RWA in the eyes of the Federal Reserve: Tokenization and Financial Stability.

Original Title: "RWA in the Eyes of the Federal Reserve: Tokenization and Financial Stability"

Original Author: Web3 Xiao Lu

In a working paper on tokenization published by the Federal Reserve on September 8th, it was stated that tokenization is a new and rapidly growing financial innovation in the cryptocurrency market, analyzed from the perspectives of scale, advantages, and risks. First, the concept of tokenization is introduced, which refers to the process of creating digital representations (cryptographic tokens) for non-cryptocurrency assets (underlying assets). In this process, tokenization establishes a link between the cryptocurrency ecosystem and the traditional financial system. In cases of sufficient scale, tokenized assets may transfer the risk of volatile fluctuations from the cryptocurrency market to the underlying asset market of traditional finance.

The following is a compilation of this 29-page paper to further understand RWA and tokenization, underlying assets and crypto assets, regulation and financial stability. To borrow a quote from the principal: "Any financial technology comes with risks, and the deep integration of regulatory technology with RWA and DeFi will be an important driving force for the development and iteration of future encryption technologies."

This is another RWA research report following our previous compilations on Binance (Real World Asset Tokenization RWA, bridging TradFi and DeFi), Citigroup (the next billion users and trillion-dollar value of blockchain, money, tokens, and games), and our own analysis of the current implementation path and future prospects of RWA-Fi. Enjoy:

The address of the Federal Reserve working paper can be found here.

One, What is Tokenization

"Tokenization" refers to the process of linking the value of underlying assets (Reference Assets) to the value of a cryptocurrency. Strictly speaking, tokenization will allow token holders to have legal rights to dispose of underlying assets. So far, most tokenization projects on the market have been initiated by small VC-backed cryptocurrency companies, while traditional financial institutions such as Santander Bank, Franklin Templeton Fund, and JPMorgan Chase have also announced their tokenization pilot projects related to cryptocurrency assets.

Like stablecoins, tokenization also has different characteristics due to different design schemes. Generally, tokenization usually includes the following 5 features: (1) based on blockchain; (2) owning underlying assets; (3) a mechanism for capturing the value of underlying assets; (4) a way to store/custody assets; (5) a redemption mechanism for tokens/underlying assets. Overall, tokenization connects the crypto market with the market where underlying assets are located, and the design of tokenization schemes will differentiate various tokens and affect traditional financial markets to varying degrees.

The first factor to consider in tokenization scheme design is the underlying blockchain, which is used for token issuance, storage, and trading. Some projects issue tokens on permissioned private blockchains, while others issue them on permissionless public blockchains. Permissioned blockchains are typically controlled by a centralized entity that approves selected participants to enter a private ecosystem. Issuing tokens on permissionless blockchains (such as Bitcoin, Ethereum, Solana, etc.) allows for greater public participation and fewer restrictions, but also weaker control by the issuer. Tokens on permissionless blockchains can also be integrated into decentralized finance (DeFi) protocols, such as decentralized exchanges. Examples of project token cases issued on permissioned and permissionless blockchains are shown in Figure 1.

Another consideration is the underlying asset of the token. There are various classifications of underlying assets, such as on-chain assets and off-chain assets, intangible assets and tangible assets, etc. Off-chain underlying assets are independent of the crypto market and can be tangible (such as real estate and commodities) or intangible (such as intellectual property and traditional financial securities). Tokenization of off-chain/underlying assets typically involves an off-chain intermediary, 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 smart contracts to provide custody and asset valuation for 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 connects the crypto market with the underlying asset market. In addition, tokenized assets can also be traded on secondary markets such as centralized crypto exchanges and DeFi trading platforms. Although some security tokens involving other on-chain debts or equities do not include redemption mechanisms, they still grant token holders other rights such as cash flow disposal rights related to their underlying assets.

