Tokenizing RWA – Back to the Future
The idea of tokenizing real-world assets (RWAs) captured the imagination of many, soon after smart contracts were introduced by the Ethereum white paper back in 2014. The concept was cited as a use case in the whitepaper under the subsection “Token Systems”. Since then, much of the focus had been on blockchain protocol and application development by cryptoasset-native entities. ICOs boomed and busted after 2017, and DeFi and NFTs proliferated over 2020 and 2021 but have lost their luster with the digital assets market pullback of 2022. With the multiple applications for spot bitcoin ETFs this past June and futures-based ether ETFs, TradFi institutions are strongly signaling continued interest in the space. Their work alongside cryptoasset-native companies to tokenize RWAs is worth paying attention to. [1]
Let’s Tokenize Everything
The act of tokenizing investable assets is proving to be a journey with different companies taking small but necessary steps along the way. Each step provides a practical use case for how blockchain technology may improve segments of the existing transactional process leading to ownership. The goal is to capture all sorts of assets from securities (equities, bonds, credit) to real estate, private investments, and art, and place them on the blockchain (on-chain). The purpose is to harness the benefits of a distributed ledger technology (DLT) to provide provenance, transparency, and quicker settlements to reduce risks and costs while improving liquidity, and to leverage smart contracts built for blockchains to provide accessibility, composability, and interoperability.
Work on leveraging blockchain technology has been around for several years. In 2018, our CIO, Ruairi Hanafin, co-founded Grain Discovery, a Canadian based AgTech startup that provides “an online trading platform for physical agricultural commodities that interfaces with a blockchain-based traceability system to allow for farm-to-fork tracking.” Efforts by Grain Discovery proved that the provenance, quality, and other characteristics of agricultural products may be traced on a distributed ledger instead of being handed around with physical invoices or bills of lading.
It’s hard to trace the catalyst for the recent resurgence of attention to tokenizing RWAs. Perhaps the awareness of institutional adoption was sparked by Blackrock’s CEO Larry Fink’s interview at the New York Times Dealbook Summit back in November 2022, where he extolled the virtues of distributed ledger technology (DLT) for enabling the “tokenization of securities” and allowing for “instantaneous settlement”. Quite likely, it is the availability of fatter real-world bond yields that resulted from Central Banks of major economies raising interest rates and TradFi markets pricing in higher inflation risks that became much more enticing compared to the funding yields on cryptoasset exchanges that had collapsed in the wake of 2022.
To be clear, work to date on tokenizing RWAs is still nascent and the actual amount of RWAs on-chain is but a mere speck compared to the overall value of the asset classes. For example, according to rwa.xyz, tokenized US Treasuries account for over $600M on-chain compared to $24.9 T of marketable US Treasuries. Nonetheless, it’s instructive to look more closely at the work that is being done by the two largest providers from rwa.xyz’s chart, Franklin Templeton and Ondo Finance.
Source: rwa.xyz | Treasuries
According to its press release, the Franklin OnChain U.S. Government Money Fund is built on the Stellar blockchain and is “a regulated 1940 Act fund that invests at least 99.5% of its total assets in government securities, cash and repurchase agreements collateralized fully by government securities or cash.” Adhering to the US regulatory framework, Franklin Templeton registered a regulated mutual fund with the SEC. Because the fund is fully regulated, Franklin Templeton is performing full due diligence (KYC/AML) checks on its investors. Purchases and sales of the fund are limited only through interaction with Franklin Templeton via its Benji Investments app. The fund is not available as a token to be traded on a digital assets exchange. The blockchain is used only to record transactional activities and ownership. While this is not a fully tokenized investment asset, the work highlights the regulatory boundaries in traditional finance that Franklin Templeton had to work within to remain in compliance.
Ondo Finance takes a slightly different approach to tokenizing US Treasuries. Its OUSG token represents holdings in a Delaware Limited Partnership (LP) that holds the Blackrock iShares Short Treasury Bond ETF (SHV). Still working within the US 1940 Act fund framework, Ondo opted to use an LP to structure a private offering instead of a mutual fund and require its investors to be both an accredited investor and a qualified purchaser. Once an individual passes that screening, she is eligible to buy the token on-chain with USDC, which then gets converted into fiat USD to buy the SHV. The OUSG is then issued to the purchaser and recorded on either the Ethereum or the Polygon chain. All this seems a bit convoluted given that an investor can simply go to her brokerage account (for which she has already been KYC’d) and buy SHV on the market without any further requirements of being accredited or qualified. But then again, we know that we are far from having regulatory clarity for digital assets and the first products, like the first video games, can be a bit crude.
Where it gets interesting is the tokenization of assets for which the average investor does not have access to. According to rwa.xyz, tokenized private credit currently totals over $550 M in active loans, with the business need coming from a variety of sectors and geographies.
Centrifuge is active in this space. According to their documentation, Centrifuge created their own L1 blockchain, the Centrifuge Chain, to match Asset Originators (businesses requiring credit) with on-chain investors and DeFi protocols (entities with the capital). Real world activities are complex involving agents to originate the loans, structure Special Purpose Vehicles (SPVs), pool the borrowers to tranche the risk, perform valuation services on the SPVs, and perform KYC/AML checks on investors. The SPVs are legally structured as exempt private funds under the jurisdiction of the US Securities Act of 1933. On-chain, NFTs (ERC-721) are issued to represent the issuers’ loans. Centrifuge aggregates these NFTs into its Pool (a smart contract). Investors can provide on-chain capital (stablecoins) to the Pool either directly or from DeFi protocols.
