Original title: Tokenization and the New Market Cycle 》

Original author: David Duong, David Han

Original compilation: Block unicorn

Tokenization progress, benefits, challenges, and outlook for its future. Asset tokenization is something the crypto industry has been working on for years and is gradually gaining momentum and adoption among institutions.

Initially in 2017, the hype around tokenization centered around the creation of digital assets on the blockchain that represented ownership of illiquid physical assets, such as real estate, commodities, art, or other collectibles. But the current high-yield environment has given tokenization a different meaning, namely the digitization of financial assets such as sovereign bonds, money market funds and repurchase agreements.

We believe this could be an important use case for traditional financial institutions and could become an important part of the new crypto market cycle, although full implementation may take another 1-2 years. Compared to 2017, when opportunity costs were closer to 1.0-1.5%, we believe todays nominal rates above 5.0% allow financial institutions to more clearly appreciate the capital efficiency of immediate (versus T+2) settlement. Furthermore, in our opinion, the ability to operate around the clock, automate intermediary functions, and maintain transparent audit trails can make simple on-chain payments and settlements very powerful.

However, infrastructure and justice (legal) issues remain core challenges. Most institutions rely on private blockchains, for example, due to their concerns about smart contract vulnerabilities, oracle manipulation, and network failures, i.e. the risks they associate with public networks. But we believe that private networks may make interoperability more difficult in the future, and one possible result is the fragmentation of liquidity, which will make it more difficult to realize the full benefits of tokenization, such as having a functional secondary market.

Tokenization fails to deliver on initial promise

During the crypto winter of 2017, tokenization seemed to be failing to deliver on its initial promise of putting trillions of dollars of real-world assets (RWA) on chain. The popular idea at the time was that token issuers would convert ownership of illiquid physical assets such as real estate, commodities, art and other collectibles into digital tokens that would exist on a distributed ledger. Among the benefits are fractional ownership of these goods, allowing many people to acquire otherwise hard-to-reach assets, democratizing access to them.

Even today, real estate seems to be a particularly promising opportunity for tokenization, especially given ongoing reports about housing becoming increasingly unaffordable, especially for younger generations. However, despite clearly defined use cases, tokenization failed to gain substantial traction in 2017. Instead, the next crypto market cycle is driven by experimentation with decentralized finance (DeFi), while the disruptive promise of tokenization has been conspicuously put on hold.

We believe the recent resurgence of the tokenization theme is partly due to the crypto market sell-off in 2022, as many proponents emphasized the fundamental value of blockchain technology rather than token speculation. This is reminiscent of the now-famous “Blockchain, not Bitcoin” mantra, a disparaging rhetoric often used by tokenization skeptics in the crypto space to argue that the current enthusiasm for these projects may only This continues until crypto price action begins to recover.

How has the market changed?

While we believe this criticism has some merit, the current crypto cycle differs from previous bear markets in a number of important ways. Foremost among these is the global interest rate environment. From early 2017 to late 2018, the Fed gradually raised interest rates from 0.50-0.75% to 2.25-2.50% while keeping its balance sheet relatively stable. By comparison, in the current rate hike cycle (beginning in March 2022), the Fed has raised interest rates a full 525 basis points to 5.25-5.50% and reduced interest rates by more than 10,000% over the past 18 months. billion dollar balance sheet.

From a consumer perspective, higher short-term bond yields lead to retail/retail investors seeking higher returns. This demand has been channeled into more protocols seeking to enter the tokenized U.S. Treasury market in a way that did not exist in 2017. (Neither the two stablecoins with the highest market capitalization – USDT and USDC – have native interest-earning capabilities.) The regional banking crisis in March 2023 also made the problem of low yields on existing customer deposits increasingly apparent. Therefore, in our view, tokenized products have the potential to drive on-chain activity, but regulatory issues may be a barrier to widespread development and adoption, potentially leaving U.S. consumers in limbo.

Over the past year, rising interest rates have been reflected in a shift in real-world asset tokenization protocol allocations from private credit protocols to U.S. Treasuries (see Figure 1). In particular, the amount of RWA assets deposited as collateral within Maker DAO has grown significantly, with over $3 billion in DAI stablecoins already minted. As long-term and short-term yields in traditional finance increase, borrowing rates in traditional financial markets rise, and DAI’s relatively low borrowing rate (approximately 5.5%) looks increasingly competitive.