二、目前代币化市场规模，以及代币化资产的类别

Translation:

II. Current scale of tokenization market and categories of tokenized assets

According to public sources, we estimate that as of May 2023, the size of the tokenized market on unlicensed blockchains is $2.15 billion. 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, making it difficult to obtain a comprehensive set of data. Therefore, we will use the public data from the DeFiLlam platform to demonstrate the thriving development of tokenization in DeFi. As shown in Table 1, since June 2022, the total locked value (TVL) of the entire DeFi market has remained stable, while Table 2 shows that the TVL of real-world assets (RWA) has continued to grow compared to similar assets or the entire DeFi market since July 2021. Many new tokenization projects have recently been announced, including various types of underlying assets such as agricultural products, gold, precious metals, real estate, and other financial assets.

Recently, a typical tokenization project involves agricultural products such as SOYA, CORA, and WHEA, which respectively refer to soybeans, corn, and wheat. The project is a pilot program launched by Santander Bank and cryptocurrency company Agrotoken in Argentina in March 2022. By embedding the underlying asset's recourse rights in the token and building infrastructure for verifying, processing transactions, and redemption, Santander Bank can accept these tokens as collateral for loans. Santander Bank and Agrotoken stated that they hope to promote commodity tokenization projects in larger markets such as Brazil and the United States in the future.

Another type of tokenized underlying asset is gold and real estate. As of May 2023, the market size of tokenized gold is approximately $1 billion. Two types of tokenized gold, Pax Gold (PAXG) issued by Paxos Trust Company and Tether Gold (XAUt) issued by TG Commodities Limited, account for 99% of the market share. Both issuers set a token unit equal to one ounce of gold, which is stored by the issuer in accordance with the standards set by the London Bullion Market Association (LBMA). PAXG can be redeemed for equivalent US dollars, while XAUt is redeemed by the issuer selling it on the Swiss gold market. Overall, the two modes are basically the same, with the same value as gold futures.

Compared to commodities such as agricultural products and gold, real estate as an underlying asset faces challenges in standardization, weak liquidity, difficult valuation, and more complex legal and tax issues. All of these pose significant challenges to the tokenization of real estate. 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), and the shares of the LLC are tokenized instead of the property itself, allowing different investors to hold the same property. The project mainly provides a way for international investors to invest in US real estate, with rental income as the return. As of September 2022, RealT has tokenized 970 properties with a total value of $52 million.

The tokenization of financial assets involves underlying assets such as securities, bonds, and ETFs. Unlike directly holding securities, the prices of tokenized securities may differ from the prices of the securities themselves. This is due to the 24/7 trading of tokens on one hand, and the programmability and composability of tokens with DeFi on the other hand, which can bring different liquidity to tokens. We use Table 345 to show the differences in prices and trading volumes of META securities and their corresponding tokenized securities, MEAT (based on Bittrex FB).

You can tokenize traditional compliant trading platforms or issue tokens directly on the blockchain. Akionariat, located in Switzerland, provides tokenization services for Swiss companies. US listed companies such as Amazon (AMZN), Tesla (TSLA), and Apple (AAPL) have or have had tokenized securities traded on Bittrex and FTX.

In early 2023, Ondo Finance issued tokenized funds, with the underlying assets being ETFs of US bonds and corporate bonds. The shares of these tokenized funds represent the corresponding shares in the ETFs. In addition, Ondo Finance holds a small amount of stablecoins as liquidity reserves. Ondo Finance serves as the manager of the tokenized funds, Clear Street serves as the broker and custodian of the funds, and Coinbase serves as the custodian of the stablecoins.

Three, the benefits that tokenization may bring

Tokenization can bring many benefits, including allowing investors to enter markets that were previously difficult to access due to high investment thresholds. For example, tokenized real estate can allow investors to purchase a small fraction of a specific commercial building or residential property, which is different from real estate investment trusts (REITs) that are investment tools for real estate portfolios.

The programmability of tokens and the ability to use smart contracts allows for additional functionality to be embedded into the tokens, which may also benefit the underlying asset market. For example, liquidity savings mechanisms can be applied to token settlement processes, which are difficult to implement in the real world. These blockchain features may lower the entry barriers for investors, making the market more competitive and liquid, as well as enabling better price discovery.

