Author: Aquarius

Tokenized real-world assets (RWAs) are digital tokens recorded on a blockchain that represent ownership or legal rights to tangible or intangible assets. The scope of tokenization encompasses a wide range of asset classes, including real estate (residential, commercial properties, and real estate investment trusts REITs), commodities (gold, silver, oil, and agricultural products), artworks and collectibles (high-value artworks, rare stamps, and vintage wines), intellectual property (patents, trademarks, and copyrights), and financial instruments (bonds, mortgages, and insurance policies).

By enabling fractional ownership, tokenization enhances the liquidity of assets, making investment opportunities that were once limited to high-net-worth individuals and institutional investors more accessible to the general public. The immutable ledger of blockchain ensures transparent ownership records, reducing the risk of fraud; at the same time, tokenized assets traded on decentralized exchanges bring unprecedented market accessibility and efficiency.

According to McKinsey's analysis, the total market value of various tokenized assets (excluding cryptocurrencies and stablecoins) is expected to reach approximately $2 trillion by 2030, with a pessimistic scenario of $1 trillion and an optimistic scenario of up to $4 trillion. These estimates do not include stablecoins (including tokenized deposits, wholesale stablecoins, and central bank digital currencies CBDCs) to avoid double counting, as these tools are often used as cash payment instruments in the settlement of tokenized asset transactions.

Current System

The tokenization of real-world assets refers to representing off-chain asset ownership in the form of digital tokens through blockchain or similar distributed ledger technology. This process connects the characteristics, ownership, and value of the asset with its digital form. Tokens serve as a digital holding tool, allowing their holders to assert ownership of the underlying asset.

Historically, physical certificates were used to prove asset ownership. While useful, these certificates are vulnerable to theft, loss, forgery, and money laundering. In the 1980s, digital holding tools began to emerge as a potential solution. However, constrained by the computing power and cryptographic technology of the time, these tools failed to materialize. Instead, the financial industry turned to centralized electronic registration systems to record digital assets. Although these paperless assets brought some efficiency improvements, their centralized nature required the involvement of multiple intermediaries, introducing new costs and inefficiencies.

Distributed Ledger Technology-Based Systems

The development of distributed ledger technology (DLT) has made it possible to re-examine the concept of digital holding securities or tokens.

DLT consists of a series of protocols and frameworks that allow computers to propose and verify transactions within a network while maintaining the synchronization of records. By decentralizing record-keeping, this technology shifts responsibility away from a single central authority. Such decentralization reduces administrative burdens and minimizes the risk of system failures associated with reliance on central entities, thereby making the system more resilient (see Figure 1).

These charts compare the transaction processes between traditional systems and DLT-based systems. Figure 1 illustrates how multiple intermediaries in the current system handle transaction execution, clearing, and settlement. Figure 2 shows how DLT-based systems simplify these processes through a single consensus mechanism.

Decentralized Solutions

Blockchain is a distributed ledger technology that operates through a decentralized network of computers. Tokens can be issued on two types of blockchains: private permissioned chains and public permissionless chains.

Private permissioned chains (like Ripple) are controlled by a central entity and restrict access to specific users, forming a controlled ecosystem. Public permissionless chains (like Ethereum), on the other hand, do not require central authority control and provide open access to all users. When tokens are issued on a public permissionless chain, they can be integrated with decentralized finance (DeFi) protocols (such as decentralized exchanges), enhancing their utility and value.

The choice of blockchain—whether a private controlled environment or a public open network—determines the level of control that the token issuer can maintain. Compared to private permissioned chains, public permissionless chains grant issuers less control. The choice of blockchain architecture should align with the issuer's objectives and the intended functions of the tokens.

A key advantage of asset tokenization is the automation enabled by smart contracts. Smart contracts are programs on the blockchain that execute when both parties meet specific conditions. These contracts automate financial transactions and administrative tasks, reducing the need for manual work and intermediaries. By eliminating counterparty risk, this automation makes operations more efficient and secure, resulting in faster and cheaper transfers.

Tokenization Methods

The tokenization of real-world assets has traditionally adopted a simple binary classification: assets are either tokenized or not. However, as we enter the era of digital assets, this overly simplistic view is no longer applicable. A more nuanced approach is to analyze assets based on two key attributes: their manifestation and ownership.

Manifestation includes the economic characteristics of the asset—its function, underlying asset, maturity date, and interest rate. Additionally, the verification of ownership requires a ledger, which can be off-chain or on-chain. Off-chain assets maintain their rights and manifestations through physical certificates (such as holding bonds) or paperless forms (such as electronic stock records), all operating within a legal framework. In contrast, on-chain assets exist in digitally enhanced or natively digital forms, governed by blockchain consensus mechanisms.

