RWA: The New Wave in the World of DeFi

Introduction

Blockchain is considered a disruptive technology, but it does not have a significant consumer interface like emerging technologies such as electric vehicles, ChatGPT, or Metaverse, so it is difficult to perceive its innovation at first glance. However, what sets blockchain apart is its involvement in value transfer and its entry into the realm of currency.

Blockchain technology has a wide range of applications and is currently being widely used in areas such as DeFi, GameFi, SocialFi, and more. The successful application of blockchain technology will have over a billion end users, many of whom may not even be aware that they are using this technology. The tokenization of digital assets will drive a market worth trillions of dollars in the future, including CBDCs, stablecoins, and the tokenization of real-world assets. This will spur innovation at both the legal and technical levels, including privacy solutions, cross-chain technology, and smart contracts in law.

Reasons for the Emergence of RWA

As the risk-free interest rates in traditional financial markets rise and the investment returns of DeFi decline, investors are flocking to the U.S. bond market. In order to expand the market size and provide sustainable and stable returns to users, DeFi protocols have introduced Real-World Assets (RWA) as a source of collateral or new investment opportunities. This change means that DeFi will no longer be limited to digital assets, but also include real-world assets. This move further promotes the integration between DeFi and traditional finance and provides investors with more diversified choices.

Traditional financial giants are also actively positioning themselves in RWA. Goldman Sachs launched GS Dap to tokenize traditional assets, and Siemens issued $60 million in bonds using RWA. Citigroup even pointed out in its report “Money, Tokens, and Games” that RWA will be the killer application that drives the blockchain industry into the trillion-dollar scale, as almost any asset that can be valued can be tokenized. It is optimistically estimated that the size of RWA will reach $4 trillion in value by 2030.

By introducing real-world tangible assets into the blockchain financial ecosystem, RWA involves a wide range of physical assets such as real estate, commodities, and artworks, making them representable assets on the blockchain. These digital assets are used as collateral to issue on-chain credit. Moreover, by using tangible assets as collateral, the on-chain credit market can become more stable and resistant to risks compared to other forms of crypto lending.

Overview of the Traditional Fixed Asset Market

Currently, a significant portion of global wealth is tied up in illiquid assets that are difficult to liquidate. A survey conducted in the United States in 1997 revealed that out of all the assets held by taxpayers, approximately 5,646 assets had a net value between $600,000 and $1,000,000, all of which fell under the category of illiquid assets. Under similar conditions, illiquid assets are typically traded at a discount and have characteristics such as high inventory, high liquidity ratios, low trading volume, and imperfect valuation.

Illiquid assets primarily include real estate (such as home equity), natural resources, land, commodities, public infrastructure (such as mines and ports), artwork, infrastructure projects, and private equity. Additionally, many other asset classes are only accessible to a limited number of wealthy investors and institutions due to investment size restrictions, such as publicly traded stocks, hedge funds, infrastructure projects, commodities, and other alternative investment tools, private credit, etc. It is estimated that by 2030, the total tokenization volume of global illiquid assets will reach $16 trillion.

Data Source: BCG analysis: Relevance of on-chain asset tokenization in ‘crypto winter’

The main reasons for inadequate asset liquidity include:

1. For ordinary investors, their ability to bear risks is limited due to the large asset size (ranging from $250,000 to $5 million), which depends on the type of assets such as real estate, bonds, hedge funds, etc.
2. The inability to divide fixed utility (e.g., 100 investors sharing a housing unit)
3. Lack of professional wealth management knowledge, leading to information gaps for retail/high net worth individual investors (e.g., assets like livestock, plantations, alternative investments)
4. Stringent admission requirements
5. Regulatory restrictions
6. Complex user pathways for access permissions (e.g., KYC and payments spread across multiple platforms without a single customer interface)
7. Lack of existing scalable technological solutions to unlock the liquidity of these assets

The Driving Forces for Introducing RWA into the Crypto World

As U.S. Treasury yields rise and DeFi returns diminish, institutions are beginning to seek high-yield products with lower risk. DeFi, easily impacted by token volatility and technical security issues, is no longer the preferred choice for investors. Currently, one of the main drivers for integrating real-world assets into the crypto world is that these assets can provide a stable, risk-free return to the crypto market. DeFi protocols are capturing the yield value of underlying assets through RWA projects, essentially establishing an asset class based on the U.S. dollar. These underlying assets possess actual yields, similar in logic to how LSDs create interest-bearing assets pegged to ETH.

Moreover, most mature RWA projects are currently built based on the unilateral demand of DeFi protocols for real-world assets. This demand stems from various aspects, including:

• Asset Management Needs: Traditionally, on-chain earnings mainly come from staking, trading, and lending activities. However, during downturns in the crypto market, the inactivity of on-chain operations directly leads to a decline in on-chain yields. Against the backdrop of higher yields on U.S. Treasury bonds, some traditional DeFi protocols have started gradually incorporating U.S. Treasury bonds. This helps secure vault assets while earning stable returns.
• Portfolio Diversification: In times of extreme market volatility, the high volatility and correlation of crypto-native assets can lead to asset mismatches and liquidations. Introducing RWA assets, which are relatively low in correlation and stable compared to on-chain crypto-native assets, can effectively mitigate these issues. This enables investors to achieve diversified asset allocation, creating more robust and effective investment portfolios.
• Introducing New Asset Categories: Building DeFi Lego on the basis of RWA further unleashes the potential of RWA assets.

