The crypto space has had a number of opportunities to achieve mass adoption, but has been slowed by a series of high-profile failures. FTX was a regulation-friendly exchange that promised a bright future for everyone until it collapsed after mismanagement of investor funds. Crypto lender Celsius was also brimming with potential until it went bankrupt, missing $1.3 billion in funds. Poor business practices have continually undermined progress.
We now stand on the precipice of another opportunity for mainstream adoption of blockchain technology: real-world asset tokenization (RWA) has the potential to create a new financial market that combines the choice and flexibility of DeFi with the security 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 in the crypto space have been burned too many times and the industry is on its last lifeline to put things right. Tokenized RWAs could lead to mass adoption of cryptocurrencies or be the final nail in the coffin for the industry.
The risks of a poorly managed tokenization process
In this context, tokenization involves using real assets and creating a token representation that moves on the blockchain. This token can then be used for a variety of activities, allowing people to make better use of their collateral. While the concept is quite simple, the process of making it trustworthy, insolvency-proof and legally binding requires a lot of effort.
First, there is the question of certification. For asset-backed tokens, the typical model is for a financial institution to purchase the underlying collateral from public markets, such as U.S. Treasury ETFs, Tesla or Apple stocks, and then mint a token representing those assets. It is critical that an independent third party acting as a token escrow agent can certify the collateral held so that the token can be minted. There is a huge market opportunity for trusted companies like the Big Four to take on an auditing and certification role for tokenization purposes.
Second, well-documented crypto and DeFi collapses in 2022 have led to greater industry demand for transparency about the collateral held reflecting the tokens traded on-chain.
Following the collapse of FTX, Binance championed Proof-of-Reserves (PoR), where a snapshot of assets held in reserve by a financial institution corresponds to the assets the firm holds on behalf of its customers. Seemingly logical, this approach does not take into account whether the same collateral is used elsewhere after the snapshot is created.
Tokenization providers provide snapshots of assets held in reserve, equivalent to tokens issued on-chain, but more frequently. Swarm, for example, publishes monthly disclosure reports and has announced its intention to move to a real-time verification process, which is currently only prevented by limitations in the Web2 infrastructure.
Finally, token holders need bankruptcy protection. There are some organizations that offer “contract for difference” tokens, which do not entitle the buyer to the underlying asset should the company become insolvent. This approach is based on the health of the company’s balance sheet, which does not need to be disclosed to token holders. It’s a calculated risk that investors must take.
Where does the momentum for RWAs come from?
Private investors in emerging markets – People in regions like India, Africa or South America cannot easily open accounts on platforms like Robinhood or eToro 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 among people in these regions who need a safe haven to invest in while remaining on-chain. Tokenized stocks and bonds are more stable assets for those who want to escape the volatility of cryptocurrencies and their local fiat currencies.
Private investors in established markets – Tokenized assets allow you to do more than just wait for the price to rise or fall. There are many yield-generating activities that DeFi enables. For example, decentralized finance is working on being able to exchange assets from liquidity pools. In DeFi, anyone who contributes liquidity to a pool receives a prorated share of the trading fees on assets exchanged through that pool. By acting as a liquidity provider, retail investors can earn a real return on their collateral.
Over time, retail investors will also be able to lend their collateral at an agreed interest rate, something currently only available to institutions within the traditional financial infrastructure.
DeFi natives – About a third of business development leads for regulated DeFi platform Swarm come from DeFi-native protocols that seek to improve the health of the on-chain lending ecosystem by providing diversified collateral options. An example of this is between Arf, a global liquidity and settlement platform, and Huma Finance, which is building infrastructure for on-chain lending, which announced a partnership to tokenize receivables that can be used for lending to provide liquidity for Cross to create -limit payments.
Centralized crypto exchanges – Most, if not all, major crypto exchanges have a tokenization strategy. Many are looking for ways to offer a diversified range of asset classes to retain the customers they have spent time and money acquiring in their ecosystem. Coinbase CEO Brian Armstrong made the comments to the Wall Street Journal after the SEC filed a lawsuit against the crypto exchange, discussing a vision for a platform where all tokens representing different asset classes could be traded side by side . Developments in European regulation have already made this possible on platforms like Swarm.
Issuers of stablecoins – Since the last bull market, there has been a flight to the quality of reserve assets that support a stablecoin’s peg to fiat currency. For example, US-pegged stablecoins such as MakerDAO’s DAI are diversifying away from volatile cryptoassets and commercial papers towards highly liquid tokenized traditional financial products such as US treasuries. The growth of tokenized short-term U.S. Treasury securities has exploded to over $600 million in 2023 alone.
Traditional financial institutions – Inflation is around 10 percent in the UK, meaning institutional investors need to find a way to get 10 percent out of the economy. One possibility is to make trading more efficient, which blockchain technology offers through disintermediation by automating these functions through smart contracts. As Marex executives Ilan Solot and Mark Arasaratnam wrote, DeFi trades credit risk for smart contract risk, and the level of automation the code offers means it becomes easier for professional traders to trade structures and exotic options to build.
The time is now
Tokenization still feels like a crypto-native story, but there are signs that it will impact other areas of the financial ecosystem. A recent EY market survey on tokenization found extremely optimistic metrics for adoption: 57 percent of institutional investors said they were interested in investing in tokenized assets, with 40 percent saying they were interested in starting this year or next.
As long as tokenization providers get this right, blockchain will achieve mass adoption.
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