Understanding the distinction between digitally enhanced assets and natively digital assets is crucial. Digitally enhanced (or augmented) assets maintain ownership through off-chain ledgers, which serve as their security, while using blockchain tokens as their digital manifestation. For example, ownership of a stock may exist on an electronic ledger but is tokenized through blockchain to enhance its functionality. Conversely, natively digital assets (such as cryptocurrencies) are inherently digital, with their tokens directly representing value and ownership. This means that while the tokens of digitally enhanced assets provide the right to assert ownership from off-chain ledgers, the tokens of natively digital assets directly represent ownership without relying on any off-chain components.

With an understanding of asset types and the basis of tokenization, we can further explore four methods of tokenization. These methods differ in the degree of direct association between the token and its underlying asset. Next, we will systematically examine each method, from the most direct relationship between the token and the asset to the least direct.

• Direct Title: In this method, the digital token itself serves as the official record of ownership, eliminating the need for custodians. This method is applicable only to natively digital assets (see Figure 2). The system uses a single ledger (which may be a distributed ledger) to record token ownership. For instance, rather than issuing tokens supported by a share registration system, it is preferable to tokenize the registration system itself, making the token the actual record of ownership. This streamlined approach eliminates the need for custodians or duplicate registrations. While this method can utilize distributed ledgers, the registration system itself does not necessarily need to be distributed. However, the legal frameworks for most asset classes applicable to this tokenization method remain limited, and the regulatory structure is still immature.

• 1:1 Asset-Backed Tokens: In this method, a custodian holds the asset and issues tokens that represent direct rights to that underlying asset. Each token can be exchanged for the actual asset or its cash equivalent. For example, a financial institution may issue bond tokens based on bonds held in a trust account, or a commercial bank may issue stablecoin tokens backed 1:1 by commercial bank money in a dedicated account.

• Collateralized Tokens: This method issues asset tokens backed by assets that differ from the expected representation of the asset or related rights. Typically, to address fluctuations in the value of the collateral relative to the expected asset value of the token, the tokens are over-collateralized. For example, the stablecoin Tether is backed not only by cash but also by a range of other assets (such as fixed-income securities). Similarly, a government bond token can be created backed by commercial bank bonds, or a stock token can be supported by an over-collateralized basket of related stocks.

• Under-Collateralized Tokens: Tokens issued under this method aim to track the value of an asset but are not fully collateralized. Similar to a fractional reserve banking system, maintaining the value of the token requires active management of a partially reserved asset portfolio and open market operations. This is a higher-risk form of asset tokenization, with historical examples of failures. For instance, the collapsed Terra/Luna stablecoin was not backed by independent assets but relied on algorithmic stability through supply control mechanisms. Other lower-risk partially collateralized tokens have also been issued.
  

Why Choose Tokenization

The tokenization of real-world assets primarily achieves efficiency improvements through distributed ledger technology (DLT). This technology enhances transparency, automates processes, reduces operational costs, and eliminates intermediaries and counterparty risks. Compared to traditional financial systems, these advantages enable faster settlements and cost savings through streamlined and flexible market infrastructure.

• Atomic Settlement: The combination of distributed ledger technology with tokenized assets introduces the concept of atomic settlement. Currently, settlements are primarily conducted through central counterparties, and the commonly adopted method for securities settlement is rolling cycles. In this approach, although transactions are executed on a specific day, actual settlement (the transfer of ownership according to predetermined agreements) typically takes one to three days to complete. This involves two stages or transfers: the delivery stage, which transfers ownership of the securities from the seller to the buyer; and the payment stage, which transfers cash from the buyer to the seller. Atomic settlement is achieved through smart contracts, whose programmable code simultaneously executes both stages of the transaction or does not execute at all if predetermined conditions are not met. This approach eliminates counterparty risk while significantly enhancing transaction speed and efficiency. Additionally, settling transactions through smart contracts also eliminates the need for margin requirements, as there is no risk of delivery failure and subsequent transaction reconciliation. This further frees up funds tied up in margin, indirectly enhancing liquidity in financial markets.

• Increased Liquidity: Tokenization significantly enhances the transferability of assets, making previously non-tradable assets tradable. For example, traditional real estate transactions face significant barriers—high transaction costs, complex legal processes, and inherent lack of liquidity. These barriers, combined with the unique attributes of each property (such as location, condition, and legal status), make it impractical to trade individual properties on public exchanges like stocks or bonds. Tokenization addresses these challenges through smart contracts, which optimize transaction processes by eliminating intermediaries, simplifying ownership transfers, and automating compliance checks, thereby significantly reducing transaction costs. The same benefits apply to other traditionally illiquid assets, such as artworks, collectibles, infrastructure projects, and private equity shares. Furthermore, tokenization has enabled new decentralized markets through automated market makers (AMMs). These systems automatically match buyers and sellers through asset pools managed by smart contracts, providing continuous liquidity. Unlike traditional markets with fixed trading hours, these blockchain-based systems operate year-round. Greater accessibility is further enhanced through fractional ownership, lower investment thresholds, and simplified transaction processes.

