Original title: "RWA in the eyes of the Federal Reserve: Tokenization and financial stability"
Original author: Web3 Xiaolu
In a working paper on tokenization published by the Federal Reserve on September 8, tokenization is stated to be a new and rapidly growing financial innovation in the crypto market, and is analyzed from three perspectives: scale, advantages, and risks. First, the concept of tokenization is introduced, which refers to the process of building a digital representation (crypto token) for non-crypto assets (underlying assets). In this process, tokenization establishes a link between the crypto asset ecosystem and the traditional financial system. With sufficient scale, tokenized assets may transfer the risk of volatile fluctuations from the crypto market to the underlying asset market of traditional finance.
The following is a compilation of this 29-page paper so that everyone can further understand RWA and tokenization, underlying assets and crypto assets, regulation and financial stability. To borrow a sentence from the president: "Any financial technology is accompanied by risks behind it. The deep integration of regulatory technology and RWA and DeFi will be an important driving force for the future development and iteration of crypto technology."
This is another RWA research report after the previous compilation of Binance (RWA tokenization of real-world assets, a bridge between TradFi and DeFi), Citi (the next billion users and trillions of value of blockchain, money, tokens and games), and our own RWA research report: In-depth analysis of the current implementation path of RWA and the future prospects of RWA-Fi. Below, enjoy:
The address of the Federal Reserve working paper can be found here.
1. What is Tokenization?
"Tokenization" refers to the process of linking the value of the underlying assets (reference assets) with the value of the crypto token. Strictly speaking, tokenization will allow token holders to have the right to legally dispose of the underlying assets at the legal level. So far, most of the tokenization projects on the market have been initiated by small VC-backed crypto companies, while traditional financial institutions such as Santander Bank, Franklin Templeton Fund and JPMorgan Chase have also announced their tokenization pilot projects related to crypto assets.
Like stablecoins, tokenization will also have different characteristics due to different design schemes. In general, tokenization usually includes the following five characteristics: (1) based on blockchain; (2) owning underlying assets; (3) a mechanism to capture the value of underlying assets; (4) a way to store/custody assets; (5) a redemption mechanism for tokens/underlying assets. In general, tokenization connects the crypto market with the market where the underlying assets are located. The design of the tokenization scheme will distinguish various tokens and affect the traditional financial market to varying degrees.
The first factor to consider when designing a tokenization solution is the underlying blockchain, which is used to issue, store, and trade tokens. Some projects issue tokens on private permissioned blockchains, while others issue them on permissionless public blockchains. Permissioned blockchains are usually controlled by a centralized entity that approves selected parties to enter a private ecosystem. Issuing tokens on permissionless blockchains (Bitcoin, Ethereum, Solana, etc.) allows for public participation and fewer restrictions, but also provides less control over the tokens by the issuer. Tokens on permissionless blockchains can also be integrated into decentralized finance (DeFi) protocols, such as decentralized exchanges. See Figure 1 for examples of project tokens issued on permissioned and permissionless blockchains.
Another consideration is the underlying assets of the token. There are many classifications of underlying assets, such as on-chain assets and off-chain assets, intangible assets and tangible assets, etc. Off-chain underlying assets are independent of the crypto market and can be tangible (such as real estate and commodities) or intangible (intellectual property and traditional financial securities). Tokenization of off-chain/underlying assets usually involves an off-chain agent, such as a bank, to assess the value of the underlying assets and provide custody services. Tokenization of on-chain/crypto assets needs to include smart contracts to provide custody and asset valuation of crypto assets.
The last factor to consider is the redemption mechanism. Like some stablecoins, the issuer allows token holders to exchange their tokens for underlying assets. This redemption mechanism can connect the crypto market with the underlying asset market. In addition, tokenized assets can also be traded in secondary markets, such as centralized crypto exchanges and DeFi exchanges. Although some security tokens involving other on-chain claims or shares do not include a redemption mechanism, they still grant token holders some other rights, such as the right to dispose of cash flows related to their underlying assets.
