What is Real World Asset Tokenization and How Does it Work?

Blockchain proponents have long held the belief that the technology is capable of transforming global financial markets and ushering in a new era of digitization and efficiency that solves many of the longstanding problems facing the system as it currently exists. 

The launch of the first spot Bitcoin (BTC) exchange-traded funds (ETFs) on the United States market brought a newfound legitimacy to the asset class, but even before that point, large financial institutions were starting to explore the tokenization of real-world assets (RWAs), bringing investments like U.S. Treasuries and stocks on-chain. 

As global finance embarks on the next stage in its evolutionary journey, tokenized RWAs are sure to play a crucial role in its transformation, so here’s a closer look at what they are, how they work, and how they are helping to shape the future of finance. 

The concept of tokenization is unique to the world of blockchain and involves the conversion of assets or utilities into digital tokens that can then be transferred and stored on the blockchain. 

In the world of blockchain, when someone mentions Real World Assets, they are referring to the tokenization of tangible assets with clear monetary value – such as gold, carbon credits, artwork, real estate, or uranium – into tradable digital formats. 

The sector of the cryptocurrency ecosystem that stands to see the biggest benefit from RWAs is decentralized finance (DeFi), as they will allow trillions of dollars of value held in the real world to be represented on-chain, greatly increasing the total value included in the ecosystem. 

The process of creating legitimate tokens that represent the real-world assets they are intended to involves three phases: off-chain formalization, information bridging, and RWA protocol demand and supply.

Off-chain Formalization

In order to integrate a real-world asset with a digital ledger, its value, ownership, and legal standing must first be unequivocally established in the physical world.

Data like market price, performance history, and physical condition of the asset are some of the factors that are taken into consideration when determining the value of an RWA, and the asset must also have undisputed legal ownership, documented by deeds or invoices.

Information Bridging

This phase is where the tokenization process occurs and involves the transformation of the asset’s information into a digital token. Data regarding the asset’s value and rightful ownership are embedded within the token’s metadata, allowing anyone to verify the token’s authenticity via a block explorer.

When tokenizing assets that fall under the purview of regulators or are classified as securities, it is imperative that regulatory technologies – such as employing licensed security token issuers, adhering to crypto-specific KYC (Know Your Customer) and KYB (Know Your Business) standards, and leveraging cleared security token exchanges – are involved in the tokenization process. 

RWA Protocol Demand and Supply

Having an RWA tokenized and hosted on a blockchain is all well and good, but they don’t have much use without a viable, liquid market where buyers and sellers can freely trade. 

That is where DeFi protocols that focus on RWAs come into play.

These types of platforms serve two purposes: (1) They help bring new RWAs into existence, increasing the number and variety of investment opportunities for DeFi users; and (2) they help to generate investor interest in buying and trading these assets, which helps tackle the issues of liquidity and necessary minimal trading volumes. 

Once the steps of off-chain formalization, information bridging, and RWA protocol demand and supply have been completed, real-world assets are transformed into practical, functional, and (soon to be) vital components of the DeFi landscape, carrying the weight and trust of real-world valuation and legal frameworks into the decentralized digital asset arena.

RWAs and DeFi are a Match Made in Heaven

In the world of DeFi, a key metric used to determine the health and vitality of a protocol is Total Value Locked (TVL). TVL measures the amount of capital that is locked on the protocol, and a higher TVL generally translates into higher utility. 

During the 2021 bull market, the TVL of the entire DeFi market hit a high of around $180 billion – but was primarily comprised of crypto tokens, many of which had dubious valuations, lacked any real utility, and had poor tokenomics. 

By June 2022, the total DeFi TVL fell to $49.87 billion, a drop of 72.3% in just 7 months, as projects like Terra/Luna met their demise and dragged much of the ecosystem down with them. 

As a result of the events of 2022 and the crypto winter of 2023, many crypto investors have matured in their appetites and are now focused on stable, long-term investment opportunities rather than chasing quick gains.

With the rise of interest rates in the U.S. came tokenized Treasuries, which allowed holders to earn a yield above 4% (as of Feb. 20, 2024) through an on-chain instrument. In 2023, RWA on-chain value (not including stablecoins) grew by $1.05B, of which $855.7M (82%) came from yield-bearing assets such as treasuries, real estate, and private credit.

As more assets are tokenized in the future, the TVL of DeFi will only increase, creating more value to be tapped into and utilized across the ecosystem. 

Multiple benefits come with incorporating RWAs and DeFi, including increased liquidity, transparency, fractional ownership, and inclusivity. 

• Liquidity: Many assets, such as real estate and artwork, exist in traditionally illiquid and slow-moving markets. Tokenization allows a wider pool of investors to engage with these assets. 
• Transparency: Public blockchains ensure that every transaction and ownership detail of an RWA is recorded and openly verifiable. 
• Fractional Ownership: Large assets like real estate can be divided into multiple tokens, lowering the barrier to entry for everyday investors as they can now pool their funds with other investors to collectively own a property. 
• Inclusivity: Blockchain and DeFi also remove the barriers to entry to financial services that many around the world face, bringing fresh opportunities to existing investors as well as new participants, helping to enhance the overall stability and growth potential of the global financial ecosystem. 

There are pros and cons to all things, and the use of RWAs in DeFi is no exception. 

• Regulatory concerns: There are unique regulatory requirements that apply to RWAs and DeFi, some of which can dissuade the average investor from engaging. Making matters more complicated is the fact that these requirements can change depending on the asset, geolocation, jurisdiction, and even the specific blockchain platform used for tokenization.
• Security concerns: With RWA tokens representing tangible assets, it is vital to maintain the link between the physical asset and the digital tokens, and the link needs to be capable of holding up against fraud and legal disputes. 
• Scalability: Platforms hosting RWA tokenization must be capable of handling an increase in transactions and data to ensure properly functioning markets. 

RWAs are significant for a variety of reasons, chief among them being the ability to bring trillions of dollars on-chain and introduce millions of new investors to blockchain and DeFi. RWAs hold the promise of creating a more interconnected, inclusive financial system that combines the best of TradFi and DeFi to usher in finance of the future. 

While there will be hurdles along the way – from both a technological and regulatory standpoint – it’s possible that one day in the future, all assets will be represented in digital token form on a blockchain, and those who are reading this today will be able to say that they were there when it all began, but only had an inking of how transformative the process would be.