How Tokenization of RWAs is Emerging as the Next Killer Use Case

TL;DR

Tokenization of real world assets is reshaping the investment landscape with market sentiment showing 57% of institutional investors interested in investing in them

Institutional interest and growing adoption indicate a shift toward mass adoption, with forecasts projecting a $16 trillion market by 2030

Firms such as Citigroup are referring to tokenization as a ‘killer use case’

The Emergence of Tokenization

Over the past few years, we have seen the adoption of new technology come in waves, much like the eminent professor Carlota Perez has remarked in her Technological Revolutions and Financial Capital research where she explains that bouts of surges precede what appear to be profound downturns, setting the stage for extended periods of flourishing “golden eras”.

A perfect example is the dot-com bubble, where new technology arose that sought to connect the world through a wide web - the internet - and which received considerable criticism, having skeptics even declare it as essentially defunct after the big burst.

Now, more than twenty years later, we have seen how the internet has flourished and transformed the economy as we know it. Think of online retail giants such as Amazon, for example, which have transformed the way we shop.

Blockchain is another such technological revolution, which is currently experiencing the boom and bust cycle we have become acquainted with.

The creation of a new financial model known as DeFi (decentralized finance) has set the scene for a novel manner of doing business; however, the majority of tokens were not tied to anything of value, making them susceptible to a number of issues such as a much higher volatility.

Cue tokenization of real world assets: a process within which traditional off-chain assets are brought on-chain, with the most prevalent example being fiat-backed stablecoins. This went on to become a dominant trend with various asset classes following after.

This new method sees the perfect marriage of traditional assets and blockchain, offering a myriad of potential benefits - such as improved liquidity, efficiency, and financial inclusivity to name a few - whilst adapting to a new emerging technology that is set to change the business landscape once more; so much so that the TVL for U.S. Treasury Bill-related products alone has soared from $100 million at the beginning of 2023 to a current total value of $784 million during the crypto winter per DigiFT research report.

Asset-backed tokens as an on-chain representation of RWAs

Given the nature of asset-backed tokens, it can be surmised that they are a representation of real world assets that have been transferred on-chain to unlock new use cases.

As earlier mentioned, a tokenized RWA consists of a tangible asset in the real world transposed onto the blockchain where a token represents it and its value. Here are some examples of the tokenization of assets that can be executed:

• Government Debt: tokenization can enable composability,accessibility and transparency of government-backed securities, the details of which we explore in our tokenized T-Bills dedicated article.
• Equity tokens: instead of traditional equity shares, startups can issue equity tokens, allowing for easier transfer of ownership amongst investors.
• Real estate: where the ownership of a commercial or residential estate allows for fractional ownership.
• Commodities: such as oil, gas, and precious metals. An example is PAXG issued by Paxos, which represents one fine troy ounce of gold.

As more use cases for on-chain representation of RWAs are found, it is important for issuers to make every effort to remain compliant with regulatory requirements and ensure safety and security.

Source: galaxy.com

Permissioned tokens

Also known as security tokens, these digital assets operate on a blockchain or distributed ledger, but with access controls or restrictions on who can participate: participants must in fact obtain authorization or permission to join and contribute to the network.

As their use gains popularity, it is crucial to consider the legal aspects of issuing them. Given they are often regarded as securities, it is necessary to comply with applicable securities laws, including registration with regulatory bodies for market integrity and investor protection.

To maintain compliance with regulations and legal frameworks, it is therefore essential to rely on token issuers that are recognized and regulated by respected authorities.

Why tokenize TradFi assets

One of the main benefits of the tokenizing of off-chain assets is the ability to fractionalize the underlying asset, enhancing its liquidity. This aspect, however, is not always relevant. With Treasury Bills, for example, liquidity is already a prominent feature. So why tokenize traditional finance assets when the capital market is already highly liquid?

The answer lies in the user base: US Treasury Bills, traditionally, can be invested in by US citizens for as little as $100. Investors from overseas will not find the same ease of access, considering the hussle of opening a brokerage account.

Blockchain technology is the key to expanding the reach of traditional finance assets beyond geographical boundaries. The on-chain tech aids a seamless and inclusive global market where investors from around the world can access and participate in the ownership of traditional financial assets that were once excluded from their reach.

What other benefits can onchain TradFi assets offer for its investors? Read about the example of T-Bills in this article - Closer Look at Onchain T-Bills Strategies.

Security issues

In an effort to safeguard one’s investments, it is crucial to apply best practices to cover vulnerabilities and ensure the integrity of asset-backed tokens. These practices include proper management and verification of the underlying assets, strict procedures for custodianship, and secure smart contract design. Implementing these strategies enhances the security and integrity of asset-backed tokens while minimizing the risks of fraud and exploitation.

In an effort to provide transparency, companies such as Chainlink - a decentralized blockchain oracle network - provide reliable and tamper-proof data oracles that feed off-chain information into on-chain financial transactions for smart contracts. By nature, anyone can verify the accuracy of data used in transactions, offering a high level of clarity to users - another beneficial aspect of blockchain technology being applied to traditional finance.

That said, Web3 is still in its inception phase, and several exploits and fraudulent activities have occurred in the past where regulations were not yet set in place.