2. Current Tokenization Market Size and Types of Tokenized Assets
Based on publicly available information, we estimate that the tokenized market on permissionless blockchains is worth $2.15 billion by May 2023. These assets are typically issued by DeFi protocols such as Centrifuge and traditional financial companies such as Paxos. Due to the different tokenization schemes, there is no unified standard, making it difficult to obtain a comprehensive set of data information. Therefore, we will use public data from the DeFiLlam platform to show the booming development of tokenization in DeFi. As shown in Table 1, the locked value (TVL) of the entire DeFi market has remained basically stable since June 2022, while Table 2 shows that the TVL of the real world assets (RWA) asset class has continued to grow compared to similar assets or compared to the entire DeFi market since July 2021. Many new tokenization projects have been officially announced recently, covering a variety of underlying assets such as agricultural products, gold, precious metals, real estate, and other financial assets.
A recent typical tokenization project involves agricultural product types SOYA, CORA and WHEA, which refer to soybeans, corn and wheat respectively. The project is a pilot program launched in Argentina in March 2022 by Santander Bank and crypto company Agrotoken. By embedding the right of recovery of the underlying assets in the tokens, and building infrastructure to verify and process transactions and redemptions, Santander Bank is able to accept these tokens as collateral for loans. Santander Bank and Agrotoken said they hope to promote the tokenization of commodities in larger markets such as Brazil and the United States in the future.
Another type of underlying asset that is tokenized is gold and real estate. As of May 2023, the market size of tokenized gold is approximately $1 billion. Two types of tokenized gold account for 99% of the market share, namely Pax Gold (PAXG) issued by Paxos Trust Company and Tether Gold (XAUt) issued by TG Commodities Limited. Both issuers set a token unit equal to one ounce of gold, which is kept by the issuer itself in accordance with the standards set by the London Gold Market Association (LBMA). PAXG can be redeemed for the equivalent of US dollars, while XAUt is sold and redeemed by the issuer through the Swiss gold market. Overall, the two models are basically the same and the value is the same as gold futures.
Compared with commodities such as agricultural products and gold, real estate as an underlying asset faces difficulties in standardization, weak circulation, difficulty in value assessment, and more complex legal and tax issues. These have posed great challenges to real estate tokenization. Real Token Inc. (RealT) is a real estate tokenization project that collects residential properties and tokenizes their equity. Each property is independently held by a limited liability company (LLC). The property itself is not tokenized, but the shares of the LLC are tokenized, so that each property can be jointly held by different investors. The project mainly provides international investors with a way to invest in U.S. real estate, with real estate rent as a return. As of September 2022, RealT has tokenized 970 properties with a total value of US$52 million.
The tokenization of financial assets involves underlying assets such as securities, bonds, and ETFs. Unlike directly holding securities, the price of tokenized securities may be different from the price of the securities themselves, partly because tokens are traded 24/7, and partly because of the programmability of tokens and composability with DeFi, which can bring different liquidity to tokens. We use Table 345 to show the difference in price of META securities and the corresponding security tokens of MEAT, as well as the difference in trading volume (based on Bittrex FB).
Securities on traditional compliant trading platforms can be tokenized, or tokens can be issued directly on the blockchain. Akionariat, based in Switzerland, provides tokenization services to Swiss companies. U.S. public companies such as Amazon (AMZN), Tesla (TSLA), and Apple (AAPL) now or in the past have tokenized securities traded on Bittrex and FTX.
Earlier in 2023, Ondo Finance issued tokenized funds whose underlying assets are ETFs of US Treasuries and corporate bonds. The shares of these tokenized funds represent their shares in the corresponding ETFs. In addition, Ondo Finance also holds a small portion of stablecoins as liquidity reserves. Ondo Finance is the manager of the tokenized fund, Clear Street is the broker and custodian of the fund, and Coinbase is the custodian of the stablecoins.
3. Potential Benefits of Tokenization
Tokenization can bring many benefits, including allowing investors to enter markets that were previously difficult to access with high investment barriers. For example, tokenized real estate can allow investors to purchase a small share of a specific commercial building or residential property, which is different from real estate investment trusts (REITs) that are investment vehicles for real estate portfolios.
The programmability of tokens and the ability to leverage smart contracts allow for some additional functionality to be embedded into tokens, which may also benefit the market for the underlying assets. For example, liquidity savings mechanisms can be applied to the token settlement process, which are difficult to implement in the real world. These blockchain features may lower the barrier to entry for a wide range of investors, leading to more competitive and liquid markets, as well as better price discovery.