Tokenization may also promote lending by using tokens as collateral, as discussed earlier in the case of tokenized agricultural products, as using agricultural products directly as collateral would be costly or difficult to implement. In addition, settlement of tokenized assets is more convenient compared to underlying assets or financial assets in the real world. 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 throughout the settlement cycle, usually one business day after the transaction.

ETF is the financial instrument most similar to tokenized assets, and existing empirical evidence suggests that tokenization can improve liquidity in underlying asset markets. Academic literature on ETFs has demonstrated a strong positive correlation between ETFs and underlying asset liquidity, and has found that the additional trading activity in ETFs leads to higher information exchange/circulation in underlying assets. For tokens, a mechanism similar to ETFs could mean that greater liquidity of tokens in the crypto market may be more advantageous for the value discovery of underlying assets.

Four, the impact of tokenization on financial stability

The market size of tokenization below one billion dollars is relatively small compared to the overall size of the cryptocurrency market or traditional financial market, and it does not pose a systemic financial stability issue. However, if the tokenization market continues to grow in quantity and scale, it may pose financial stability risks to both the cryptocurrency market and traditional financial systems.

Long-term, the redemption mechanisms established in tokenization between the cryptocurrency ecosystem and traditional financial systems may have potential impacts on financial stability. For example, in a large enough scale, emergency selling of tokenized assets could affect traditional financial markets, as the price discrepancies in the cryptocurrency market provide arbitrage opportunities for market participants to redeem underlying assets of tokenized assets. Therefore, a mechanism may be needed to address the value transmission in both markets mentioned above.

In addition, due to the lack of liquidity in underlying assets, tokenized assets may face problems. Examples may include real estate or other underlying assets with poor liquidity. This issue has also been discussed in academic literature on ETFs, where there is a strong correlation between the liquidity, price discovery, and volatility of underlying assets in ETFs.

Another financial stability risk is the token issuer itself. Token assets with redemption options may encounter similar problems as asset-backed stablecoins like Tether. Any uncertainty about underlying assets (especially lack of disclosure and issuer information asymmetry) may increase incentives for investors to redeem underlying assets, triggering the sale of tokenized assets.

This type of liquidity transmission may also be exacerbated by the characteristics of the cryptocurrency market. Cryptocurrency trading platforms allow for continuous trading of cryptocurrency assets 24/7, while most underlying asset markets are only open during business hours. The mismatch in trading times may have unpredictable effects on certain investors or institutions in special circumstances.

For example, tokenized assets with redemption options may face token sell-offs on weekends, as the underlying assets are held off-chain and traditional markets are closed on weekends, making it difficult for redeemers to quickly obtain the underlying assets. This situation may further deteriorate, and the decline in the value of tokenized assets may threaten the solvency of institutions holding a significant portion of these assets on their balance sheets. In addition, even if institutions can obtain liquidity from traditional markets, they may find it difficult to inject liquidity during periods when traditional markets are closed.

Therefore, the large-scale sale of tokenized assets may quickly reduce the market value of holding asset institutions and issuers, affecting their borrowing ability and thus their debt repayment ability. Another example may be related to the automatic margin call mechanism of DeFi trading platforms, which triggers the requirement for liquidation or token redemption, which may have unpredictable effects on the underlying asset market.

With the development of tokenization technology and tokenized asset market, tokenized assets themselves may become underlying assets. Considering that the prices of crypto assets fluctuate more than similar underlying assets in the real world, the price fluctuations of such tokenized assets may spread to traditional financial markets.

With the continuous expansion of the tokenized asset market, traditional financial institutions may participate in various ways, such as directly holding tokenized assets or holding tokenized assets as collateral. Examples in this regard may include Santander Bank using tokenized agricultural products as collateral to provide loans to farmers. As mentioned above, we also see cases such as Ondo Finance tokenizing US government money market funds.

