Tokenization: The next big thing in crypto

by Ryan Shea

Key Take-aways

• Crytpo has received a confidence boost after the world’s largest asset manager filed an application to establish what would be – if accepted – the first spot Bitcoin ETF in the US.
• BlackRock’s digital asset ambitions do not stop there. Like other large tradfi institutions, they see tokenization of real world assets (RWA) as the next big thing.
• Given the pool of RWA is in the order of hundreds of trillions of US dollars it is easy to understand the attraction.
• It is not just private tradfi that is keen on tokenized RWA. The BIS last month publishing a blueprint for a future monetary system with tokenized assets an integral component.
• Crypto companies are also interested, and not just because RWA assets have a market cap 200X that of cryptocurrencies. It could greatly mitigate one of crypto’s perceived problems, its self-referential nature.
• However, tokenizing RWA assets is a more complex process than simply minting tokens on a blockchain and users will face more stringent regulatory requirements.
• One crypto entity that could be majorly impacted by this is MakerDAO, a defi crypto lender at the vanguard of tokenized RWA.

What a difference a few months makes. Last October, in the aftermath of the failure of FTX, the whole world and his dog seemed to be writing off crypto, consigning it to the dustbin of financial history. The extinction event was upon us, or so we were told by the naysayers. Fast forward to today, and despite the best efforts of the US authorities to thwart (either by accident or design [delete as you feel appropriate]) its fledgling crypto industry by shutting down some crypto-friendly banks and adopting a regulation-via-enforcement approach, all of a sudden things are looking up.

BlackRock, the world’s largest asset manager with AUM of $10tr, recently filed an application to establish what would be the first spot Bitcoin ETF in the US and given their track record of successful ETF listings (575-1) the odds of it going through look good¹. Additionally, numerous other large financial institutions are either following suit or, via alternate avenues, seeking to increase their exposure to crypto.

Obviously, that companies representing such large pools of private capital are embracing crypto is welcome news for the bulls. But offering their clients cryptocurrency-based products is just the tip of the iceberg when it comes to tradfi’s digital asset ambitions. Indeed, Larry Fink – BlackRock’s CEO – has previously predicted that the next big thing in finance will be the tokenization of assets². He is not alone in such beliefs. Goldman Sachs, JP Morgan and other large tradfi firms have made similar predictions.

Efficiency + Liquidity = Better

So what is tokenization? In their recently published 2023 annual report, the BIS define tokenization as “the process of representing claims digitally on a programmable platform” and there are a multitude of reasons why this is considered to be the next big thing in finance.

The primary benefit of tokenization is that it does away with legacy financial infrastructures that, having been built out incrementally over many decades, are fragmented and inefficient at recording, storing and transferring value. A great illustration of this can be found in an earlier research note where I compared cross-border money transactions on a blockchain versus the incumbent tradfi correspondent banking system.

Utilizing a blockchain to make cross-border payments is not only cheaper – see chart below - as there are fewer intermediaries who all take a revenue slice from processing the transaction, but settlement (or finality in crypto lingo) occurs in a matter of minutes/hours rather than days/weeks under the current system. It also runs 24/7, 365 days a year.

Source: IMF

Tokenisation of assets not only increases efficiency. Because tokens constitute digital ownership they can be fractionalized. It will be possible, for example, to own 1/100th of an apartment, something that is currently not practical to do. This opens up tokenized assets to a much wider and diverse set of investors as not everyone has access to large pools of private capital. Moreover, these tokens can be traded on secondary markets further enhancing their liquidity. This makes them a particularly attractive option for private assets (private equity/debt) and/or long-term investments. Indeed, one could readily imagine tokenization being used to finance large-scale infrastructure projects (Net Zero anyone?) whose payoffs are typically a long-way off in the future.

