Real-World Assets in DeFi: Driving Mainstream Adoption of Decentralized Finance
by Hannes Detlefsen on May 11, 2023 5:29:00 PM
In the era of DeFi, Real World Assets (RWAs) have emerged as a transformative force, offering the potential to democratize access to various asset classes and reshape the financial landscape. These assets currently exist off-chain but are tokenized and brought on-chain to be used as a source of yield within DeFi. Traditional financial service providers, as well as fintechs and DeFi projects, are relying on tokenization to create the infrastructure for the capital market of the future. By fractionating RWAs into tradable tokens, liquidity is significantly boosted, providing investors with the capacity to participate in the ownership of high-value assets that might otherwise be inaccessible due to their indivisible nature. Concurrently, the nature of public blockchains fosters unprecedented levels of transparency, reducing information asymmetry in asset transactions. Furthermore, smart contracts streamline transactions and remove unnecessary intermediaries, leading to a significant reduction in associated costs. This article explains the process of tokenization and presents various applications of RWAs in DeFi.
Authors: Hannes Detlefsen, Valentin Kalinov
Traditional financial systems (TradFi) rely on intermediaries to handle processes and to ensure KYC, AML, and other regulatory requirements. However, these systems have inherent limitations and inefficiencies that often result in increased transaction costs and hindered access for potential investors.
DLTs, and Decentralised Finance, in contrast, allow the exchange of assets to be traded barrier-free in a shared registry 24/7 and are available to any user with internet access. Up until now, mainly cryptocurrencies such as utility tokens or governance tokens of various protocols have been traded via decentralized exchanges, but there are numerous efforts also to map traditional assets on the blockchain — they are becoming tokenized.
Tokenization of RWAs refers to the process of creating a Web3 native digital certificate for any physical object, financial asset, or digital file. The process involves linking an asset to a uniquely identifiable digital image (token) in a decentralized trade repository and splitting it into either a full or pro-rata number of tokens. The ability to split an asset into a large number of tokens is also known as fractionalization, which lowers the price barriers to investment and makes pro-rata investments accessible to a broader spectrum of investors. Tokenization can therefore increase divisibility and liquidity, lower costs of price discovery, and create less fragmented markets, especially for real-life assets that currently do not have high market liquidity.
Technically, these are database entries within a DLT that represent (a share of) an asset and can be held as proof of ownership. The issued tokens can be used, owned, and transferred by the holder, while the role of previous intermediaries and analog proofs of ownership becomes increasingly less important.
Examples of frequently tokenized assets are real estate, securities, rights, or even art. Here are some advantages of tokenization:
- Cost reduction: Increases in efficiency and elimination of intermediaries and custodians
- Tradability and Speed of Settlement: Automated settlement of processes via smart contracts; Trading is possible 24/7, 365 days a year
- Accessibility: Private investors gain new investment opportunities; Fractionalisation enables small-scale investing
- Increased transparency: Transaction data is recorded publicly in a common register; Transparent and immutable transaction history
Until now, tokenized projects have often been issued on permissioned forks of Ethereum which reduces the efficiency benefits of the blockchain and the associated tokenization.
Tokenized Assets in Decentralized Finance
A narrative in DeFi that is being adopted by more and more protocols is the relevance of described tokenized assets. The idea is that RWAs that exist off-chain are brought on-chain through tokenization and can be used as a source of yield in various DeFi protocols.
Real World Assets (RWAs) offer several attractive features for the DeFi ecosystem:
- Diversification: Integrating RWAs allows DeFi platforms to diversify their portfolios beyond digital assets. This diversity reduces risk by limiting exposure to the highly volatile cryptocurrency market.
- Stability: RWAs are typically less volatile than cryptocurrencies, as they are anchored to real-world economic activities. This stability makes DeFi more attractive to risk-averse investors.
- Increased Liquidity: Tokenizing RWAs unlocks previously illiquid assets, making them easily tradable and accessible, which significantly increases the overall liquidity within the DeFi ecosystem.
- New Investment Opportunities: The inclusion of RWAs opens up new opportunities for investment and collateralization, potentially attracting more participants to the DeFi ecosystem.
- Financial Inclusion: RWAs democratize access to assets that would otherwise be out of reach for many investors, particularly in regions with less developed financial infrastructure.
The area of RWAs on public blockchains has already gained considerable importance and is also becoming increasingly relevant in percentage terms, as the following data from the Ethereum Blockchain shows:
TradFi institutions such as Goldman Sachs or Siemens have announced that they are working on bringing RWAs on DLTs. Likewise, crypto protocols such as MakerDAO and Aave are working to make their platforms compatible with RWAs.
The new investment vehicles allow the DeFi sector to tap into a promising market beyond the current roughly $1 trillion in digital assets by targeting the traditional financial sector with over $600 trillion in assets. If implemented successfully, this could lead to significant growth potential for DeFi and pave the way for further diffusion and adoption of digital assets.
