why even bother?
A historically heavy tightening cycle took control over capital flows. Within that new paradigm, Real World Assets (RWAs) are quickly becoming an area of high interest both inside the crypto industry and outside. According to Coinbase’s Head of Tokenization, traditional financial infrastructures reached peak efficiency, hence, there’s only one path of migration: blockchains. As we outlined in the last Investment Navigator, an increasing amount of DeFi protocols seek exposure to RWAs for various objectives while the purely RWA dedicated on-chain ecosystem is experiencing a Cambrian explosion. The most powerful force comes from Treasuries which offer substantial yields as central banks try to curb inflation. The torch who lit the fire initially and connected traditional financial markets with digital asset infrastructure was stablecoins. At a market capitalization of around $130b and trillions in volume just this year, they are approaching payment giants like Visa. Outside, traditional players like Paypal, that recently launched a stablecoin, JP Morgan, State Street, Deutsche Bank or Goldmann Sachs recognize the immense potential and benefits of tokenization. They are excited about the implications of putting ownership of precious metals, art, securities or real estate on-chain. For instance, Siemens issued a $63m digital bond in February 2023 utilizing Polygon for capital investments. In April, UBS successfully executed its first intraday cross-border repo trade with Broadridge’s Distributed Ledger Repo. Larry Fink doesn’t rule out a financial revolution induced by the efficiency and power of tokenization and the FED is already heavily discussing its impact.
As of writing, a mere 0.06% of the global population utilize the borderless power of DeFi. No surprise that Boston Consulting estimated in a 2022 report that the total amount of tokenized illiquid assets could easily hit $16.1t by 2030, 10% of global GDP, see Illustration 1.
Illustration 1: Tokenized Illiquid Assets by 2030
The enabling technology for all that is a decentralized, immutable and tamper proof blockchain. While the current environment acts as a development catalyst, blockchains had time to mature while the regulatory landscape is taking more shape with every day. Combining that with the benefits of tokenization and we have an explosive cocktail where the abovementioned forecast might even become rather conservative. In a best-case scenario, the BCG report projected a tokenization potential of $68t by 2030 (for reference, global M2 is $98t, global equities are $97t, Gold is $12t). We can already observe the materialization of these forecasts based on data. The RWA category climbed up to rank 8 on Defillama with 28 protocols tracked. YTD, RWAs grew from $125m to $2.4b in TVL. Moreover, the RWA rails being the underlying blockchain heavily benefit from that vast amount of value being settled. Not only will more users and asset managers find a new home on-chain, but as that value is secured and settled on public blockchains, their economic bandwidth will rise alongside as well.
The next generation of markets and securities will be tokenization of securities.
Larry Fink, CEO of BlackRock
Tokenization: process, benefits, and challenges
Tokenized real-world assets are digital tokens that represent ownership of real-world assets, such as real estate, equity, commodities, or art. RWAs are tokenized by dividing them into smaller units and creating digital tokens that represent each unit. These tokens can then be traded on decentralized exchanges or other financial platforms. The process of tokenizing a real-world asset typically involves several steps.
Tokenization process
- A legal framework has to be in place that clarifies ownership rights and makes the tokenization process legally compliant.
- The owner creates a digitized representation of the asset (can be tangible or intangible). As a link between the binary and analog world is necessary, oracles are crucial that provide data feeds for RWA pricing and ensuring accurate collateral valuation for CDPs and internal redemption mechanisms of RWA protocols.
- The digitized asset can then be fractionalized into smaller units or gets assigned a unique digital token. The current market value hast to be set to price the tokens correctly.
- The tokens are then issued to the asset owner or investors. The tokens can potentially be accessible via secondary markets. It usually has a redemption possibility and if applicable, asset management has to be in place for distributing benefits to token holders.
Benefits of tokenized RWAs
- Increased accessibility: Tokenized RWAs can make it easier for investors to access and invest in assets that are traditionally difficult to invest in, such as real estate and private equity.
- Increased liquidity: Tokenized RWAs can be traded on decentralized exchanges, which means that investors can buy and sell them 24/7 without having to go through a traditional financial intermediary.
- Reduced costs: Tokenization can reduce the costs associated with trading assets, such as brokerage fees and transaction costs.
- Fractional ownership: Tokenization allows investors to own fractions of assets, which can make it more affordable for people to invest in high-value assets.