Tokenization may also facilitate lending by using tokens as collateral, as discussed above for tokenized agricultural commodities, where directly using agricultural commodities as collateral would be costly or difficult to implement. In addition, tokenized assets can be more easily settled than real-world underlying assets or financial assets. Traditional securities settlement systems, such as Fedwire Securities Services and the Depository Trust and Clearing Corporation (DTCC), generally settle transactions on a gross or net basis over the entire settlement cycle, usually one business day after the trade.
ETFs are the financial instruments that are most similar to tokenized assets, and existing empirical evidence may suggest that tokenization can also improve the liquidity of the underlying asset market. The academic literature on ETFs demonstrates a strong positive correlation between ETF and underlying asset liquidity, and finds that additional trading activity in ETFs leads to higher information exchange/circulation of the underlying assets in the ETF. For tokens, a similar mechanism to ETFs means that greater liquidity of tokens in crypto markets may be more conducive to value discovery of underlying assets.
IV. The Impact of Tokenization on Financial Stability
The tokenization market size of less than one billion US dollars is relatively small for the entire crypto market or the traditional financial market, and does not cause overall financial stability problems. However, if the tokenization market continues to grow in number and size, it may bring financial stability risks to the crypto market and the traditional financial system.
In the long run, the redemption mechanism established between the cryptoasset ecosystem and the traditional financial system involved in tokenization may have potential impacts on financial stability. For example, at a sufficient scale, the emergency sale of tokenized assets may have an impact on traditional financial markets, because the price dislocation in the crypto market provides market participants with opportunities to redeem the underlying assets of tokenized assets for arbitrage. Therefore, a mechanism may be needed to deal with the value transmission in the above two markets.
Additionally, tokenized assets may be problematic due to the illiquidity of the underlying assets. Examples may include real estate or other illiquid underlying assets. This issue is also discussed in the academic literature on ETFs, where there is a strong correlation between the underlying assets and the liquidity, price discovery, and volatility of ETFs.
Another financial stability risk is the token issuers themselves. Tokens with redemption options may encounter similar issues as asset-backed stablecoins, such as Tether. Any uncertainty about the underlying assets (especially lack of disclosure and information asymmetry about the issuer) - may increase investors' incentives to redeem the underlying assets, thereby triggering a sell-off of tokenized assets.
This liquidity transmission may also be exacerbated by the characteristics of the crypto market. Crypto trading platforms allow crypto assets to be traded continuously 24/7, while most underlying asset markets are only open during business hours. The mismatch in trading hours may have unpredictable effects on investors or institutions in special circumstances.
For example, issuers of tokenized assets with redemption options may face a sell-off of tokens on weekends, as redeemers cannot quickly access the underlying assets because the underlying assets are held off-chain and traditional markets are closed for trading on weekends. This situation may further deteriorate, and the decline in the value of tokenized assets may threaten the solvency of institutions that hold a significant share on their balance sheets. In addition, even if institutions can obtain liquidity from traditional markets, it is difficult for them to inject liquidity during the period when traditional markets are closed.
Therefore, a large-scale sell-off of tokenized assets could quickly reduce the market value of the institutions holding the assets and the issuers, affecting their borrowing capacity and thus their ability to repay debts. Another example may be related to the automatic margin call mechanism of DeFi trading platforms, which triggers the requirement to liquidate or redeem tokens, which may have unpredictable effects on the underlying asset market.
As tokenization technology and the tokenized asset market develop, tokenized assets themselves may become underlying assets. Considering that the price of crypto assets is more volatile than similar underlying assets in the real world, the price fluctuations of such tokenized assets may be transmitted to the traditional financial market.
As the market size of tokenized assets continues to grow, traditional financial institutions may participate in various ways, either by directly holding tokenized assets or by holding tokenized assets as collateral. Examples of this may include Santander Bank using tokenized agricultural products as collateral to provide loans to farmers. As mentioned above, we have also seen cases such as Ondo Finance tokenizing US government money market funds.
