What is Real World Asset Tokenization? An Introduction.

After exploring my projects in the last couple of blog posts, I now wanted to explore more niche topics and use cases of Web3. In the future I want to explore use cases of web3, which are already used or just emerging. My goal is to shed a light on the most exciting areas of Web3 and how they can improve our daily lives.

While Web3 has been seen as synonymous with Crypto in the past couple of years, which was not always in the best interest of this space, I want to bring to light topics, which are based on more than theories and hype. During the last bull run and in the aftermath of period after that, there have many shady dealings been unveiled. FTX among other things is probably in the memory of all people watching the Web3 and Crypto space. One thing has to be said, unless this space does not manage to weed out bad actors effectively, it will not be able to garner a favorable image in the eye of the general public.

But that being said, I want to now go into the topic of Real World Asset Tokenization. On the surface the name already hints on what the technology behind this buzz words wants to achieve. The goal is to have assets of all sorts, be it real- estate, cars, watches or many other things, be represented on the blockchain. The promise of Real World Asset Tokenization is atransparent, inclusive, and sustainable global economy. Assets can be visible on chain. The way this would happen, in this case on Ethereum and other EVM chains, is with a Smart Contracts. If you have ever interacted with the Crypto and DeFi (Decentralized Finance), you probably have already interacted with a smart contract. For example, most Crypto Tokens on Ethereum follow a standard called ERC20. Non-Fungible Tokens also follow a token standard, most of the time it is the ERC721 or ERC1155 standard. These standards exist to help developers in creating smart contracts which can operate with another. Token standards are crucial for blockchain growth, simplifying token development and boosting liquidity while ensuring interoperability across platforms. They promote innovation by providing a common foundation, streamlining token transfer and accelerating deployment across blockchains.

The case for Real World Asset Tokenization

"Asset tokenization" refers to utilizing smart contracts and blockchain technology to represent ownership or rights to an asset in the form of a tradable token on the blockchain. While it typically involves financial or fungible assets like company shares or gold, it can theoretically apply to anything with monetary value. This concept holds significant promise for blockchain use cases, potentially encompassing a vast portion of global economic activity, estimated at over a hundred trillion dollars annually. However, as with any interaction between Web3 applications and the external world, known as the oracle problem, asset tokenization presents security risks and complexities. Reliable information about underlying assets, essential for processes like minting, trading, and management, requires secure oracles to realize the full potential of asset tokenization.[1]

Asset tokenization, beyond providing a decentralized alternative to real-world assets, brings numerous benefits. It enhances the value, accessibility, and utility of assets by leveraging blockchain technology, enabling off-chain data integration within the DeFi ecosystem. This method offers increased liquidity by tokenizing traditionally illiquid assets and enabling fractional ownership, thereby broadening the investor base and reducing transactional costs.

Moreover, it enhances accessibility to otherwise inaccessible high-return assets, resembling a crowdfunding model where investors share in the financial gains. Transparency is improved through tokenization, as blockchain records provide transparent ownership, returns, and provenance tracking, minimizing investment risks associated with fraudulent activities. Asset tokenization also facilitates composability within the DeFi ecosystem, allowing real-world assets to be leveraged in decentralized money markets, enhancing liquidity and expanding investment opportunities for retail investors. Looking ahead, asset tokenization opens doors for innovative smart contract developers to explore new synthetic assets, indexes, and token baskets, as well as enabling the integration of real-world revenue streams as collateral, driving further innovation in the expanding DeFi landscape.[1]

From an investor’s point of view, RWA tokenization revolutionizes the financial landscape by providing liquidity to traditionally illiquid assets through digital tokenization. This process divides assets like real estate, fine art, and collectibles into digital tokens, enabling fractional interests and simplifying transactions that were once capital-intensive and complex. This liquidity unlocks previously inaccessible markets, allowing assets to be easily traded on digital platforms, increasing transaction velocity, and broadening investor participation. For average investors, this means newfound opportunities for portfolio diversification and wealth generation, reducing risk and enhancing returns. On a global scale, increased liquidity fosters financial market efficiency and stability, encouraging capital flow, investment, and economic growth across sectors. This democratization of investment opportunities not only preserves wealth among the affluent but also creates avenues for wealth creation accessible to a wider population.[2]