- Improved transparency: Tokenized RWAs are recorded on a blockchain, which makes them transparent and tamper-proof. This can help to reduce fraud and improve investor confidence.
Potential use cases for tokenized RWAs
- Real estate: Tokenized real estate can make it easier for investors to buy and sell fractional ownership of real estate assets. This could help to democratize access to real estate investment and make it more affordable for people to invest in real estate.
- Private equity: Tokenized private equity can make it easier for investors to access and invest in private equity funds. This could help open up the private equity market to a wider range of investors.
- Commodities: Tokenized commodities can make it easier for investors to trade commodities without having to worry about the logistics of storing and transporting physical commodities. This could make the commodity market more accessible to a wider range of investors.
- Art: Tokenized art can make it easier for investors to buy and sell fractional ownership of art pieces. This could help to democratize access to art investment and make it more affordable for people to invest in art.
Challenges of tokenized RWAs
- Regulatory uncertainty: The regulatory landscape for tokenized RWAs is still evolving in many jurisdictions leading to increased risks for businesses to develop and launch tokenized RWA products and services. Securities are one of the key areas, where regulatory frameworks are still insufficient.
- Technical challenges: Tokenizing RWAs can be a complex and technical process. This can be a barrier for businesses that do not have the necessary expertise or resources.
- Awareness: As the developments are still young, investors lack awareness of the benefits of tokenized RWAs leading to a more challenging setup to establish a market for their products and services.
- Default risk: As with many financial products on traditional rails, undercollateralized positions are fairly common and subject to default risk.
The RWA landscape
The RWA landscape is multifaceted and ranges among the more important fields from real estate, climate, private and public fixed income, emerging markets, or private equity. The top 10 RWA protocols by TVL include debt markets, real estate, treasuries and private equity, see Illustration 2.
Illustration 2: Top10 RWA Protocols by TVL
As demand for sustainable yield surges, protocols such as MakerDAO or Frax finetune their business models by incorporating e.g. government bonds into their products and join dedicated RWA projects like Maple or Ondo. Ondo recently launched a yield bearing stablecoin (USDY), aiming to bring institutional-grade low-risk yield on-chain. Stablecoins Even traditional payment giants like Paypal recently launched a stablecoin (PYUSD) together with Paxos Trust Company that is, similar to Ondo’s solution, backed by short-term U.S. treasuries, USD deposits and other cash equivalents.
Most of the protocols that gained traction reside on Ethereum, Polygon and Stellar. There are efforts made however to expand towards Layer2 solutions such as Arbitrum or Base since scaling and transaction cost become increasingly important as adoption continues to grow. For instance, Centrifuge’s liquidity pools have the potential to attract vast liquidity to these rollups with institutional-grade assets. While momentum sustains within the RWA space, more protocols aim to join the flourishing space to secure a share of the cake that is projected to dominate in growth, see Illustration 3.
Illustration 3: Mapping the RWA Ecosystem
Tokenized Treasuries, the new on-chain hype
As the zero-interest rate asset bubble popped, DeFi yields spurred by leverage seeking players faded below the real-world risk-free rate as well. It sparked a wave of protocols trying to figure out the best way to bring the whole grail of yield on-chain. In a quick fashion, a heterogenous landscape of tokenized treasury solutions evolved ranging from passively to actively managed products on the one scale and from highly regulated to unregulated solutions on the other scale. With it, on-chain Treasuries based on sovereign U.S. issued debt became significantly more relevant for the space. Considered the benchmark risk free rate in TradFi, on-chain Treasuries experienced a boom in the recent months, see Illustration 4 as a proxy.
Illustration 4: Daily Active Users on Selected Chains
Blockchain technology is now increasingly used for custody, trading, and settling, amounting to more than $600m in U.S. Treasuries at an average yield to maturity (weighted avg. of all tokenized treasury product assets if held to maturity) of 5.25% at an average maturity (weighted as well) of 0.18 years, therefore rather on the short-term side. The maturity is the period until principal repayment.