Advantages and Disadvantages of RWA

RWA offers an opportunity to address the limitations of inadequate liquidity in fixed assets, facilitates the entire process of connecting investors with investment opportunities, and also benefits investors by identifying secondary market opportunities once the investment is completed.

Data Source: BCG analysis: Relevance of on-chain asset tokenization in ‘crypto winter’

Advantages

RWA brings many benefits to financial assets, mainly in the areas of clearing, settlement, custody, and asset servicing.

1. Increased liquidity: RWA enhances the liquidity of high-value illiquid assets. It allows for fractional ownership of assets, making trading, ownership transfer, and record updating more accessible. This lowers the investment threshold and meets personalized asset needs, such as selling or mortgaging only a portion of an asset while retaining the rest for appreciation and income. Tokenization offers investors decentralized access to invest in premium global assets.
2. Enhanced Operational Efficiency: The distribution process on the blockchain is transparent and eliminates intermediaries, enabling anyone with internet access to easily own assets.
3. Lowered Barriers: RWA helps individuals access assets previously available only to institutional clients or high-net-worth investors.
4. Potential User Base: The demographic embracing RWA is typically younger, more tech-savvy, and diverse, making them potential clients for traditional financial institutions.
5. Lowered Financing Barriers: Tokenization opens new financing avenues for small and medium enterprises and other assets that struggle to secure funding.
6. Improved Operational Efficiency: Smart contracts make issuance, trading, and follow-up processes more efficient and faster, reducing communication costs between parties.
7. Fostering Innovation in Financial Products: The composability of RWA assets fosters financial product innovation, allowing for the blending and combination of real-world assets, financial assets, and digital assets. Asset and wealth management firms can create more diversified and flexible investment portfolios.
8. Minimized Trust and Maximized Transparency: RWA reduces reliance on counterparty trust through the automatic execution and recording of transactions via smart contracts.
9. Efficiency and Security of Blockchain Technology: RWA also offers more robust risk management and clear ownership through the use of blockchain technology.

Disadvantages

1. Increasing regulatory scrutiny, regional differences, and related governance uncertainties may prolong the path of cross-border tokenization. Variances in regulatory frameworks across multiple major markets require multiple revisions or adjustments to operational models, thereby extending the expansion path.
2. Lack of coordinated and consistent plans to enhance awareness and adoption rates of new product investors.
3. Technology related to RWA is still immature. Issues stemming from risks such as DLT risks, platform risks, coding errors in smart contracts, and cybersecurity risks continue to arise.
4. The investor acceptance of RWA remains relatively low. While the demand for asset tokenization continues to grow, this demand is still not strong enough among some investors.

Bringing RWA Assets On Chain

According to Binance Research’s report, it divides the implementation process of RWA into three stages: Off-chain formalization, information bridging, and RWA protocol demand and supply.

Source: https://research.binance.com/en/analysis/real-world-assets-s

Off-Chain Formalization

To bring real-world assets into DeFi, it is necessary to first wrap these assets off-chain to digitize, financialize, and ensure compliance, clarifying details such as asset value, asset ownership, and legal protection of asset rights.

This process requires clarity on the following key points:

• Representation of economic value: The economic value of assets can be represented in various ways.
• Ownership and legitimacy of ownership: The ownership of assets must be clearly defined through contracts, mortgages, notes, or other legal forms.
• Legal support: In cases involving asset ownership or equity changes, there must be clear legal procedures.

Information Bridging

This process includes:

• Tokenization: After the off-chain packaged information is digitized, it is put on the blockchain and represented using metadata from digital tokens. This metadata is open to everyone and can be accessed through the blockchain, achieving complete transparency of asset value and ownership. Different types of assets can correspond to different DeFi protocol standards.
• Regulatory Technology/Securitization: For assets that need to be regulated or considered securities, they can be introduced into DeFi in a legal and compliant manner.
• Oracle: For real-world assets, external data needs to be referenced to accurately reflect the value of the assets. However, since the blockchain cannot directly access external data, an oracle is needed to connect on-chain data with real-world information and provide data such as off-chain asset value to DeFi protocols.

RWA Protocol Demand and Supply

The RWA protocol has driven the entire process of real-world asset tokenization, bringing together supply and demand. On the supply side, DeFi protocols oversee the formation of RWAs, while on the demand side, DeFi protocols facilitate investors’ demand for RWAs.

Conclusion

The field of cryptocurrency has always been controversial, mainly because it seems to lack tangible value in the real world. However, the emergence of RWAs has changed the situation, attracting the attention of traditional financial giants and businesses due to their potential to enhance the liquidity of real assets. Particularly, linking real assets with blockchain technology offers investors a more diversified range of investment options. In the short term, RWA’s current participants and audience are primarily institutional and corporate, with general investors yet to find a suitable entry point. In the long term, RWA presents a vast prospect for bridging traditional finance with crypto finance, ripe with innovative possibilities. As a financial innovation, it is crucial to closely monitor the development of RWAs and be vigilant of associated risks, as the RWA field still requires more experimentation and exploration.