In addition, although in essence similar to JPMorgan's first use of money market fund (MMF) equities as collateral for repurchase and securities lending transactions, Ondo Finance's initiative may have a more profound impact on traditional financial markets. Ondo Finance's tokens are deployed on the public blockchain Ethereum, rather than on 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 fund accounted for 32% of the entire tokenized asset market. According to DeFiLlama, Ondo Finance is the largest tokenization project in this category, and its token OUSG can also serve as collateral for the 19th largest lending protocol Flux Financ.

Finally, similar to the role of asset securitization, tokenization may package underlying assets with higher risks or lower liquidity into safe and easily tradable assets, potentially leading to higher leverage and risk-taking. Once the risks are exposed, these assets may trigger systemic events.

Five, Conclusion

1. This article aims to provide a background on asset tokenization, and discuss the potential benefits as well as the financial stability risks it may bring.

2. Currently, the scale of asset tokenization is very small, but tokenization projects involving various types of underlying assets are under development, indicating that asset tokenization may occupy a larger part of the cryptocurrency ecosystem in the future.

3. Among the benefits that tokenization may bring, the most prominent is the reduction of barriers to entry into markets that were previously inaccessible and the improvement of liquidity in such markets.

4. The financial stability risks brought about by asset tokenization mainly manifest in the interconnection between tokenized assets in the encrypted ecosystem and the traditional financial system, which may transfer risks from one financial system to another.

Attachment: Information on some asset tokenization projects

欧洲投资银行发行的数字债券

European Investment Bank issued digital bonds.

The European Investment Bank has issued multiple blockchain bond products. The first bond was issued through the HSBC Orion platform, based on a combination of private and public blockchains, with a total size of 50 million pounds. Blockchain serves as a record of bond ownership and manages floating rate tools and bond lifecycle events. The bond will be held in digital accounts through the HSBC Orion platform.

The second bond was issued through Goldman Sachs' private blockchain GS DAP, with a total size of 100 million euros and a term of 2 years. The bond is represented in the form of security tokens, and investors can use fiat currency to purchase them. Goldman Sachs Bank Europe, Santander Bank, and Société Générale acted as joint managers and settled with the issuer in the form of CBDC. These tokens are provided by the Bank of France and the Central Bank of Luxembourg. Société Générale Securities Services (SGSS Luxembourg) serves as the custodian of on-chain assets, and Goldman Sachs Europe serves as the account custodian of CBDC.

The characteristic of this bond is T+0 real-time settlement, and secondary trading can only be conducted over-the-counter, with settlement in fiat currency off-chain. The bond interest is paid in legal euros, and Goldman Sachs Europe acts as the payment agent to distribute these funds to bondholders.

Morgan Stanley's Onyx platform

Morgan Stanley's Onyx platform has the ability to tokenize assets and conduct transactions of encrypted assets. Onyx is based on a licensed blockchain and primarily serves institutional clients, providing cross-currency transactions for digital yen and digital new yuan, and services for the issuance of Singapore government bonds. In the future, Morgan Stanley says it will enable ledger transactions for US Treasury bonds or money market funds on the Onyx platform.

The Onyx platform has also completed daytime repurchase agreement settlement between J.P. Morgan brokers and bank entities. Both the collateral and cash portions of the repurchase agreement can be settled using the Onyx platform. For cash transactions in repurchase agreements, settlement is made using its JPM Coin, a blockchain-based banking account system. Since its launch in 2020, the platform has generated $300 billion in revenue.

Obligate

Investors will be able to access Obligate through their existing cryptocurrency wallets. For each investment, investors hold a corresponding eNote (ERC-20) token, which grants them the right to receive payment upon maturity or collateral in the event of default.

Franklin Templeton

The US asset management company Franklin Templeton offers tokenized US government money market funds based on the Stellar and Polygon public blockchains. Investors can purchase Benji tokens, with each token representing a share in the tokenized fund. The goal of each share is to maintain a stable $1 share price and can be redeemed at any time. Share ownership is recorded on the proprietary system of the Stellar blockchain network.

The tokenized fund has 92.5% of its assets from US institutions, with the remaining portion in cash. Investors can purchase through the Benji Investments application. The tokenized fund currently manages assets exceeding $272 million.