I(n) R(eal) L(ife)

In the world of crypto, where the concept of tokenization was born, a token represents a claim of ownership on the value created by the network of users of the blockchain in question. A Bitcoin can, for instance, be considered a 1/21,000,000th of the value people collectively ascribe to the Bitcoin network. With the exception of Casacius Bitcoins³ – see image below - which are physical Bitcoins coins minted by Mike Caldwell that contained the Bitcoin wallet address and the private key hidden under a hologram sticker, cryptocurrencies only exist in digital form. By their very nature they constitute an intangible asset that sits natively on-chain.

Casascius Bitcoins

Source: casascius.com

While tradfi institutions are interested in cryptocurrencies as an distinct asset class – hence the spot Bitcoin ETF filings - their primary focus is the tokenization of what is known in crypto circles as RWAs (real world assets). That is to say assets that exist in the physical world such as real estate, bonds, equities and a myriad of other capital market products. Given this stock of assets is valued in the hundreds of trillions of US dollars (200X the current market cap of cryptocurrencies) it is not difficult to understand the attraction.

Moreover, it is not just the private sector tradfi firms that have their eyes on tokenization. Just last month the IMF⁴ and the BIS⁵, who readers of these research notes will recall have been tasked by the G20 to publish papers and recommendations seeking to establish standards for a global crypto regulatory framework this year, published their visions for the “future monetary system” and tokenization was an integral feature.

Strength Through Unity⁶

In their Annual Report, the BIS outlined a new blueprint for a future monetary system, the key elements of which are CBDCs, tokenized deposits and other tokenized claims on financial and real assets. To bring all of these elements together they are proposing a new type of financial market infrastructure – a “unified ledger”.

According to the BIS,

“[A] unified ledger transforms the way that intermediaries interact to serve end users. Through programmability and the platform's ability to bundle transactions ("composability"), a unified ledger allows sequences of financial transactions to be automated and seamlessly integrated. This reduces the need for manual interventions and reconciliations that arise from the traditional separation of messaging, clearing and settlement, thereby eliminating delays and uncertainty. The ledger also supports simultaneous and instantaneous settlement, reducing settlement times and credit risks. Settlement in central bank money ensures the singleness of money and payment finality.”

What they envisage is a radical redrawing of the global financial architecture, one that seeks to leverage the benefits of infrastructure that has been developed by the crypto industry because it is demonstrably superior to the incumbent, organically evolved, tradfi system. Not a bad result for an industry kickstarted by an anonymous cypherpunk just over 14 years ago!

Of course, what Satoshi Nakamoto brought to the world with Bitcoin and what the BIS is proposing are radically different. The former designed a trust-minimizing system for creating digital money that freed its users from having to rely on a centralized public issuer with a penchant for debasing its value, whereas the set-up outlined by BIS keeps a centralized public money issuer right at the heart of things – see image. Indeed, the BIS states this explicitly when it concludes, “the development of a wholesale CBDC is core to the functioning of a tokenised environment.”

Source: twitter

Given the BIS is colloquially referred to as the central banks’ central bank, it is not at all surprising their blueprint keeps central banks at the core of the financial system. It makes sense from their perspective. However, in support of their proposal, they argue that even though crypto has a better tech stack than tradfi, it is flawed as a potential replacement because crypto lacks the anchor of the trust in money provided by the central bank and because its self-referential nature means it has little connection to the real world.

The former point is complete nonsense for reasons I have elaborated on in an earlier research note, but the latter point is certainly valid.

As I have outlined previously, last year’s crypto winter was exacerbated because crypto lenders issued loans based almost exclusively on the value of other crypto assets. During the 2020-21 bull market this combination of leverage and high correlation produced spectacular returns, but when the cycle turns as it inevitably does, it produces equally spectacular losses (and took down many crypto lenders in the process).