The different types of RWAs in the DeFi ecosystem can be differentiated as the following:
Equities and Real Assets
Stablecoins are one of the most relevant use cases in this context.
Stablecoins are crypto assets that are created with the function of linking their value to a specific underlying asset — usually a fiat currency. They represent an on/off ramp and also allow investors to reduce their risk in volatile times without having to leave the ecosystem.
Besides stablecoins, the most widely used assets so far are real estate, climate-related underlyings such as carbon credits and public bonds/stocks.
However, the strict regulation of the public markets and the complexity of the off-chain components have so far limited the adaptation of backed tokens.
In addition to backed tokens, there are also decentralized exchanges for derivatives that represent values such as shares and make them tradable on the blockchain without having a physical underlying, e.g. Synthetix.
Besides equities and real assets, fixed-income securities represent a relevant DeFi Use Case. Private credit offerings in DeFi already comprise a volume of over $4 billion, and as described earlier, fractionalisation lowers the barriers to entry for potential investors. In this context, DeFi is developing a new market dynamic, as not only credit funds or investors of similar size have the opportunity to invest, as traditionally, but also private investors who are invigorating the DeFi ecosystem.
Broadly speaking, fixed income investment products can be divided into public credit and private credit. Public credit refers to a market of debt instruments that are publicly tradable and issued by governments, such as government bonds. Private credit, on the other hand, refers to a market for debt instruments issued by non-governmental legal entities or individuals, such as corporate bonds. These debt instruments are usually less liquid than public credit, as only a special class of investors has access to these markets.
Private credit can be further subdivided into asset-backed private credit and unsecured private credit.
Asset-backed private credit is a well known type of debt instrument in DeFi. Here, one can borrow through overcollateralization, for example by locking ETH into a smart contract. Over collateralization makes it possible in the decentralized world to extend credit without knowing the counterparty. Since the counterparty’s default risk is unknown, a higher value is deposited as collateral than is issued as a loan. These high capital costs reduce capital efficiency and present barriers to entry for users with little on-chain capital. Possible use cases for RWAs in this context would be collateralization in the form of RWAs, as well as borrowing RWAs with overcollateralized backing.
The unsecured private credit is extremely rare in DeFi so far. Protocols that offer unsecured personal loans need to minimize their risk by conducting KYC processes and background checks to verify the creditworthiness of each user. Wallets are typically whitelisted for both lenders and borrowers to subsequently allow free trade between authenticated parties. In this context, zero-knowledge proofs are an interesting development that allow identity to be verified on the blockchain without exposing it to everyone.
The protocols utilizing this form of credit are often criticized because they deviate from the basic idea of DeFi and create problems such as the possibility of censorship. In the past, the Stablecoin Issuer Circle, for example, had the option of freezing blacklisted wallets and removing their access to USDC. However, these protocols implement many components of traditional DeFi protocols and strive to be both regulatory compliant and DeFi compliant.
The developments described above obviously involve a trade-off, but one that should be viewed with caution, as the financial products described have great potential, especially in an institutional context.
Protocols in the RWA Context
Through a partnership with Huntingdon Valley Bank, MakerDAO was able to secure its stablecoin DAI with Real World Assets (RWA), increasing the stability and liquidity of DAI. This partnership resulted in a significant increase in revenue for the protocol and by December 2022, RWAs accounted for around 70 percent of revenue. The founder of MakerDAO, Rune Christensen, proposed to limit the share of RWAs in the portfolio to a maximum of 25 percent to maintain decentralization, presumably because DAI had recently been criticized for its high share of backing of USDC, a centralized stablecoin. Currently, the MakerDAO platform holds around $680 million worth of RWAs, up from just $40 million in December 2022.
Ondo Finance has launched a tokenized fund that allows stablecoin holders to invest in bonds and US Treasuries in order to facilitate access to traditional capital markets. Ondo Finance aims to help investors switch between stablecoins and traditional investments, with a focus on highly liquid and low-risk products such as short-term US government bonds.
Investors in the fund will receive tokenized ownership of the fund and will be able to transfer their ownership to other whitelist investors. The fund will launch with three share classes offering a range of institutional-level return opportunities: Ondo US Short-Term Government Bond Fund (OUSG), Ondo Short-Term Investment Grade Bond Fund (OSTB) and Ondo High Yield Corporate Bond Fund (OHYG).
The classification of Maker (MKR) according to the ITC
The International Token Classification (ITC) is a multi-dimensional, expandable framework for the classification of tokens. In this example we will classify the MKR token according to the latest version of our ITC.
Economic Purpose (EEP): MKR is listed as a Governance Token (EEP22NT02) due to its design.