In addition, although similar in nature to JPMorgan Chase's first use of money market fund (MMF) equity interests as collateral for repo and securities lending transactions, Ondo Finance's move may have a more far-reaching impact on traditional financial markets. Ondo Finance's tokens are deployed on the public blockchain Ethereum, rather than the institution's own private permissioned blockchain, which means that Ondo Finance cannot control how users and DeFi protocols interact. As of May 2023, Ondo Finance's tokenized funds account for 32% of the entire tokenized asset market. According to DeFiLlama, Ondo Finance is the largest tokenized project in this category, and its token OUSG can also be used as collateral for Flux Financ, the 19th largest lending protocol.
Finally, similar to the role of asset securitization, tokenization may package underlying assets with higher risks or poor liquidity into safe and easy-to-trade assets, which may bring higher leverage and risk-taking. Once the risks are exposed, these assets will trigger systemic events.
V. Conclusion
1. This article aims to provide a background on asset tokenization and discuss the possible benefits as well as the risks to financial stability.
2. Currently, the scale of asset tokenization is very small, but tokenization projects involving various types of underlying assets are under development, which indicates that asset tokenization may occupy a larger part of the crypto ecosystem in the future.
3. Among the possible benefits of tokenization, the most prominent are lowering barriers to entry into otherwise inaccessible markets and improving the liquidity of such markets.
4. The financial stability risks brought about by asset tokenization are mainly reflected in the interconnections between tokenized assets in the crypto ecosystem and the traditional financial system, which may transfer risks from one financial system to another.
Appendix: Information on some asset tokenization projects
Digital bonds issued by European Investment Bank
The European Investment Bank has issued several blockchain bond products. The first bond was issued through the HSBC Orion platform in the form of a combination of private and public blockchains, with a total size of 50 million pounds. The blockchain serves as a record of the legal ownership of the bond and manages floating rate instruments and bond life cycle events. The bonds will be held in the form of digital accounts through the HSBC Orion platform.
The second bond was issued through Goldman Sachs' private blockchain GS DAP, with a total size of 100 million euros and a 2-year term. The bonds are represented by security tokens, which investors can purchase using fiat currency, and Goldman Sachs Bank Europe, Santander Bank and Soci'e G'en'erale as co-managers, which then settle the issuer in the form of CBDC. These tokens are provided by the Bank of France and the Central Bank of Luxembourg. Soci et'et G'en'erale Securities Securities Services (SGSS Luembourg) serves as the on-chain asset custodian, and Goldman Sachs Europe serves as the account custodian of the CBDC.
The bond features T+0 instant settlement, secondary trading can only be done over-the-counter, and is settled off-chain in fiat currency. Bond coupons are paid in fiat euros, and Goldman Sachs Europe acts as a payment agent to distribute these payments to bondholders.
JPMorgan Chase's Onyx platform
The Onyx platform operated by JPMorgan Chase has the ability to tokenize assets and conduct crypto asset transactions. Based on a licensed blockchain, Onyx mainly serves institutional clients, such as providing cross-currency transactions for digital yen and digital Singapore dollars, and providing services for the issuance of Singapore government bonds. In the future, JPMorgan Chase said it will conduct bookkeeping transactions for U.S. Treasury bonds or money market funds on the Onyx platform.
The Onyx platform also settles intraday repo trades between JPMorgan’s brokers and banking entities. Both the collateral and cash portions of repo trades can be settled using the Onyx platform. For repo trades, cash trades are settled using its JPM Coin, a blockchain-based bank account system. Since its launch in 2020, the platform has generated $300 billion in revenue.
Obligate
Obligate is a blockchain-based debt tokenization protocol that allows companies to issue bonds and commercial paper directly on the blockchain. The protocol supported the issuance of euro-denominated bonds by German industrial company Siemens on the Polygon network, with a total debt size of $64 million. Obligate also supported Swiss commodity trading company Muff Trading AG. When investors purchase these bonds, they receive ERC-20 tokens in their crypto wallets. According to their website, all future bonds will be denominated in USDC and issuers must pass a KYC process.
Investors will be able to access Obligate through existing crypto wallets. For each investment, investors hold a corresponding eNote (ERC-20), which carries the right to receive payment upon maturity or collateral in the event of default.