Crypto players are not stupid. Like their tradfi counterparties they too see tokenization of RWA as a major positive and not just because of the huge potential pool of assets that could be tokenized. RWA tokens would also greatly mitigate crypto’s self-referential issue, because their value would be based on assets generating cash flows derived from real economic activity, reducing the speculative component of crypto demand and bringing much-needed diversification to the industry. However, pivoting to a model where crypto-assets are backed by RWA will almost certainly entail some sacrifices for the DeFi community.

TradFi (Probably) Has The Edge

Unlike cryptocurrencies, which as mentioned are natively on-chain, tokens representing RWAs are simply an on-chain digital title of ownership of an off-chain asset (exceptions include intangible RWAs, such as equities or bonds, that are issued on-chain, something that has only just begun to happen⁷). As a result, tokenizing RWA is a more complex process. Due diligence in the form of an audit is required to verify the RWA’s unique characteristics to be included on-chain and they must also be custodied to ensure safe and secure storage. Finally, those engaged in tokenizing RWA must determine what regulations and legal requirements need to be applied because in light of the recent actions by the SEC it is clear that tokenized RWAs will be deemed securities. As a result, companies issuing them will have to carry out rigorous KYC/AML checks on their clients and they will be obliged to store transaction histories for tax purposes.

The regulatory standards that are almost certain to be applied to RWA-backed tokens favours tradfi firms over crypto firms because they have a long history and considerable experience operating in a highly regulated environment. In addition, Tradfi institutions have long-standing relationships with the issuers of RWA, and combined these two effects probably mean tradfi firms have an edge when it comes to the nascent tokenized-RWA market.

Blockchain Trilemma

One assumption often made in the crypto community is that tokenized RWA will sit on public blockchains. However, it is far from clear that this will be the case if tradfi institutions take the lead in tokenizing RWA.

According to the blockchain trilemma, a problem well-known in crypto circles, only two of the three following characteristics can be achieved at a given point in time: scalability, security and decentralization. In a future where RWA assets worth hundreds of trillions of US dollars are tokenized, which of those three attributes do you think will be sacrificed? Certainly not scalability nor security. The casualty will, of course, be decentralization.

Decentralization, namely splitting up authority and oversight from a single/small select group to a wide diverse group, is the foundational principle of blockchain because it is the mechanism to ensure trust-minimization.

For crypto users, trust-minimization is considered a valuable, if not integral, aspect of blockchain technology. It was, after all, what motivated Satoshi to come up with the blockchain design in the first place. However, tradfi firms are much less concerned with trust-minimization because they are used to operating in a trusted environment as it is a key requirement to make finance work with today’s infrastructure. Hence, if tradfi firms take the lead then one cannot simply assume tokenized RWA will sit on a public blockchains. It is quite plausible that tradfi firms will see their goals as being better achieved by using private, permissioned blockchains (especially as it will also be a better-fit with the BIS’s blueprint and hence will likely receive their blessing).

DeFi fans may, of course, riposte that there is no reason why one public blockchain should be used to tokenize RWA, numerous public blockchains could be deployed and connected (interoperability) in order to generate sufficient scale and capacity. They are totally correct, but it will be market forces that determine what infrastructure will be developed to support tokenized RWA, shaped of course by the requirements imposed by the regulators.

That is not the only challenge regulatory requirements present for the DeFi crypto community embracing tokenized RWA: anonymity, for example, is a big no-no. This represents a serious challenge for one leading DeFi lender, MakerDAO.

Meet Your Maker

MakerDAO – a decentralized crypto lender that uses crypto deposits to back its DAI stablecoin - has been one of DeFi’s leaders in RWA tokens. Over the past two years, Maker’s RWA holdings have increased to $1.2 billion in an attempt to diversify its reserves and reduce its reliance on crypto-assets and stablecoins – see chart.⁸

MakerDAO – Assets by Type (USDbn)

Source: Dune (@steakhouse)

Given the implosion of numerous crypto lenders last year, something that greatly exacerbated the crypto winter as already mentioned, the timing of MakerDOA’s move into RWA proved to be extremely fortuitous. Indeed, as can be seen in the following chart, RWA revenues have risen to an annualized rate of $53mn, accounting for just over half of the total.