As you can see, there are many things, which Real World Asset Tokenization promises to disrupt. The most common claim by supporters is the increased liquidity of traditionally illiquid assets. Together with this there is also the promise of better traceability of the movement of assets and the opening up of markets to a global decentralized financial market place. In the same manner as DeFi has already promised, this could give people from across the globe the opportunity to partake in a more open, equal and less restricted market than today is possible for many people. How these assets are managed is a whole other question. But just like in today´s DeFi market, I speculate, that we will see many different forms of handling this problem.

Risks and Hurdles

Tokenizing physical assets also has notable risks and hurdles. Regulatory barriers pose a significant challenge, given the regulatory frameworks that vary between jurisdictions. To safeguard tokenized asset initiatives from legal issues, compliance with securities laws and other regulations is essential. Also, asset custody presents a substantial obstacle. Safeguarding the underlying financial or legal assets supporting digital tokens is vital in order to prevent theft, fraud, or mishandling. This is why selecting dependable and secure custody solutions is critical. Consideration must also be given to market acceptance and liquidity. Stable and Collateralized marketplaces or exchanges are essential for sustaining liquidity and ensuring price stability of tokenized assets. Insufficient trading volumes or limited adoption may undermine investor confidence due to liquidity issues and price volatility. Moreover, assessing the value of tokenized assets can be a challenge. Determining the precise worth of real-world assets and their division into tradable tokens can be subjective and error-prone, potentially leading to valuation disputes among investors. Projects involving tokenization should address privacy and data security concerns, as blockchain transparency may expose sensitive information. Clarifying the legal enforceability of smart contracts and dispute resolution processes is necessary to minimize potential issues. E educating the public is essential, as a lack of understanding among investors, companies, and regulators may hinder uptake and regulatory acceptance of tokenized assets.[3]

One of the probably very well-known problems of blockchains is the fact, that they are not able to gather data from their surroundings. This is why there are so called Oracles, which enable the use of real-world data on the blockchain. This is how you for example can get the exchange rate or value of different assets. Using verifiable and true data is, in my opinion, the most important part, not only for the topic discussed in this post, but also Web3 and its adoption in general. Tokenized asset projects will need enhance transparency and security by utilizing Proof of Reserve (PoR), which basically means a decentralized way on verifying data. This allows off-chain data, such as collateralization information, to be relayed onto the blockchain. Oracles used for tis need to enable diverse data sourcing from professional providers, appraisers, and markets, facilitating trusted valuations.

To solve all these problems, there will still be a lot of developments on the way. For example, there would need to be trusted and regulated processes in place in order to ensure, that a tokenized asset is really there. In the EU there have been developments regarding this with MiCA. The Markets in Crypto-Assets Regulation (MiCA), established by the European Union, is a framework designed to regulate the issuance and trading of crypto-assets. Its primary goals are to protect consumers and investors, mitigate potential risks to financial stability, and foster responsible innovation within the crypto asset space. MiCA claims to achieve these goals by:

Enhancing transparency and disclosure: Crypto-asset issuers and service providers must adhere to new regulations that ensure investors have clear and accurate information, reducing the risk of fraud and manipulation.

Introducing licensing and supervision: Crypto-asset service providers, such as exchanges and custodians, require authorization and supervision by national authorities, promoting market stability.

Establishing conduct standards: MiCA sets clear guidelines for how service providers operate, including mandatory know-your-customer (KYC) and anti-money laundering (AML) requirements.

MiCA entered into force in June 2023 and will be fully implemented by December 2024. It represents a significant step towards regulating crypto-assets and is expected to have a major impact on the market within the EU and potentially beyond.[4]

No matter how you view the involvement of governments in Web3, the bottom line is, that without a clear legal way to operate and partake in this space, there simply will be a lot of room for growth left out. The more unorganized and chaotic the regulation or lack thereof around crypto is, the more the markets will suffer, as we have seen due to contradictory statements by government institutions.