Separately, RealT is a US-based tokenized real estate platform that has been tokenizing houses and apartment buildings, mostly in Detroit and the surrounding areas. Net rental income yields average around 9-10%.
Source: RealT
Off-chain, RealT creates a unique LLC for each property and the LLC issues its own ERC-20 tokens to represent the fractional ownership of the specific property. The LLC also hires a property management company to maintain the physical properties and collect rent. Investors are KYC’d and once successful, have access on-chain to buy the tokenized property using a stablecoin (USDC or XDAI) and to store it using a variety of hot and cold wallet options. Quite unlike a typical real estate transaction, buying a RealT tokenized residential real estate requires investments of only around $50 to $150. Tokenized RealT property prices can be tracked on the secondary market. Here’s one such example for a property located in Detroit.
Source: CoinGecko
With these few examples, we can understand what challenges tokenizing RWAs need to overcome and what opportunities they can offer. Companies that undertake this effort need to work within the existing regulatory framework to permission the appropriate investors and to structure the investment for proper governance, maintenance, and division of investor rights. On-chain, selecting the proper blockchain is important for transactional efficiency and accessing the proper digital assets platforms. Providers need to ensure that smart contract risks and risks of pool and/or wallet hacks are minimized. Real world and on-chain governance need to evolve as investor preferences and legal frameworks evolve.
Done correctly, a broad swath of asset classes may be opened to investors who previously never had access to such assets including private equity and credit, venture, commercial real estate, and art due to the lack of information or the required minimum ticket sizes to make such investments. Tokenized RWAs are composable and may, for example, serve as collateral for traditional or on-chain loans. Tokenized assets may be further augmented with other digitized data, improving transparency for better valuations. For example, commercial real estate may be augmented with electricity and water usage or parking lot traffic to confirm changes in tenancy rates.
All That Glitters [for Tokenization], Is Not Gold
The trend of tokenizing any and all RWAs is generally a good thing but we are in the early stages, and design and usage choices need to be carefully thought out.
For one thing, democratizing access to previously unavailable investment opportunities is not the same thing as providing permissionless financial access that Bitcoin ushered in. The purveyors of tokenized assets are still working within existing regulatory frameworks to select the appropriate investors for their tokenized products. Centralized agents remain in the middle albeit with better efficiency of transactions and interoperability across the different asset classes.
Fractionalization brings along challenges of governance. Consider in the real world, the challenges that that a condominium board must go through to get its owners to vote on building improvements, increasing monthly condo assessment fees, or sometimes even getting a quorum for the annual general meeting. Consider, as well, how many equity shareholders actively vote their proxies regarding board composition and compensation, activist investor proposal, and changes in capital structure. Fractionalization risks compounding this difficultly. Tokenization adds another layer, in that the token holders need to be actively engaged in the governance of the on-chain protocol as well.
Improved access, transparency, and liquidity are generally good for illiquid private assets. However, there can be too much of a good thing. Conventionally, illiquid assets are expected to have an illiquidity return premium. For example, two comparable companies of the same sector and size, except that one is privately held and the other publicly traded, will be expected to exhibit different return potentials. The private firm is expected to be traded at lower prices to provide a higher return to compensate for its illiquidity risk. However, due to increasing interest and higher prices for private investments, Cliff Asness, the CEO of AQR, argued whether private investments should carry an illiquidity return discount instead (The Illiquidity Discount? (aqr.com)). He muses, “pricing opacity may actually be a feature not a bug! … What if many investors actually realize that this accurate and timely information will make them worse investors as they’ll use that liquidity to panic and redeem at the worst times?” Consider the RealT property in the above chart located in Detroit. What significantly changed about that property in a one-year time span such that the prices oscillated from a low of $52 to a high of $70, or close to a 35% spread? Imagine improved liquidity access pushing up residential real estate prices, pricing out renters who may want to buy a property in its entirety. Imagine further that the investors decide to tear down the old building and put up an apartment complex on the same property, leaving renters out on the street. Recent meme stock and token trading prove that prices can get away from intrinsic valuations. One only needs to look to the events around the 2008 Global Financial Crisis to understand how this can pose systemic risks both on the way up and when prices revert and overshoot to the downside.
Tokenization of real-world assets should be a net benefit. Being able to augment the information on private investments and track it on the blockchain provides much needed transparency to an asset class rife with information asymmetry and allows for more informed valuations. Fractionalization opens the door for smaller investment ticket sizes and allows more investors to access a wider breadth of asset classes to diversify their savings. Tokenization on blockchains allows for composability which will enable financial products to work more compatibly with different protocols, settlements to occur more quickly thereby reducing counterparty risks, and collateral to be used more effectively. The road ahead for tokenizing RWAs remains long, requires careful design of the regulatory frameworks and the investment products, and requires proper usage by the investors, but it is one that holds the promise of better and broader financial participation.
Endnotes
[1] This article is written for informational and educational purposes only. Any discussion of platforms, protocols, and/or asset classes is not meant to provide investment advice or an endorsement.