Industry Type (EIN): The issuer of MKR is active in the field of Decentralized Lending, Saving and Asset Management (EIN06DF02).
Technological Setup (TTS): MKR is an Ethereum ERC-20 Standard Token (TTS42ET01).
Legal Clam (LLC): MKR does not entitle its holder to any legal claim or rights against the issuing organization, therefore, it is listed as a No-Claim Token (LLC31).
Issuer Type (LIT): The dimension “Issuer Type” provides information on the nature of the issuer of the token. MKR’s platform is built by private company. Its Issuer Type is an Private Sector Legal Entity (LIT61PV).
Regulatory Framework (EU) (REU): The dimension “Regulatory Status EU” provides information of the potential classification of a token according to the European Commission’s proposal for a Regulation on Markets in Crypto Assets (MiCA, Regulation Proposal COM/2020/593 final). MKR qualifies as a Utility Token (REU52) according to the definition provided in Article 3 (5) of Regulation Proposal COM/2020/593 final.
Consensus Mechanism (TCM): The dimension describes the mechanism that is deployed to achieve consensus on the token’s distributed ledger. MKR tokens are issued on Ethereum; therefore, they are listed as Proof-of-Stake (TCM71PS).
Type of Maximum Supply (EMS): The dimension describes the token’s type of maximum supply. If the MakerDAO system is governed well, the total amount of MKR will decrease which makes the MKR token Deflationary in nature (EMS82DF).
Primary Mode of Origination (EMO): The Dimension Type of Maximum Supply forms part of the Economic Dimensions Group and describes the token’s type of maximum supply.The MKR token is listed in the Tokenbase as Sale (EMO92).
Taxes (RTA): One common distinction can be drawn between crypto-assets: those crypto-assets that resemble ‘conventional’ assets, like securities, and which are merely recorded on DLT systems (Conventional Asset Tokens DTA71), and those assets and activities that raise new regulatory challenges such as virtual currencies (New Asset Tokens DTA 72; OECD 2020). MKR is listed in the Tokenbase as a New Asset Token (RTA72).
If you are interested in learning more about RWAs, please also read our article on Ondo Finance (https://itsa-global.medium.com/defi-insight-investing-in-bonds-and-us-treasuries-with-ondo-finance-3c4c08ddc6c1).
The International Token Standardization Association (ITSA) e.V.
The International Token Standardization Association (ITSA) e.V. is a not-for-profit association of German law that aims at promoting the development and implementation of comprehensive market standards for the identification, classification, and analysis of DLT- and blockchain-based cryptographic tokens. As an independent industry membership body, ITSA unites over 100 international associated founding members from various interest groups. In order to increase transparency and safety on global token markets, ITSA currently develops and implements the International Token Identification Number (ITIN) as a market standard for the identification of cryptographic tokens, the International Token Classification (ITC) as a standard framework for the classification of cryptographic tokens according to their inherent characteristics. ITSA then adds the identified and classified token to the world’s largest register for tokens in our Tokenbase.
- The International Token Identification Number (ITIN) is a 9-digit alphanumeric technical identifier for both fungible and non-fungible DLT-based tokens. Thanks to its underlying Uniform Token Locator (UTL), ITIN presents a unique and fork-resilient identification of tokens. The ITIN also allows for the connecting and matching of other media and data to the token, such as legal contracts or price data, and increases safety and operational transparency when handling these tokens.
- The International Token Classification (ITC) is a multi-dimensional, expandable framework for the classification of tokens. Current dimensions include technological, economic, legal, and regulatory dimensions with multiple sub-dimensions. By mid-2021, there will be at least two new dimensions added, including a tax dimension. So far, our classification framework has been applied to 99% of the token market according to the market capitalization of classified tokens.
- ITSA’s Tokenbase currently holds data on over 4000 tokens. Tokenbase is a holistic database for the analysis of tokens and combines our identification and classification data with market and blockchain data from external providers. Third-party data of several partners is already integrated, and API access is also in development.
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Hannes Detlefsen is a Community Manager at the International Token Standardization Association (ITSA) e.V. and has been active in the blockchain field for several years. Currently he is studying Business Administration at the Christian-Albrechts University in Kiel. Besides his experience in the field of digital assets, his main focus is on decentralized finance. You can contact him via email@example.com and connect with him on LinkedIn.
Valentin Kalinov is an Executive Director at International Token Standardization Association (ITSA) e.V., working to create the world’s largest token database, including a classification framework and unique token identifiers and locators. He has over five years of experience working at BlockchainHub Berlin in content creation and token analysis, as a project manager at the Research Institute for Cryptoeconomics at the Vienna University of Economics and token analyst at Token Kitchen. You can contact Valentin via firstname.lastname@example.org and connect on Linkedin if you would like to further discuss ITSA e.V. or have any other open questions.