But besides the obvious legal issues, I think that there are also philosophical and moral questions to answer before we can say, that RWAs are a net positive. Earlier I mentioned the problem of the security of data and the fear of data breeches. Be warned. Despite what many people wrongfully claim, data on the blockchain is, as a general rule of thumb, always public and immutable. This means, that all data you put there, can be seen by everyone and from now until probably forever. Therefore, you should treat the data you put on chain as such. There are already solutions for some parts of this problem on the horizon (think zero-knowledge-proof), but this sector evolves multiple times faster than other spaces. You can probably think where I am going with this. There are many possible ways in how this data could be used for malicious activities.

The issue of proving reserves is also a quite interesting one. But on this front there are already solutions evolving, like Chainlinks Proof of Reserve verification service or Cross-Chain Interoperability Protocol (CCIP). All these things will be of great use for implementing solutions. When I visited the last Chainlink SmartCon (start of October 2023) there was a lot of talk surrounding the topic of “Verifiable Internet”. In my opinion, the verifiability of where data comes from and to ensure it is correct is one of the most important considerations for the future of Web3 as a whole. But exploring the topic of the “Verifiable Web” will be a topic for future research and discussion.

Without many of the already mentioned points of consideration I highly doubt, that the Tokenization of Real World Assets will yield a net positive, whether in a financial sense or otherwise. There need to be effective measures in place to ensure, that what you are buying or investing in is in the advertised condition. As this tokenization will probably first and foremost entail the tokenization of more valuable items, which do not change hands too often, this will probably also include the verification of the current location, the value, past changes and so on. This Verification could in turn also positively affect these markets as a whole. Just imagine the positive possibilities which could follow the Verification of the repairs done to a car or mileage. As long as the data put into the system is correct this could put and end to uninformed buying decisions. But this again is also a problem not yet solved in a sufficient manner, no matter if it is in Web3 or outside of it.

Conclusion

While this article is by no means a comprehensive guide, I hope, I could shed some light on the topic of Real World Asset Tokenization. In my opinion this topic is one of the most promising use-cases of Web3, but still has, just like the rest of the space, a lot of maturing and development to achieve. But just by looking at the lightning speed at which this space evolves, I can say with confidence, that there will be solutions and standards implemented in order to facilitate a strong and decentralized ecosystem. I think there is a strong possibility of this being the next hype in Web3 (which I might add is not always positive and comes with negative developments and greed associated with it). I think it will just be a matter of time until we see as much development happening in this area as we have seen in the past on DeFi and NFTs. What we can hope though, is that as this space matures, there are fewer and fewer exploits. In conclusion I think that we could very well see more and more development happen on this area of Web3 as well. But only time will tell.

Sources and further Information

[1] N.N., Asset Tokenization: What It Is and How It Works, In: Chainlink, Education (December 14th, 2023), link: https://chain.link/education/asset-tokenization

[2] Anthony Clarke, How Is RWA (Real World Asset) Tokenization Disrupting Industries?, In: Nasdaq, Articles (February 7th, 2024), link: https://www.nasdaq.com/articles/how-is-rwa-real-world-asset-tokenization-disrupting-industries

[3] N.N., What are tokenized real-world assets (RWA), and why do they matter in DeFi, In: Cointelegraph, Learn (n.n.), link: https://cointelegraph.com/learn/tokenized-real-world-assets-rwa-in-defi

[4] N.N., Markets in Crypto-Assets Regulation (MiCA), In: European Securities and Markets Authorities, Digital Finance and Innovation (n.n.), link: https://www.esma.europa.eu/esmas-activities/digital-finance-and-innovation/markets-crypto-assets-regulation-mica

[4] N.N., Markets in Crypto-Assets Regulation (MiCA), In: European Securities and Markets Authorities, Digital Finance and Innovation (n.n.), link: https://www.esma.europa.eu/esmas-activities/digital-finance-and-innovation/markets-crypto-assets-regulation-mica