DeFi used to attract money based on outcompeting yields while being in a low interest rate environment. With the sudden flip in monetary policy, DeFi finds itself in unprecedented territory, struggling to offer the best yields, being forced to reinvent. Clearly, not only the tough market conditions played a role in the recent trajectory of DeFi’s TVL. As the risk-free rate skyrocketed, the on-chain TVL faced a significant dent with money pulled into traditional financial vehicles and money markets. For instance, Compound pays around 3%, way below the Fed Funds Rate of 5.5%. While this seems dark for crypto, the opposite is true. On the one hand, a relevant part of declining DeFi TVL can arguably be attributed to more capital efficient protocol design. To name one example, UniswapV3 heavily reduced capital requirements while offering more liquidity. More importantly, decentralized protocols adjusted quickly to the altering interest rates and as adoption grows, they will likely be even able to offer the most competitive yield regardless of the current central bank mood. How? By distributing protocol revenues on top of the RWA yield. With Liquid Staking Tokens (LSTs) becoming the competitive yield bearing source for RWAs, we might even see some kind of hybrid restaked solutions that combine the best of both worlds. Moreover, RWAs are a door opener for financial advisors and institutions to crypto.
While this report does not deal with the ups and downs of central bank issued money, it’s reasonable to point out that the term risk free rate in that context is a stretch. To date, any fiat currency eventually faded and in the current environment, we observe an ever-growing debt burden of now $33t, U.S. debt to GDP ratios above 120% and a massive burn rate to maintain that debt at high interest rates. Without a significant boost in GDP, there is a real risk of getting trapped in a debt spiral, not really that risk free isn’t it.
Credit, undercollateralized loans in DeFi
Along with the increasing interest rates, on-chain protocols tapped into traditional credit markets with great success. The private credit market boasts $1.6t in TradFi. Only $0.55b of which is split between 1’748 loans at an average APR of 9.94% carried by on-chain credit protocols that facilitate originations, deal funding or borrower repayments by businesses. Businesses, for instance, usually prefer debt financing as they retain control while getting access to liquidity. One of the key features of decentralized credit protocols is lowering the barrier for entry to said businesses. This holds especially true for emerging markets. While loan adoption is geographically pretty much distributed with some hubs in Mexico, Panama, Peru, India, Nigeria, Kenya or the Philippines, the active loans are mostly allocated within the Consumer, Auto or Fintech Sectors, see Illustration 5.
Illustration 5: Active Loans by Sector
According to key metrics, Centrifuge, Maple and Goldfinch range highest in active loans. TrueFi, Maple and Goldfinch capture most fees while TrueFi ranks first in defaulted loans followed by Goldfinch and Maple. Interestingly, most RWA credit protocols offer substantially higher interest rates, some even up to 10%. While another benefit for DeFi users lies in diversification, RWA credit protocols come with additional default risk for the protocols but also the lenders due to undercollateralized loans and the human component (e.g. KYC, AML, whitelists) that must be handled. There is no such problem in vanilla DeFi given the smart contracts are properly designed. However, primarily small businesses in emerging markets might be a major beneficiary and from the borrower perspective, they are also able to build a tamper proof on-chain credit profile given the transparent nature of blockchains and their ability for sustained provenance.
Conclusion and Outlook
RWAs are primed for growth, period. Three substantial catalysts add fuel to the fire: elevated risk-free rates, technology advancements such as Chainlink’s CCIP and credibility based on regulatory progress as well as the sheer number of commitments by financial powerhouses. Hence, we have a triple point accelerator into off-chain assets.
RWAs will bring more opportunities and diversification potential to the user, DeFi native and TradFi alike. They will democratize access via fractionalization and the open borders of a global network to a spectrum of traditional asset classes, making each of them more inclusive. They will bring liquidity and capital efficiency to illiquid off-chain assets while importing sustainable yield via crypto wrappers. They will render DeFi more compatible with traditional asset frameworks. Bringing the risk-free rate on-chain will arguably also alter the dynamics of the next liquidity cycle as instant and interconnected settlement networks partake. If that was not enough, RWAs will also finally enable us to build traditional investment portfolios fully on-chain.
Tokenized RWAs have the potential to transform the way we invest and trade assets. As technology develops and the regulatory landscape matures, we can expect to see more and more tokenized RWAs come to market and with it, trillions in value that migrate towards blockchain infrastructure. With a sector expected to grow that substantially in the upcoming years, there will be plenty of investment opportunities based on protocols that get the RWA narrative right.
Disclosure: At the time of writing, Dominic Weibel holds BTC and ETH.