Explainer: tokenization of RWA demystified

Tokenomics consultant Diana Ilieva explains one of the hottest sectors of crypto over the past several years: real-world asset (RWA) tokenization.

Intro

Real-world asset (RWA) tokenization has been one of the hottest sectors of crypto for the past several years, and with better clarity of the regulatory stance of the US, interest is at a current high. The nascent of decentralized finance, blockchain technology, and growing institutional involvement in crypto paved the way for a great variety of traditionally illiquid or inaccessible assets to find themselves on the blockchain - art, bonds, real estate, even private credit. The promise of RWA is simple and attractive - they take an asset, typically accessible only to institutional investors and high net worth individuals (HNWI); and divide it into cheaper ‘fractions’ represented by the tokens. Through this one ‘trick’, you can theoretically transform an illiquid asset into a liquid one and offer it to a broader basket of accredited investors. Not everyone can buy a USD 10 million luxury property, but holding 1/100,000 of it? Maybe. Especially if the promise to sell it easily exists. 

However, several very important questions are looming over the sector, not least of which is the very understanding of what tokenization is and how it can be fully utilised to its potential. In this explainer, we’ll attempt to demystify the pros, cons, and challenges of RWA tokenization.

What this is not: This article is not legal or investment advice. It is a high-level overview of tokenization. Please seek professional services for legal and investment advice pertaining to RWA and their tokenization.

Where it all began - origin of RWA tokenization and the fall of the ‘illiquidity premium’

The evolutionary road of financial markets has been long, slow, and convoluted for most of its history. For a long time, the illiquidity of many assets, now up for tokenization, was sold to investors as a feature and not a bug. Committing funds to long-term uncertainty and irregular pricing of your assets is not for every investor profile, but it offered higher returns, and some did prefer the perceived lesser volatility of the illiquid asset classes. These illiquid markets are not freely accessible to everyone, as not everyone can afford to leave considerable sums for years on end. However, the digital revolution has sped up the process of modernisation and liberalisation of access, and the tokenization of illiquid, expensive, and exclusive real-world assets appears to be the next evolutionary step. The hurdles along the way were and still are plentiful, but in the early days, two stood above all:

• Is tokenization of assets technically feasible?
• Is there even a market for it? 

With the progression of blockchain technology and the creative boom of DeFi protocols in 2020-2021, known as DeFi Summer, the success of multiple diverse financial protocols more or less answered the first question. Further, without intervention from institutions, everyday retail investors were lending, swapping, and even creating highly leveraged and derivative positions. Perhaps there was indeed a market?

Discounting stablecoins from the group of RWA, initial efforts focused on tokenization of real estate with one clear goal: fractionalise real estate ownership, package it as an investment opportunity, and offer it to a larger base of smaller investors. Theoretically, an active market with deep liquidity would facilitate secondary trading after initial purchase from the issuer, and this can be a very attractive proposal for a broad group of investors. The ‘size’ of the fraction to split the asset into is decided, hopefully, based on market research, and is completely flexible and facilitated by code.

Leaving behind the promises (and challenges) of the ‘illiquidity premium’, entrepreneurs and institutional investors expanded their tokenization appetite to other asset classes - commodities, private credit, corporate bonds, and art. The platform for early experimentation with the process of tokenizing this diverse basket of assets was Ethereum - the home of the shining stars of DeFi Summer. Over time, institutional investors launched their own private blockchains to rival Ethereum’s first-mover advantage and perceived primacy in RWA tokenization. JP Morgan Chase forked Ethereum to create their own private blockchain - Quorum, and their JPM Coin, but currently, still over 70% of (confirmed) locked RWA value is on Ethereum (including its L2s*), and pioneering protocols like Ondo have most of their TVL** on Ethereum.

Eventually, institutional interest adapted to a less centralised way of operating. In 2019, Société Générale successfully issued EUR 100 million in covered bonds directly on the Ethereum mainnet. Two years later the European Investment Bank (EIB) executed several issues of EUR 100 million digital bond tranches settled in CBDC. These events demonstrated confidence in the budding technology, proving in practice the security and efficacy of the process. It is believed that the ripple effect of these transactions leads to the continued interest of many other institutional players.