Ondo Finance

Ondo Finance offers several tokenized fund products, including OUSG, OSTB, OHYG, and OMMF. The underlying assets of these tokenized funds are Blackrock US Treasury ETF, PIMCO Enhanced Short Maturity Active ETF, Blackrock iBoxx High Yield Corporate Bond ETF, and American Beacon Funds. The returns of OMMF tokens are airdropped daily to token holders, while the returns of other tokens, such as OHYG, are automatically reinvested in the relevant assets. Token holders can receive traditional fund accounting reports from third-party service providers to verify fund assets.

Tokens can be redeemed daily, but settlement may take several days. If the fund has US dollars on hand, redemption will occur immediately. If not, the fund will sell ETF shares, transfer the dollars from Clear Street to Coinbase, convert the dollars to USDC on Coinbase, and then pay the USDC to the token holder.

RealT

Real Token Inc. (RealT) tokenizes the equity of residential properties by collecting them. Each property is independently held by a limited liability company (LLC), and the shares of the LLC are tokenized, not the property itself. Therefore, the shares of each company that owns a property are fractionalized and can be collectively held by investors. The project primarily provides international investors with a way to invest in US real estate and receive rental income returns. As of September 2022, RealT has tokenized 970 properties with a total value of $52 million.

At the legal level, RealT is a company registered in Delaware, named Real Token LLC. The existence of this entity is to simplify the process of issuing tokenized real estate, by placing each property under a series of LLC companies and offering shares to earn returns.

RealT's tokens can be used as collateral for the RMM DeFi lending protocol, which is based on Aave V2. So far, only non-US users can access the RMM protocol and borrow stablecoin DAI.

MatrixDock

MatrixDock has issued its stablecoin (STBT), with each stablecoin anchored to 1 US dollar. The stablecoin is supported by US Treasury bonds and repurchase agreements with a maturity date of no more than 6 months. STBT can be minted or redeemed, and users must first deposit USDC/USDT/DAI. Once the purchase of underlying assets is "confirmed", the deposited USDC/USDT/DAI will be used to mint STBT tokens. Redemption can be done through MatrixDock's application or by transferring STBT to the issuer's dedicated address, with a deadline of T+4 (only on New York banking days). If the holder redeems STBT before maturity, the execution price is calculated by dividing the settlement price of the Treasury bond by the fair market value (FMV) of the previous day.

Lofty

Lofty will tokenize US real estate on the Algorand blockchain. Its operation is very similar to RealT, where after the property is transferred from the seller to Lofty, Lofty will place each property in a separate LLC company and tokenize the shares of the LLC company. Holding these tokens earns income from rental income and property appreciation of the underlying assets. Since the underlying assets are a legal right, rather than the underlying assets themselves, it is unlikely that there will be a way to redeem them.

Tangible

Tangible is an NFT marketplace for real-world assets, allowing users to convert wine, gold bars, watches, and real estate into NFTs. Real-world assets are held and stored in Tangible's secure storage facilities. Users can purchase NFTs using the platform's native stablecoin (Real USD, primarily supported by real estate interest income, with an expected APY of 10%-15%) or tokens such as DAI. Only when the holder owns all shares of an NFT can all NFTs be redeemed as underlying assets.

Aktionariat

Aktionariat is a legally compliant digital platform limited to Switzerland. The Aktionariat platform provides tools for other companies to tokenize their shares and enables trading. As Aktionariat is capable of holding and trading tokenized stocks as well as traditional stocks, the price of the stocks will depend on the total supply, including the listed shares and the company's valuation. Aktionariat maps the shareholder register by tracking transaction addresses on the blockchain and addresses stored in off-chain databases, and updates it in real-time. However, due to the difference between shareholders and token holders, the transfer of tokens may not necessarily result in changes to the register. Companies can also convert back to traditional shareholding by repurchasing their tokens from shareholders and "burning" them.

