RWAs in the Eyes of the Fed: Tokenization and Financial Stability
In a September 8 article by the Federal ReserveTokenIn a working paper on tokenization, the authors stated that tokenization is a new and rapidly growing financial innovation in the crypto market, and analyzed it 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 to help you further understand RWA and tokenization, underlying assets and crypto assets, regulation and financial stability.Any financial technology is accompanied by risks behind it. Regulatory technology and the deep integration of RWA and DeFi will be important scenarios for the future development and iteration of encryption technology."
This is a follow-up to the previous compilationBinance(Real-world asset tokenization RWA, a bridge between TradFi and DeFi),CitigroupBlockchainThe Next Billion Users and Trillion in Value, Money, Tokens, and Games), and our ownRWA Research Report: In-depth analysis of the current RWA implementation path and the future prospects of RWA-Fi, and then another RWA research report. Below, enjoy:
Federal Reserve Working Papers
1. What is Tokenization?
“Tokenization” refers to the process of linking the value of underlying assets (reference assets) to the value of crypto tokens.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 in 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 have different characteristics depending on the design.Generally speaking, tokenization usually includes the following five characteristics: (1) Based onBlockchain; (2) Owning the underlying assets; (3) A mechanism to capture the value of the underlying assets; (4) A way to store/custody the assets; (5) A redemption mechanism for the 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 underlyingBlockchain,Blockchain用于代币的发行、存储和交易。一些项目的代币发行在需要许可的私有许可Blockchain上，而另一些项目则发行在无许可的公共区块链上。许可区块链通常由一个集中的实体控制，该实体批准选定的参与方进入一个私有的生态系统中。而在无许可的区块链（比特币、以太坊、Solana等）上发行代币可以让大众参与，且限制较少，但是发行方对代币的控制也更弱。无许可区块链上的代币也可以接入去中心化金融（DeFi）协议中，如去中心化exchangeSee 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 types of underlying assets, such as on-chain assets and off-chain assets, intangible assets and tangible assets. The underlying assets off-chain are independent of the crypto market and can be tangible (such as real estate and commodities).Xiaobai Navigation) 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 requires the inclusion of smartcontract, 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 the secondary market, such as centralized cryptocurrencies.exchange和DeFiexchange。虽然一些涉及其他链上债权或股份的证券型代币不包含赎回机制，但它们仍会授予代币持有人一些其他权利，如与其底层资产相关的现金流处置权等。
2. Current Tokenization Market Size and Types of Tokenized Assets
Based on public information, we estimate that the tokenization market on permissionless blockchains will be 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, and it is difficult to obtain a comprehensive set of data information. Therefore, we will use the public data of 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 thatSince July 2021, 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.Many new tokenization projects have been 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 by Santander Bank and crypto company Agrotoken in Argentina in March 2022. 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 for tokenization is gold and real estate. As of May 2023, the market size of tokenized gold is approximately US$1 billion. Two types of tokenized gold account for 99% of the market share, namely Pax Gold (PAXG) issued by Paxos Trust Company and T-Coin issued by TG Commodities Limited.ethPAXG is a token that is equivalent to one ounce of gold, and 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. On the one hand, this is because the tokens are traded 24/7, and on the other hand, based on the programmability of the tokens and their composability with DeFi, they can bring different liquidity to the tokens. We use Table 345 to show the difference in price and trading volume of the corresponding security tokens of META securities and MEAT (based on Bittrex FB).
Securities on traditional compliant exchanges 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, the underlying assets of which 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.
Token Programmability and Utilization IntelligencecontractThe ability to embed additional functionality into tokens may also benefit the market for the underlying asset. 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 in the case of tokenized agricultural commodities discussed above, where directly using agricultural commodities as collateral would be costly or difficult to implement. In addition, the settlement of tokenized assets is more convenient than that of underlying real-world 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 most closely resemble 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 mechanism similar to ETFs means that greater liquidity of tokens in the crypto market 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 present problems 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 asset issuer itself. Token assets with redemption options may encounter similar problems as asset-backed stablecoins, such as Tether. Any uncertainty about the underlying assets (especially lack of disclosure and information asymmetry on 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 exchanges 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 ability to borrow and, therefore, their ability to repay debts.Another example may be related to the automatic margin call mechanism of DeFi exchanges, which triggers requirements 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 expand, 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 the US government money market fund.
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 accounted 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 risk or lower liquidity intoSafetyAssets that are easy to trade may lead to higher leverage and risk-taking. Once the risks are exposed, these assets will trigger systemic events.
V. Conclusion
This article aims to provide a background on asset tokenization and discuss the possible benefits as well as the risks to financial stability. Currently, asset tokenization is very small in scale, but tokenization projects involving various types of underlying assets are under development, which suggests that asset tokenization may occupy a larger part of the crypto ecosystem in the future. Among the possible benefits of tokenization, the most prominent ones are lowering barriers to entry into otherwise inaccessible markets and improving the liquidity of such markets. The financial stability risks brought about by asset tokenization are mainly reflected in the interconnections between the crypto ecosystem and the traditional financial system created by tokenized assets, which may transmit risks from one financial system to another.
The article comes from the Internet:RWAs in the Eyes of the Fed: Tokenization and Financial Stability
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