MakerDAO – Revenues by Assets (USDbn)

Source: Dune (@steakhouse)

Despite the short -term success of their RWA programmes, the problem facing MakerDAO is that, as mentioned, tokenized RWA are almost certainly going to be deemed securities by regulators. This means that holdings and transactions in them will have to be recorded using personally identifiable information. However, MakerDAO uses anonymous delegation voting to drive its governance process and this includes decisions in relation to its RWA programmes. Because Maker has to partner up with a tradfi bank to act as Trustee⁹ for the RWA, it is possible that this is sufficient to assuage regulators’ concerns, but given the ultimate beneficial owners of these RWA are anonymous holders of the Maker token this may well not fly. We will have to see, but my guess is that MakerDAO will have a hard-time finding a practical workaround that maintains the anonymity of Maker holders while satisfying the regulators.

Concluding Remarks

As I have outlined tradfi companies, crypto companies and even central banks are all keen to see increased tokenization of RWA. With so many powerful and interested parties, there is very little doubt that tokenized RWA will be the next big thing. The question though is how will the sector develop because they each have radically different visions for the future.

Crypto companies envisage a future where they are able to raise financing for projects from a large swathe of the population, a democratizing process that disintermediates parasitic private VC funds and bankers, where users funds and investments are safeguarded by virtue of always being visible on a public blockchain. Tradfi firms, by contrast, see RWA tokenization as a way to reduce costs and streamline their business models, while the BIS, if it gets its way, sees RWA tokenization as a key component of a radical redrawing of the global financial architecture.

It will be interesting to see how all this plays out. Tokenized RWA could be a huge positive for the crypto industry but equally it could be viewed as a trojan horse that allows tradfi institutions to see off the threat from crypto companies whilst also enabling central banks to safeguard their position as the unchallenged monetary authority.

Personally, I am not overly concerned about the latter aspect. No matter how much they leverage on the infrastructure developed by the crypto community over the past decade neither tokenized RWA nor a unified ledger can overcome the problems with the global fiat money system. As a result, there will always be demand for private decentralized cryptocurrencies running on public, permissionless, blockchains.

Crypto prevails!¹⁰

Until next time.

Ryan Shea, Crypto economist

1After the SEC said that BlackRock’s initial filing was inadequate because they didn’t name the underlying market in the SSA (surveillance sharing agreements), BlackRock resubmitted its application naming Coinbase. That the SEC didn’t simply reject the application outright is, in my view, bullish as it shows the regulator engaging with BlackRock, which increases the probability that a spot ETF application will eventually succeed.

2See: https://www.forbes.com/sites/davidbirch/2023/03/01/larry-fink-says-tokens-are-the-next-generation-for-markets/

3Production of these physical Bitcoins were suspended in 2013 after the US Treasury informed Mike that minting these coins required a state license and federal registration. They have subsequently become collectors items.

4See: https://www.imf.org/en/Publications/fintech-notes/Issues/2023/06/16/The-Rise-of-Payment-and-Contracting-Platforms-534794

5See: https://www.bis.org/publ/arpdf/ar2023e3.htm

6Part of a slogan from the film V For Vendetta. The full quote is “Strength Through Unity, Unity Through Faith"

7See: https://www.coindesk.com/markets/2023/03/22/blockchain-based-debt-protocol-obligate-records-first-bond-issuance-on-polygon-network/

8Fiat-backed stablecoins such a USDT and USDC are also, technically, tokenized RWA assets because they represent on-chain representations of off-chain assets, but given they do not generate interest (that goes to the token issuers), they are a special case.

9For more details on the structure of one of MakerDao’s RWA programme – see: https://www.rwa.company/blog/x6emykhzcnxta1jjupvmks0yllyzkx

10A play on the slogan “England Prevails”, which is another quote from the film V for Vendetta.