Agrotoken

Agrotoken provides a solution for tokenizing agricultural products such as soybeans, corn, and wheat. Each token represents 1 ton of the underlying commodity, and the expiration date of the commodity can be marked as 30, 60, or 90 days or renewed to the maximum contract date. Exporters or collectors will ensure grain reserve certificates through oracles. The protocol runs on the Ethereum public blockchain, and each token is an ERC-20 token.

This project is a pilot program launched by Santander Bank and cryptocurrency company Agrotoken in Argentina in March 2022. By embedding underlying commodity recovery rights in the tokens and building infrastructure for verifying, processing transactions, and redeeming them, Santander Bank is able to accept these tokens as collateral for loans.

Through cooperation with Visa, Agrotoken has created a bank card that is accepted by 80 million stores and businesses related to tokenized agricultural products. The company is effectively connecting Argentine farmers and exporters with the global business network to deal with surplus food.

Paxos Trust

Paxos is a financial institution specializing in blockchain infrastructure and payment systems, and is also the custodian of many encryption projects, such as stablecoin USDP and tokenized gold Pax Gold (PAXG). PAXG only runs on the Ethereum blockchain and is available for settlement 24/7, accounting for about half of the tokenized gold market. One PAXG token is equivalent to one ounce of gold and can be exchanged for physical gold itself, as well as gold equity/credit rights, or sold directly for US dollars through Paxos' platform. Paxos is regulated by the New York State Department of Financial Services.

TG Commodities Limited

TG Commodities Limited is the issuer of Tether Gold (XAUt) and is headquartered in London. Legally, it is not the same entity as Tether Limited (USDT), the stablecoin issuer based in Hong Kong, but both will be considered the same issuer. One XAUt is equivalent to one ounce of gold and can be redeemed for either the physical gold itself or the fiat currency obtained from selling the physical gold on the Swiss gold market. All XAUt is backed by physical gold and holders can search for specific gold bars related to their XAUt through the Tether Gold website. Redemption is only available for whole gold bars ranging from 385 to 415 ounces.

Toucan Protocol

The Toucan protocol allows users who have carbon credits in the carbon registry to tokenize them and allow for trading. The tokenized carbon credits are called TCO2s, which are programmed as NFTs and can be differentiated by adding additional names (such as TCO2-GS-0001-2019) to distinguish the project and specific circumstances of the carbon credit. Toucan also manages two liquidity pools: the base carbon pool and the natural carbon pool, to increase liquidity and aggregate similar carbon credits. The natural carbon pool only accepts TCO2 tokens generated from natural projects.

Centrifuge

Centrifuge is an open DeFi protocol and a real-world asset market. Owners of real-world assets act as initiators to create asset pools fully collateralized by real-world assets. The protocol is not limited to asset types and has multiple categories of asset pools, such as mortgage loans, trade invoices, microloans, and consumer finance, etc. At the same time, Centrifuge can be integrated into other DeFi protocols, such as hosting most of the RWA assets in MakerDAO.

The tokenization of real-world assets is initiated by Asset Originators who establish asset pools. Each asset pool is connected to a special purpose vehicle (SPV), which obtains legal ownership of the assets from the Asset Originator to separate the SPV's assets from the Asset Originator's business. Real-world assets are tokenized into NFTs and associated with off-chain data. Investors deposit stablecoins (usually DAI) into the asset pool and, in return, receive two types of tokens representing the asset pool based on their risk preference: TIN and DROP tokens. TIN and DROP tokens can be redeemed periodically, and investors' returns come from the fees paid by borrowers who obtain financing from the asset pool. Investors can also receive rewards from the platform token CFG.

Goldfinch

Goldfinch is a decentralized lending protocol that provides encrypted loans for fully collateralized off-chain assets. The protocol has three main participants: investors, borrowers, and auditors. Investors can also support the development of the protocol by providing funds to the Goldfinch member vault.

The borrower is a lending entity outside the chain, who proposes transaction terms related to the loan amount in the agreement, called the loan pool. Investors can directly provide funds to the lending pool or indirectly provide funds to the agreement and participate through the automatic allocation process in the agreement. Investors can redeem their tokens on specific dates, such as once every quarter.

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