The crypto space has had a number of opportunities to reach mass adoption but has been held back by a series of high-profile failures. FTX was a pro-regulation exchange that promised a bright future for all until it collapsed after mismanaging investor funds. Similarly, crypto lender Celsius was brimming with potential until it went insolvent, leaving $1.3 billion in missing funds. Bad business practices have continuously eroded progress.
We are now on the precipice of another opportunity for mainstream adoption of blockchain technology to take place: Tokenization of real-world assets (RWA) has the potential to create a new financial market, one that intertwines the choice and flexibility of DeFi with the safety and regulatory nature of TradFi.
Tokenized RWAs have the potential to realize the promise of DeFi and bring crypto to the masses. However, this is a double-edged sword. Participants within the crypto space have been burnt too many times and the industry is on its last lifeline to get things right. Tokenized RWAs could bring mass adoption for crypto or be the final nail in the coffin for the industry.
The risks of a mismanaged tokenization process
Tokenization in this context takes real-world assets and produces a token representation that moves around on the blockchain. That token can then be used in a plethora of activities, enabling people to do more with their collateral. Whilst the concept is fairly simple, the process to make it trusted, insolvency-proof and legally binding requires a lot of effort.
Firstly, there is the issue of attestation. For asset-backed tokens, the typical model is a financial institution buys the underlying collateral from public markets, for example, US Treasury bond ETFs, Tesla, or Apple stock, and then mints a token representing those assets. It is crucial that an independent third party, acting as token trustee, can attest to the collateral held in custody in order for the token to be minted. There is a large market opportunity here for trusted firms, like the big four, to assume an auditing and attestation role for the purposes of tokenization.
Secondly, well-documented crypto and DeFi collapses in 2022 have resulted in greater industry demand for transparency over the collateral held in custody that mirrors tokens being traded on chain.
In the wake of the FTX collapse, Binance championed proof-of-reserves (PoR) where a snapshot of assets held in reserve by a financial institution corresponds to the assets that the company holds on behalf of its customers. Seemingly logical, the approach does not account for whether the same collateral then gets used elsewhere after the snapshot is taken.
Tokenization providers are providing snapshots of assets held in reserve that correspond to the tokens issued on chain but on a more frequent basis. For example, Swarm publishes monthly disclosure reports and has announced its intentions to move towards a real-time verification process which is currently only prevented by restrictions in web2 infrastructure.
Finally, token holders need insolvency protection. There are some organisations that offer ‘contract for difference’ tokens, which do not entitle the buyer to any claim for the underlying asset should that entity become insolvent. This approach relies on the health of the company’s balance sheet, which does not need to be disclosed to token holders. It's a calculated risk investors must make.
Where is momentum for RWAs coming from?
Retail investors in emerging markets - People in areas like India, Africa, or South America cannot open accounts with platforms like Robinhood or eToro so easily, to access global markets. They also live in places where their local currency is plagued by hyperinflation. In Argentina for example, inflation will reach an average of 147 percent this year, according to ICIS.
Hyperinflation is driving crypto adoption amongst people in these regions who need safe haven assets to deploy into, whilst remaining on chain. Tokenized stocks and bonds are more stable assets for those looking to escape the volatility of crypto and their local fiat currencies.
Retail investors in established markets - You can do more with tokenized assets than simply wait for the price to go up or down. There are many yield-generating activities that DeFi enables. For example, decentralized finance works on being able to swap assets from liquidity pools. In DeFi, anyone who contributes liquidity to a pool receives a prorated share of trading fees for assets swapped using that pool. By acting as liquidity providers, retail investors can generate real yield on their collateral.
In time, retail investors will also be able to lend out their collateral for an agreed interest rate, something that is currently only reserved for institutions within the traditional financial infrastructure.
DeFi-natives - About a third of business development leads for regulated Defi platform, Swarm, are from DeFi-native protocols who are looking to improve the health of the on-chain lending ecosystem by offering diversified collateral options. One example of this is between Arf, a global liquidity and settlement platform, and Huma Finance, which builds infrastructure for on-chain lending, who have announced a partnership to tokenize receivables that can be used for lending, in order to create liquidity for cross-border payments.
Centralised crypto exchanges - Most, if not all, major crypto exchanges have a tokenization strategy. Many are looking at ways to offer a diversified set of asset classes to keep the customers they have spent time and money acquiring, in their ecosystems. Brian Armstrong, CEO of Coinbase, made comments to The Wall Street Journal, after the SEC filed a lawsuit against the crypto exchange, discussing a vision for one platform where all tokens representing different asset classes could be traded alongside each other. Developments in European regulation have already made this possible on platforms like Swarm.
Stablecoin issuers - Since the last bull run, there has been a flight to quality for reserve assets that support the peg of a stablecoin to the denominated fiat currency. For example, US-pegged stablecoins, Like DAI from MakerDAO, are diversifying away from volatile crypto assets and commercial paper and towards highly liquid tokenized traditional financial products like US Treasury bonds. The growth of tokenized short-term US Treasury Bills has exploded to over $600 million in 2023 alone.
Traditional financial institutions - Inflation sits at roughly 10 percent in the UK meaning institutional investors need to find a way to take 10 percent out of the economy. One option is to make trading more efficient, which blockchain technology offers through disintermediation, automating those functions through smart contracts. As Marex executives, Ilan Solot and Mark Arasaratnam, wrote, DeFi swaps credit risk for smart contract risk, and the level of automation that code provides, means it will be easier for professional traders to build structures and exotic options.
The time is now
Tokenization still feels like a crypto-native story but there are signs that this will cross-pollinate into other areas of the financial ecosystem. A recent market survey on tokenization by EY found hugely optimistic metrics for adoption: 57 percent of institutional investors said to be interested in investing in tokenized assets, with 40 percent interested in starting this year or next.
As long as tokenization providers get this right, blockchain will reach mass adoption.
Lead image: upklyak