At the time of writing, rwa.xyz analytics show USD 18.7 billion in private credit live on the blockchain, followed by USD 8.7 billion in US treasury debt and USD 2.9 billion in commodities. Blackrock and Franklin Templeton both have launched tokenized MMF (BUIDL, FOBXX), Apollo - private credit vehicles (ACRED), and institutional alternative funds of diverse asset offerings have locked ~3 BN USD on-chain. 

*L2 - a second-layer blockchain, which is built on top of a primary blockchain.
**TVL - total value locked

How the tokenization of RWAs works

Firstly, we’ll review the process of tokenizing RWA from the point of view of the issuer. To tokenize any of the asset classes mentioned so far, it is inevitable that part of the process will be centralised, trust-based, and off-chain. The general steps, which may not all be applicable to each tokenized asset class, are as follows:

1. Procurement of assets;
2. Appraisal or audit of assets;
3. Conceptual product development - how issuance, rebalancing, repricing, and redemptions, etc., will work for the issued token;
4. Technical implementation (in-house or via industry partner);
5. Regulatory compliance - includes incorporation and licensing/registration of a legal entity;
6. Initial offering;
7. Ongoing business operation.

Now let’s expand a bit on those points. 

Procurement: Procurement is obvious, as selling something you do not actually have presents a difficulty of its own, so we will skip point one. However, of course, a valid and verifiable asset must be legally held by the persons or entities attempting to tokenize it. 

Appraisal/Audit: You want to tokenize a building in Dubai? Is the building really there, and is its appraisal accurate? A company tokenizes gold - is the gold really all in its or its partners’ vaults, and is it of the quoted quality? There is an inevitability of trust, centralisation, and regulation to RWA that blockchain has not solved yet. 

Conceptual product development: It’s mission-critical to design a robust and efficient, but attractive token product with all the bells and whistles required by both regulators and the target user. This is the step where you decide whether you tokenize all or part of the asset, what fraction of it a single token represents, and consequently - what will be the initial price of a single token. Further, you must establish the processes of initial and further issuance, price rebalancing, potential burning, and redemptions. 

Technical implementation: The conceptual work can be done in parallel with technical implementation, as in many aspects, both complement each other. Examples include the selection of the initial blockchain for the asset, the selection of the token standard (i.e., ERC-20), and so on. Importantly, technical implementation includes the creation of all mandated and elective token functions and smart contracts. 

Regulatory compliance: A legal team is necessary to sign off on the conceptual plan for tokenization and smart contract functions. They must also register the needed legal entities - this can be a holding company, or, depending on the specific asset, a licensed/registered legal entity with the respective regulator. Procedures for KYC/AML must be established and maintained throughout the whole operation of the company.

Initial offering: While the theoretical details of an initial offering are designed at the conceptual phase, changes can happen up to the actual release. These can include changes to the size/value of the represented asset, the fraction of it represented by a single token (consequently, the total number of tokens), and so on. A release platform is selected and all necessary promotion and precautions are enacted.

Ongoing business operations: This step includes the ongoing procurement and tokenization of assets, if appetite for them exists, the maintenance of liquidity, payout issuance (if applicable), the undertaking of stabilising action, and so on.

Pros and cons of tokenization

From the perspective of the potential user of this market, as long as they complete the required legal work, such as KYC, accreditation, and other documents necessary, they can create a portfolio of varied assets entirely on the blockchain. (The following are examples and NOT investment advice.) They can choose to invest a flexible sum in properties by simply buying tokens; and never be concerned with further legalities of actually holding and maintaining properties. They can invest in gold without being beholden to standard molds. They can hold a fraction of a piece of art that they could otherwise never own outright.