Franklin Templeton
Franklin Templeton, an American asset management company, provides a tokenized U.S. government money fund based on two public blockchains, Stellar and Polygon. Investors can purchase Benji tokens, each of which represents a share in the tokenized fund. Each share aims to maintain a stable share price of $1 and can be redeemed at any time. Share ownership is recorded on the proprietary system of the Stellar blockchain network.
92.5% of the tokenized fund’s assets come from U.S. institutions, with the rest in cash. Investors can purchase it through the Benji Investments app. The tokenized fund currently manages more than $272 million in assets.
Ondo Finance
Ondo Finance offers several tokenized fund products, including OUSG, OSTB, OHYG and OMMF, with the underlying assets of the tokenized funds being Blackrock US Treasury ETF, PIMCO Enhanced Short-Term Active ETF, Blackrock iBoxx High Yield Corporate Bond ETF and US Marker Fund. The proceeds of OMMF tokens will be airdropped to token holders daily, while the proceeds of other tokens (such as OHYG) will be automatically reinvested in the underlying assets. Token holders can receive traditional fund accounting reports from third-party service agencies to verify the fund assets.
Tokens can be redeemed daily, but may take multiple days to settle. If the fund has USD on hand, redemptions occur immediately. If not, the fund will sell the ETF shares, transfer the USD from Clear Street to Coinbase, and after Coinbase converts the USD into USDC, it will then pay the USDC to the token holder.
RealT
Real Token Inc. (RealT) collects residential properties and tokenizes their equity. Each property is independently held by a limited liability company (LLC). The property itself is not tokenized, but the shares of the LLC are tokenized. Therefore, the shares of each company that owns the property will be fractionalized and can be held jointly by investors. The project is mainly to provide international investors with a way to invest in US real estate and provide them with returns on property rentals. As of September 2022, RealT has tokenized 970 properties with a total value of US$52 million.
On the legal level, RealT is a company registered in Delaware called Real Token LLC. The entity exists to simplify the process of issuing real estate tokens, that is, placing each property under a series of LLC companies and offering shares to earn returns.
RealT’s tokens can be used as collateral for the RMM DeFi lending protocol, which is based on Aave V2. So far, only non-US users can access the RMM protocol and borrow the stablecoin DAI.
MatrixDock
MatrixDock issues its stablecoin (STBT), each pegged to $1, and the stablecoin is backed by US Treasuries with maturities of no more than 6 months and repurchase agreements. STBT can be minted or redeemed, and users must first deposit USDC/USDT/DAI, and once the purchase of the underlying asset is "confirmed", the deposited USDC/USDT/DAI will mint STBT tokens. Redemption can be made through the MatrixDock application or by transferring the STBT to the issuer's dedicated address, with a term of T+4 (New York Bank Day only). If the holder redeems the STBT before maturity, the execution price is calculated by dividing the Treasury settlement price by the fair market value (FMV) of the previous day.
Lofty
Lofty will provide tokenization of US real estate based on the Algorand blockchain. It operates very similarly to RealT, that is, after the property is transferred from the seller to Lofty, Lofty will place each property in a separate LLC company and tokenize the shares of the LLC company. The income from holding these tokens comes from the rental income of the underlying assets and the appreciation of the property. Since the underlying asset is a legal interest, not the underlying asset itself, it is unlikely that there will be a way to redeem it.
Tangible
Tangible is an NFT marketplace for real-world assets, allowing users to convert wine, gold bars, watches, and real estate into NFTs. Real-world assets are custodied and stored in Tangible's secure storage facilities. Users can purchase NFTs with the platform's native stablecoin (Real USD is primarily backed by interest income from real estate, with an expected APY of between 10%-15%) or tokens such as DAI. All NFTs can only be redeemed as underlying assets when the holder owns all shares of the NFT.
Shareholders
Aktionariat is a legally compliant digital platform, limited to Switzerland. The Aktionariat platform provides other companies with the tools needed to tokenize their shares and enable them to be traded. Since Aktionariat has the ability to hold and trade tokenized shares and traditional shares, the price of the shares will depend on the total supply, including the number of shares listed, as well as the valuation of the company. Aktionariat maps and builds a shareholder register by tracking transaction addresses on the blockchain and addresses stored in an off-chain database, and updates it in real time. However, due to the distinction between shareholders and token holders, token transfers do not necessarily result in changes to the register. A company can also return to a traditional shareholding system by buying back its tokens from shareholders and "burning" them.
