What Are Real-world Assets (RWAs)?
Real-world assets (RWAs) have long captured the imagination of cryptocurrency investors and developers alike due to the sheer size of global markets and easy improvements made possible with tokenization. Moreover, the challenges presented by these traditional markets, such as entry barriers and clunky trading mechanisms, make them ripe for revolution.
RWAs refer to any assets not inherently part of the blockchain on which they are tokenized e.g. they exist “off-chain.” Generally, conversations about RWAs are centered around traditional financial assets like government bonds, private debt, real estate, and even other non-blockchain-based holdings like art or collectibles. While fiat-collateralized stablecoins such as USDT and USDC technically fall under the category of RWAs, they are frequently considered separate and apart from other RWAs due to their relatively uncomplicated nature and use case as a stablecoin.
What is Tokenization?
Tokenization involves the transformation of tangible real-world assets into digital representations through the utilization of secure and transparent smart contracts. Typically, developers design these smart contracts to generate a digital token that corresponds to a real-world asset (RWA). Concurrently, there's an external assurance ensuring that this digital token can always be exchanged for its respective underlying asset.
The concept of tokenization is set to usher in a new age of liquidity and inclusivity for these assets. Citi, a global investment bank, recognizes this potential, heralding the blockchain-based tokenization of RWAs as the impending paramount use case in the crypto realm. Their projections are ambitious, estimating the market value to surge to $4- $5 trillion by the close of this decade. Even the U.S. Federal Reserve has taken notice, recently putting out its own paper on RWAs and tokenization.
Yet, the narrative doesn't end with mere tokenization. Decentralized Finance (DeFi) brings another dimension to the table, broadening the financing avenues for RWAs. The combination of DeFi with RWAs can forge fresh investment yields, catering to participants keen on funding tangible assets.
In essence, the fusion of RWAs and crypto, spurred by tokenization and DeFi, has the potential not only to transform the landscape of asset trading but also to redefine our understanding of liquidity and inclusivity in the financial domain. The coming decade may well herald a paradigm shift, where tangible assets become seamlessly integrated into the digital world.
Why Put RWAs on a Blockchain?
Initially, blockchains found their primary application in the creation and transference of tokens, as seen with tokens like BTC. But, it's the advent of smart contract platforms and decentralized finance (DeFi), that truly underscored the expansive potential inherent in public blockchains.
One of the most transformative attributes of DeFi applications is near-instantaneous settlement. Blockchains combine cryptography with decentralized consensus to provide robust guarantees of finality in economic transactions without the need for middlemen. The removal of intermediaries and the reduction of settlement time from days to minutes/seconds are two critical advantages of DeFi over the TradFi system.
Moreover, the realm of DeFi is characterized by unparalleled transparency. Tools such as public block explorers and data dashboards offer in-depth, discerning insights into risk exposures and the overall collateralization that the TradFi system cannot offer: at least not in real time. Given that public blockchains are perpetually auditable, stakeholders gain a newfound ability to scrutinize asset collateral quality and gauge systemic risk exposure. This continuous oversight also curtails record-keeping disputes, especially when public dashboards elucidate on-chain activities, offering a transparent view of transactions.
In a move towards greater transparency, it's also noteworthy that the source code underpinning DeFi applications is open to the public, enabling any interested individual to scrutinize its architecture.
Cost efficiency is another hallmark of DeFi applications and another reason why some are experimenting with RWAs on a blockchain. DeFi platforms, by their very nature, streamline and automate operations, significantly curtailing the friction, middlemen, and costs incurred for a transaction. Such an operational model translates to diminished switching expenses when redirecting capital across varied applications. The end result is a marketplace that is adept at regulating application-level charges.
Liquidity, a critical aspect of financial markets, is also poised for transformation. By tokenizing assets that typically reside in private domains, such as pre-IPO shares, tangible real estate, and even carbon credits, previously inaccessible and illiquid markets come into the limelight. It's essential to grasp the magnitude of this shift, given that these markets encompass trillions of dollars in assets, previously ensconced beyond reach.
Yet, perhaps one of the most striking features of DeFi is its composability. A unified settlement layer, adept at executing autonomous code, paves the way for unfettered composability between a spectrum of DeFi applications, both nascent and established. This open and composable ecosystem enables any developer anywhere in the world to iterate and innovate on a global scale that they may not otherwise have been able to.
In sum, while blockchains initially burst onto the scene as conduits for token creation and movement, it's the DeFi revolution that truly magnifies their broader capabilities and potential for transformation in the financial landscape.
Challenges with RWAs
Blockchains are incredibly powerful (and valuable) for many reasons, but primary among them, are their ability to enable trustless commerce in a self-custodial way. Two people, anywhere in the world, can transact on a blockchain without having to trust that the other person has the funds they claim or will do what they say. Instead, they only need to trust in the underlying protocol. Introducing RWAs onto a blockchain eradicates a lot of those powers. The inherent nature of RWAs, being rooted in traditional financial systems, means that their trust attributes differ significantly from a purely decentralized finance (DeFi) ecosystem, primarily focused on crypto-native assets.
When a blockchain protocol integrates elements that are external to its native environment (like RWAs), it assumes the complexities and challenges of the physical world, which includes counterparty, custodial, and regulatory risks. As a consequence, if any problems surface with the RWA, they necessitate interventions at the social or community level. This dilutes the principles of "code as law" and the immutable characteristics of blockchain.