• Reduction in Intermediation: The decentralized data structure allows smart contracts integrated into the blockchain to replace traditional intermediaries in verifying data. Smart contracts can also replace central securities depositories (CSDs), automating processes such as asset ownership transfers, dividend payments, and interest distributions.

• Enabling Automation: One of the main advantages of asset tokenization is the automation enabled by smart contracts. Smart contracts are programming codes deployed on the blockchain that execute automatically when predetermined conditions are met. Smart contracts can simplify many manual tasks, especially in industries like insurance. For example, they can automate policy issuance and claims payments. If a flight is delayed or canceled, a smart contract can automatically trigger travel insurance payouts without manual intervention. The effectiveness of such automation largely depends on the integration and real-time monitoring of relevant data. Third-party services known as "oracles" provide external data to smart contracts, serving as a bridge between the blockchain and the outside world, as smart contracts cannot directly access external data. Automation is most feasible in asset classes where data is quantifiable, standardized, and reliably obtained through oracles. Stocks, bonds, and derivatives are prime examples, as their market data is easily accessible and can be seamlessly integrated into smart contracts. However, automation faces greater challenges in industries with subjective or hard-to-quantify data. For instance, real estate involves complex transactions that require manual verification of legal documents, subjective property appraisals, and compliance with diverse regulatory frameworks—making comprehensive automation through smart contracts more difficult.

• Facilitating Compliance: Compliance is a key aspect of tokenized assets. With the development of regulatory frameworks such as Know Your Customer (KYC), Anti-Money Laundering (AML), and Counter-Terrorism Financing (CTF), a safer environment for digital finance and trading has been created. The underlying technology of tokenized assets enhances the efficiency and uniformity of compliance with these requirements through standardization and automation of processes. KYC and AML regulations can be directly encoded into the blockchain or the rules governing individual asset transfers, enabling more efficient interactions. For example, when a customer establishes a relationship with a new financial institution, their identity information can be automatically transferred with their consent. Research on the impact of tokenization on banking infrastructure shows positive results. By analyzing over 50 operational cost metrics, the study indicates that improved audit capabilities and transaction transparency can reduce overall compliance costs by 30% to 50%.

• Automated Market Makers (AMMs): Smart contracts are transforming traditional market-making mechanisms through automated market makers (AMMs). Traditional market makers provide liquidity by acting as buyers and sellers of securities, while AMMs take a different approach. They use smart contracts to automatically match buyers and sellers through asset pools provided by liquidity providers. These smart contracts embedded in the blockchain algorithmically determine asset prices and manage asset pools. The automation features of AMMs significantly reduce costs and improve performance. Studies show that AMMs have significantly lower transaction costs compared to traditional systems, particularly in high-volume and low to medium volatility assets.

Risks and Costs of RWA Tokenization

Despite the numerous advantages of tokenized assets, their adoption still faces significant challenges. The primary risks stem from underlying technology and regulatory considerations. Technical concerns include cybersecurity vulnerabilities, system scalability limitations, settlement processes, network stability, and efficiency issues. On the regulatory front, key issues involve AML compliance, governance frameworks, identity verification, and data protection and privacy. Researchers suggest that addressing regulatory issues surrounding digital assets should not be limited to integrating new technologies into existing frameworks. Instead, we should explore how to leverage blockchain technology and smart contracts to enhance regulatory compliance.

In addition to technical and regulatory challenges, investor behavior and market dynamics also introduce additional complexities. Achieving widespread adoption requires extensive education and awareness efforts. Market risks include the potential overvaluation of assets due to speculative trading and increased price volatility triggered by the digital nature of these assets. Furthermore, the high energy consumption of blockchain consensus mechanisms has raised environmental concerns. To fully realize the advantages of tokenization in the financial sector, these multifaceted challenges must be addressed.

The transition to a tokenized financial system involves significant costs. The most notable expenditures arise from the infrastructure changes required to support blockchain and tokenization technologies. Organizations need to invest in secure, scalable blockchain platforms, acquire specialized software for managing tokenized assets, and train employees to adapt to these new systems. Integration costs are also non-negligible—connecting these new systems with existing financial infrastructure while maintaining security and operational integrity. Educational initiatives aimed at improving understanding and overcoming skepticism also pose significant direct and opportunity costs for governments. Finally, the high electricity consumption of blockchain consensus mechanisms presents dual financial and environmental challenges.

Disclaimer: This article is for general informational purposes only and does not constitute investment advice, recommendations, or an invitation to buy or sell any securities. This article should not be the basis for any investment decision, nor should it be used as accounting, legal, tax, or investment advice. You are advised to consult your own advisors regarding any legal, business, tax, or other related matters concerning any investment decision. Some of the information contained in this article may come from third-party sources, including portfolio companies of funds managed by Aquarius. The views expressed in this article are solely those of the author and do not necessarily reflect the views of Aquarius or its affiliates. These views may change at any time without notice and may not be updated.