Agrotoken
Agrotoken is able to provide a tokenized solution for agricultural products such as soybeans, corn and wheat, with each token representing 1 ton of the underlying commodity, and the commodity expiration date can also be marked as 30, 60 or 90 days or renewed to the maximum contract date. Exporters or collectors will ensure proof of grain reserves through oracles. The protocol runs on the Ethereum public blockchain and each token is an ERC-20 token.
The project is a pilot program launched in Argentina by Santander Bank and crypto company Agrotoken in March 2022. By embedding the right to claim the underlying commodity in the token and building the infrastructure to verify and process transactions and redemptions, Santander Bank is able to accept these tokens as collateral for loans.
Through its partnership with Visa, Agrotoken has created a bank card that is accepted by 80 million stores and businesses associated with tokenized agricultural products projects. The company is effectively connecting Argentinian farmers and exporters with surplus food to a global business network.
Paxos Trust
Paxos is a financial institution specializing in blockchain infrastructure and payment systems, and is also the custodian of many crypto projects, such as the stablecoin USDP and tokenized gold Pax Gold (PAXG). PAXG runs only on the Ethereum blockchain, is available for settlement 24 hours a day, and accounts for about half of the tokenized gold market. One PAXG token is equivalent to one ounce of gold and can be redeemed for the underlying physical gold itself, as well as the rights to gold rights/credits, or can be sold directly for US dollars through Paxo's platform. Paxos is regulated by the New York State Department of Financial Services.
TG Commodities Limited
TG Commodities Limited is the issuer of Tether Gold (XAUt) and is based in London. Legally, it is not the same entity as Tether Limited (USDT), the Hong Kong-based stablecoin issuer, but the two will be considered the same issuer. One XAUt is equivalent to one ounce of gold and can be redeemed for physical gold itself or for fiat currency after selling physical gold on the Swiss gold market. All XAUt are backed by physical gold, and holders can search for the specific gold bar associated with their XAUt through Tether Gold's website. Redemptions can only be made for whole gold bars, ranging from 385 to 415 ounces.
Toucan Protocol
The Toucan protocol allows users who own carbon credits in the carbon registry to tokenize them and allow them to be traded. Tokenized carbon credits are called TCO2s, which are programmed as NFTs and can distinguish the projects and specific circumstances of carbon credits by adding additional names (such as TCO2-GS-0001-2019). Toucan also manages two liquidity pools: the Base Carbon Pool and the Natural Carbon Pool to increase liquidity and pool similar carbon credits. The Natural Carbon Pool only accepts TCO2 tokens generated by nature-based projects.
Centrifuge
Centrifuge is an open DeFi protocol and a real-world asset market. Real-world asset owners act as initiators to create asset pools that are fully collateralized by real-world assets. The protocol is not limited to asset classes and has multiple asset pools, such as mortgages, trade invoices, micro loans, and consumer finance. At the same time, Centrifuge can be integrated into other DeFi protocols, for example, it carries most of the RWA assets in MakerDAO.
The tokenization of real-world assets is initiated by asset originators and the establishment of asset pools. Each asset pool is connected to a special purpose vehicle (SPV), which obtains legal ownership of the assets from the asset originator to separate the SPV's assets from the asset originator's business. Real-world assets will be tokenized into NFTs and associated with off-chain data. Investors deposit stablecoins (usually DAI) into the asset pool, and in return, they will receive two tokens representing the asset pool based on their risk preferences: TIN and DROP tokens. TIN and DROP tokens can be redeemed periodically, and the return to investors comes from the fees paid by borrowers who obtain financing from the asset pool, and investors can also receive rewards from the platform token CFG.
Goldfinch
Goldfinch is a decentralized lending protocol that provides crypto loans for fully collateralized off-chain assets. There are three main participants in the protocol: investors, borrowers, and auditors. Investors can also support the development of the protocol by providing funds to the Goldfinch member vault.
Borrowers are off-chain borrowing entities that propose transaction terms for loan amounts in the protocol, called borrowing pools. Investors can provide funds to the lending pool directly, or indirectly to the protocol, participating through the automatic allocation process in the protocol. Investors can redeem their tokens on a specific date, such as once a quarter.
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