At the same time, for institutional investors, the cost of occupying funds in a high interest rate environment is much higher than in a low interest rate environment. Currently, most traditional securities transactions are settled within two working days (T+2), during which funds from buyers to sellers are locked and utilization is low. In 2017, when nominal yields were approaching 1.0-1.5%, market participants effectively paid negative real interest rates on these funds. Today, nominal returns of more than 5% translate into ex-ante real returns of 3% annualized. As a result, capital efficiency is now even more important for markets with daily trading volumes ranging from hundreds of billions to over trillions of dollars. We believe that for traditional financial institutions, the value of instant settlement and T+2 settlement is clearer, which may not have existed before.

Over the past six years, many misconceptions about tokenization have also become understood among senior leadership at major institutions. They now have greater awareness of the benefits of tokenization, including the ability to operate around the clock, automate intermediation functions, and maintain transparent audit and compliance records. Additionally, counterparty risk is minimized because trades can be settled atomically in both delivery-to-payment and delivery-to-delivery scenarios. Additionally, it is important to consider that many traditional market players involved in tokenization today have dedicated teams that 1) both understand the current regulations and 2) develop the technology to enable them to comply with the requirements of these regulations.

Tokenization business case and prospects

As a result, we believe the business use cases for tokenization have shifted from putting real estate, such as real estate, on-chain to capital market instruments, such as U.S. Treasuries, bank deposits, money market funds, and repurchase agreements (repurchases). In fact, in a 5% interest rate environment, we think JPMorgans tokenized intraday repos (for example) are more attractive than they were two years ago when interest rates were near zero. However, to be clear, many of the benefits of tokenization (such as improved unit economics, lower costs, faster settlements) are not new and will still require large-scale distribution for them to work.

Forecasts on the size of the tokenization opportunity vary, but range from $5 trillion by 2030, according to Citigroup, to $16 trillion, according to Boston Consulting Group. These numbers may not seem as exaggerated as they first appear. First, they include forecasts for the growth of central bank digital currencies (CBDCs) and stablecoins. Indeed, the key variable explaining the difference in these estimates is the potential percentage of the global money supply that a tokenized asset could contain.

Indeed, stablecoins are now one of the clearest potential cases for tokenization, and in the future their reserve assets may include customer deposits and liquid cash alternatives. We believe stablecoin liquidity could be one of the clearest ways in which tokenization intersects with the broader crypto economy for the next market cycle.

Uncertainty about laws and regulations

Nonetheless, questions of legal clarity regarding the status of the assets of the United States and its bearers have not yet been resolved. And even outside the United States, many legal and regulatory hurdles still plague most tokenization efforts, as many laws covering this area are still new. Due to the nascent nature of the market, widely recognized legal precedents and templates do not yet exist, so establishing these legal frameworks requires considerable time and money.

For example, Luxembourg was one of the first countries to adopt tokenization laws, enacting its first law allowing the use of blockchain for securities trading in March 2019, and has passed several laws since then, most recently in In March 2023, tokenized collateral will be allowed. The EU’s distributed ledger technology (DLT) pilot program also doesn’t come into effect until March 2023, opening the way for broader tokenization efforts.

Because of this regulatory ambiguity, multiple platforms are often required to handle the tokenization of assets in different jurisdictions. Many on-chain tokenized treasuries, including OpenEden, Backed, Matrixdock, and Ondo, limit participants to accredited investors, and often to non-U.S. persons. A growing number of U.S. Treasury token issuers are registered in non-U.S. jurisdictions (see Figure 3). The issuing authority’s jurisdiction is not always clear to end users and ranges from highly regulated jurisdictions such as the United States and Switzerland to places like the British Virgin Islands, adding an additional layer of risk to existing smart contracts. An additional layer of counterparty risk.

The legal structure and investor requirements for private blockchains are equally complex and are only beginning to be ironed out. The euro-denominated European Investment Bank (EIB) bond issued in November 2022 is the first digital bond issued under Luxembourg law, while the Hong Kong dollar-denominated Hong Kong Monetary Authority (HKMA) bond issued in February 2023 is the first. A product regulated by Hong Kong law. The process of digitizing securities to distributed ledger technologies varies across jurisdictions, while the interplay between crypto-ownership, physically decentralized networks and jurisdiction-specific securities is still in the early stages of exploration.

financial rift

The direct consequence of the above-mentioned legal challenges is that the liquidity of the secondary market is affected, because investors need to enter new trading channels for each different platform. This can be time-consuming as know-your-customer (KYC) and anti-money laundering (AML) checks are typically not shared between protocols and institutions.