The benefits for the issuers of tokenized assets are more nuanced and case-dependent. However, a few common ones emerge:

1. Enhanced liquidity - this is particularly important for indivisible assets or assets sold in large lots. Fractional ownership can break up buy/sell processes into a small stream of transactions, each informative of the value of the whole asset.
2. Lower barrier to entry for investors - the aforementioned fractioned state of the whole asset not only facilitates more frequent, smaller trades, as a fraction is considerably cheaper than the whole, but it also allows for more participants to engage with the asset class, thus integrating the intent and reasoning of many more players on the market.
3. Reduced operational costs - this is a theoretical benefit, which is highly dependent on each issuer’s operational preferences, capabilities, and not least, on the asset of choice. Some assets have higher associated operational costs, which cannot be avoided via the blockchain. However, many human processes can be automated, and a low-fee chain and protocols can be selected to optimise costs.
4. Faster settlement - it is the impression of the outside world that TradFi transactions already settle near instantly; however, the reality is that a lot of settlements happen in T+1 or T+2 (i.e., the transaction submission day + 1 or 2 days). RWA tokenization can indeed make settlement almost instantaneous and switch the liquidity imperative to intraday liquidity. This can lead to further cost improvements.

There are drawbacks to the whole evolutionary process, which must be considered:

1. Regulatory clarity on practices - if there were ever hopes that a tokenized security is not a security anymore, May’s SEC roundtable seems to have dispelled them, which still leaves a considerable regulatory burden for the issuer and all platforms operating with the assets. More detail is needed still and active collaboration with regulators is paramount. However, a no-action letter from the SEC in September provided some clarity on the question of which types of custodians count as ‘qualified custodians’. 
2. New technical risks to security - the transparent and immutable nature of the blockchain poses a problem when attack vectors are discovered in smart contracts and tokenized securities, and other assets are misappropriated. The questions of recovery and reissuance are not universally settled, as of yet, but legal obligations should hold as per the above point. (Not legal advice, seek legal counsel on the issue.) While private blockchains don’t have these qualities, and hide transactions and can overwrite records, they fail to attract the same level of innovation, capital, and pure crypto enthusiasts. 
3. The balancing act between costs and fees - although operational savings can be made, classes like RE and commodities have a lot of associated costs, which cannot be automated away. Each business must find a balance between absorbing or transferring them to clients via fees that is both profitable to the business and still makes an attractive proposition.

Challenges ahead - can RWA be truly liquid and compliant on the public chain?

The promise of tokenizing assets offers institutions a way through the door of cutting-edge financial innovation:

• Better liquidity; 
• Cheaper programmatic management of complex processes;
• Near-instant settlement of traditionally ‘slow’ transactions;
• A larger client pool. 

However, a number of general and specific challenges lie ahead. The most common expectation of tokenization - increased liquidity, has not materialised even amongst classes such as private credit and treasuries.

The mandate to restore lost securities poses some technical challenges, which can only be fully tested when real-world situations arise.

And yes, tokenized RWA brings new asset classes to the retail investor, but the anonymity of the blockchain is gone for every individual who wants to participate, going against one of its founding principles. How a business will handle the KYC/AML and other compliance continuously is an open question. Favoured technical solutions currently are ONCHAINID and DyCIST, but the history of their application is so far short.

Finally, with the disappearance of the illiquidity premium and the new infrastructure and implementation cost, businesses will have to figure out what is an attractive value proposition for each new asset class, what fees to charge, and when a product does indeed become unattractive to its now larger pool of clients. This is as much a challenge as it is an opportunity, and the transformation of RWA is underway and cannot be stopped.

This article is part of The Paypers’ Explainers section. To access other educational materials from this section, click here. If you have suggestions about other topics that could be included in this section, we invite you to write to us at editor@thepaypers.com.

 
About the author

Diana is a tokenomics consultant at FinDaS Ltd with over 4 years of experience in creating data-driven token economy models for various crypto projects. Diana has created the tokenomics for P2E projects, stablecoins, lending & DeFi protocols, RWA, and consulted on narrow topics like DAO structures and processes. Diana holds a MSc degree in ‘Finance and Banking’ from the University of York. Find out more about Diana here.