Perhaps the most pressing concern is the need for robust regulatory clarity. Financial institutions exploring the possibility of tokenizing assets on public blockchains often find themselves stymied by the ambiguity surrounding regulations. Several regions, such as the European Union, Switzerland, the United Kingdom, and Japan, have made significant strides in architecting distinct regulatory frameworks. Yet, in contrast, jurisdictions like the United States remain in the initial stages of this process.
Permissions, Compliance, and KYC
True DeFi celebrates the permissionless and open nature of finance done on a blockchain. Yet, when RWAs enter this space, compromises must be struck. To align with financial regulations, both existing and forthcoming, token issuers might find themselves adding specific permissions. One notable aspect is the enforcement of Know Your Customer (KYC) and Anti-Money Laundering (AML) checks. These checks could come into play during various stages, like the issuance or redemption of a token or even during its transfer.
With permissions, inevitably, comes the question of identity. As institutions work towards the tokenization of RWAs, there's a pressing need for sophisticated mechanisms to ascertain user identities and gauge risk profiles. Solutions in the form of Decentralized Identifiers (DIDs) and other tools that prioritize privacy have emerged as essential elements for institutions navigating this space.
With the increasing adoption of RWAs into crypto, the associated risks also continue to expand. Notable "crypto native" stablecoins, such as Maker and Frax, are at the forefront of this trend, shifting towards integrating a higher proportion of RWAs into their collateral pools. This move aims to enhance peg stability and diversify reserves. Yet, this incorporation brings forth challenges traditionally tied to the conventional finance sector, including the vulnerabilities related to counterparty engagements and potential defaults. The process of collateral settlement during defaults requires streamlining, and its robustness remains largely unproven. As long as these liquidation processes are not executed on-chain, RWAs will remain constrained by the intricacies of off-chain settlement procedures.
Addressing the Proof of Reserves
RWAs are inherently off-chain entities, presenting unique challenges for DeFi platforms, which often struggle to gain a transparent insight into the actual collateralization of these assets. Oracle solutions, such as Chainlink's Proof of Reserves, aim to mitigate this ambiguity, albeit introducing an additional layer of complexity. While it's feasible to periodically refresh and affirm this information on-chain at no costs, the end user is still reliant on 1) the RWA custodian to truthfully represent its assets and 2) the oracle solution to accurately relay the information. To instill trust and safeguard against malicious activities related to RWAs, the industry is compelled to establish new benchmarks, whether it's through mechanisms like Proof of Reserves or by employing third-party audits. Without these protective measures, the integration and overall success of RWAs within the crypto landscape could be jeopardized by unscrupulous entities.
Introducing Middlemen and Decreasing Total Yield
While yields from RWAs may be attractive (e.g. ~5% on a 2 YR bond), getting those bonds on-chain requires specialized companies and middlemen, each of whom must take a cut of the yield before passing it on the a blockchain user. This chain of fee extractions significantly reduces lending yields in comparison to the original yield in the TradFi system. Coupled with the inherent smart contract risk associated with the lending protocol, the risk-adjusted returns begin to look less promising.
While the integration of RWAs into public blockchains holds considerable promise, navigating the associated challenges is critical.
Major financial institutions (and their RWAs) understandably seek robust mechanisms and permissions, vital not just for operational safeguards but also for navigating the complex regulatory landscape. Thus, scaling DeFi with tokenized RWAs demands a compromise from the traditional crypto enthusiast. As institutions, regulators, and tech providers engage more deeply with this intersection, the crypto ecosystem can expect richer, more nuanced solutions that serve the interests of all stakeholders.
Yet, as the finance landscape evolves, it's crucial to acknowledge that DeFi protocols, ones that are completely permissionless and lean heavily on crypto-native assets, will persist. Their value proposition lies in their ability to act as fertile grounds for permissionless financial innovation, while also standing as a robust, censorship-resistant alternative to conventional financial systems. But a stark reality accompanies this: without interfacing with RWAs, these ecosystems are incapable of tapping into a much larger economy.
At Event Horizon Capital (EHC), we believe select cryptoassets will outperform all other asset classes over the next five, ten, and possibly even twenty years due to their superior qualities as new money/assets for the internet age. Because of this, we seek the best risk-adjusted exposure to protocols that personify the blockchain benefits outlined above. With crypto markets being one of the world’s most dynamic markets, our agile and active management provides the flexibility required for swift, decisive action while also never compromising on security.
EHC’s multi-strategy approach is built upon:
Qualitative fundamental research,
Quantitative tools and valuation metrics
Narrative and sentiment-driven market swings
This newsletter from Event Horizon Capital is intended for informational and illustrative purposes only and has been prepared to provide insights on the market. It should not be construed as an offer, solicitation, or recommendation to buy or sell any security or financial instrument, nor participate in any investment strategy. The opinions and information expressed in this newsletter are as of the date it was written and are subject to change without notice due to various factors, including changing market conditions and regulations. This newsletter is not intended as investment advice and should not be considered as such. Third-party data presented in this newsletter is sourced and deemed reliable, but no guarantee is made as to its accuracy or completeness. All investments carry risk, and there is no assurance that any specific investment, strategy, or product referenced directly or indirectly in this publication will be profitable or suitable for your portfolio.