A few of them are:

• Fraudulent Issuance: where issuers misrepresent or falsely claim the assets backing the tokens, leading investors to believe they hold more valuable assets than they actually do.
  
  One such incident is the famous OneCoin, a cryptocurrency project founded by Ruja Ignatova in 2014. Widely known as one of the largest scams in the crypto sphere, OneCoin claimed to be backed by a centralized pool of assets, including a mix of fiat currencies, gold, and real estate. Through investigation, it was uncovered that the claimed blockchain technology was non-existent, and the company had no public ledger to begin with.
  
• Smart Contract Vulnerabilities: essentially lines of code, smart contracts are susceptible to hacking if left unchecked. They can be rewritten in order to manipulate the flow of execution and drain funds, or the minting and burning of more tokens than intended.
  
  In 2016, a company known as The DAO suffered from what is known as a reentrancy vulnerability. This led to an attacker draining a significant amount of ETH, causing a contentious hard fork in the Ethereum blockchain.
  
  
• Lack of Regulatory Compliance: though still a point of contention, certain tokens might be viewed by the SEC as securities. If operations do not comply with relevant securities laws, it can lead to legal consequences and regulatory actions.
  
  
• Weak Identity Verification: phishing attacks are ripe both in traditional online settings and in Web3. They have led to users unknowingly providing sensitive information, including private keys, resulting in unauthorized access to their tokenized assets.
  

The best way to avoid the above is to rely on a trusted tokenization issuer that is regulated by an official government body. The stringent standards of security it is held to ensure risks are minimized via use of several tools.

Leaning on companies with a solid reputation can also be a way to mitigate such exploits. By choosing to invest in projects associated with a proven track record, investors can leverage the trustworthiness of these entities to safeguard their interests and navigate the blockchain landscape with greater confidence.

Investors should also be mindful that proper due diligence on their part is pivotal in risk minimization. By investigating that claims are true, the assurance of accurate and transparent information becomes a cornerstone of informed decision-making, ultimately contributing to a more secure and resilient investment strategy.

Source: RWA.xyz

Moving towards mass adoption

Much like the transformative impact of the internet, tokenization has the capacity to revolutionize the way we perceive and engage with assets, ushering in a new era of business models. This, in the finance circles, has been defined as a ‘killer use case’ by the likes of Citigroup, and is speculated to be the gateway to mass adoption of cryptocurrencies and blockchain tech.

Though risks are still present, we are seeing momentum in the usage of RWA tokens mainly stemming from:

• Investors in emerging markets: in an effort to combat hyperinflation which plagues areas such as India, Africa, or South America, users have started turning to blockchain technology, driven by the demand for secure assets as a refuge for deploying funds.
  
  
• Investors in established markets: whereas hyperinflation is not an issue in these markets, individual investors have the opportunity to generate tangible returns on their pledged assets by serving as providers of liquidity. It is speculated that eventually retail investors will have the capability to loan out their collateral at a mutually agreed-upon interest rate, a privilege currently exclusive to institutional entities in the conventional financial framework.
  
  
• Traditional financial institutions: as a new business model emerges, traditional finance institutions are adapting by swapping credit risk for smart contract risk. By making trading more efficient through the deployment of smart contracts, the level of automation that code provides enables traders to optimize their time and experiment with new strategies, structures, and options.
  
  
• Stablecoin issuers: with the growth of tokenized short-term US Treasury Bills having exploded to over $600 million in 2023 alone, coupled with the most recent demand for yield-bearing stablecoins, it is no surprise issuers are now turning towards highly liquid tokenized fixed-income products like U.S. Treasury Bills.

• Onchain Treasuries: tokenized traditional fixed-income assets have become increasingly popular among Web3 companies or DAOs. It provides them with a means to deploy their idle capital to passively earn with low risk exposure.
  

The overall market sentiment certainly echoed the need to move on-chain, with a recent EY market survey on tokenization reporting that 57% of institutional investors showed interest in investing in tokenized assets, with 40% interested in starting this year or the next.

In May 2023, a study jointly released by Boston Consulting Group (BCG) and investment company ADDX projected that asset tokenization's worth is poised to hit $16 trillion by 2030. This figure represents a substantial 10% of the worldwide gross domestic product (GDP). Such a forecast surpasses the $9.6 trillion total assets under management (AUM) within global exchange-traded funds (ETFs) reported by the conclusion of 2022, significantly overshadowing the existing valuation of security tokens, as indicated in the report, which stands at $310 billion.

Citigroup also stated in its March 2023 report that they ‘forecast $4 trillion to $5 trillion of tokenized digital securities, assuming 1% of corporate and quasi-sovereign bonds, 7.5% of real estate funds, 10% of private equity and venture capital funds and $1 trillion of securities financing and collateral activity are tokenized’.

Per the same report, alongside the digitization of securities, the trade finance sector may experience volumes reaching as high as $1 trillion through the adoption of distributed ledger technology (DLT) by 2030. This equates to approximately 8%-10% of the overall global trade finance volumes.

Conclusion

Given these projections, it's evident that investors aiming to stay ahead of the curve should give careful thought to integrating tokenized assets into their investment strategy. The evolving financial landscape, driven by the increasing prominence of digital assets and innovative technologies, demands a proactive approach for those seeking to navigate and capitalize on the transformative shifts in the global market.

• Navigating Onchain Finance