As a result, many tokenized assets struggle to find transparent price discovery through decentralized finance (DeFi) channels such as trading automated market makers (AMMs). Tokenized Treasury activity on Ethereum has been weak compared to similar KYC-less assets. See Figure 4. For example, there is no significant gap in the market cap of Curve’s DeFi native 3-pool (3 Crv) token compared to Ondo Finance’s institutional-grade OUSG tokenized treasury bonds ($199 million vs. $140 million), despite the former’s holder count Almost 200 times that of the latter (that is, although the former has a higher market capitalization, it has only 56 holders, while the latter, although it has a lower market capitalization, has 9,254 holders).

The 3 Crv token has the largest daily trading volume despite its lower gains (as of October 24, 2022) and has attracted over 100 in less than a month since its launch in 2020, according to Etherscan. independent daily trading participants. In contrast, US Treasuries, which are tokenized on Ethereum, are averaging less than ten transfers per day overall, nearly a year after their launch. As a result, we believe investor barriers severely hinder the liquidity and adoption of these assets, although the controversial KYC measures introduced by Uniswap V4 may change the future adoption and liquidity path of these assets.

Permissioned chains and private tokens

Additionally, many institutions choose to build their own private blockchains for tokenization purposes because they are concerned about risks such as smart contract vulnerabilities, oracle tampering, network outages, and compromised keys that they associate with public networks. risk. Additionally, private chains offer the benefits of private, fee-free transactions and KYC (Know Your Customer) for all network participants.

Technology providers in the private blockchain space appear to be consolidating around four main solutions: (1) Hyperledger’s Platform Suite, (2) Consensys’ Quorum, (3) Digital Asset’s Canton, and (4) R3’s Corda. Each platform has its own unique ecosystem, but different projects built on the same technology stack will not automatically achieve interoperability due to the physical isolation of the network. This isolation has a negative impact on the ability to settle transactions atomically, which is one of the main advantages of tokenization.

In fact, it is worth noting that some platforms only record transaction details on the blockchain and do not involve cash delivery. That said, cash moves through traditional banking channels (and therefore still relies on independent cross-bank solutions), so the process of real-time settlement is incomplete. Additionally, using multiple platforms may spread liquidity across chains, similar to issues that arise when using different public blockchain networks.

Regarding cross-chain interoperability technology, which is discussed in detail in our latest report, many private blockchain providers are committed to promoting interoperability initiatives within their ecosystems. However, achieving interoperability between chains, especially between permissioned chains, is not just a technical issue, but also involves legal and business issues. Therefore, we believe interoperability and liquidity will persist in the short to medium term as platforms consolidate and the space continues to gain legal clarity.

Conclusion: The road ahead is long

We expect institutional interest in tokenization to continue into the next crypto market cycle as the benefits of tokenization (capital efficiency, faster settlement, increased liquidity, reduced transaction costs, improved risk management) is evident. However, something has changed, and that is the focus on the underlying assets that are being tokenized, with traditional financial institutions looking at U.S. Treasuries, money market funds, and repurchase agreements.

How this is implemented is crucial. We believe that the next one to two years will be a period of platform integration around three aspects: (1) financial verticals, (2) jurisdictional boundaries, and (3) technology stacks. Integration and interoperability have also been a focus, as tokenizing security assets on one chain and payment currencies on another greatly increases complexity and risk, while exacerbating settlement times and reducing transparency. Without integration, the tokenization space will continue to face challenges of fragmented liquidity and investor entry, especially in secondary markets.

However, traditional companies are often slow to transform, and many have committed to building their own tokenization platforms. As a result, we believe it is too early to select potential winners, although we believe a flywheel effect of adoption will be driven by early network effects and the ability to flexibly respond to changing legal and technological environments.

Ultimately, we believe the interest in tokenization reflects the industrys shift from a focus on pure decentralization to a practical combination of centralized entities and semi-decentralized networks that can onboard more users. As more jurisdictions develop legal frameworks for tokenization, we expect a gradual shift toward unlocking tokenized liquidity over the long term through integration and interoperability.