Original author: Zach Pandl, Grayscale

Original translation: Frank, Foresight News

· Asset tokenization refers to the registration of asset ownership on blockchain infrastructure. In tokenized form, assets can benefit from the functions of blockchain, such as more efficient settlement and the ability to interact with smart contracts;

· The modern financial system is already quite efficient to a large extent, and tokenization itself may not bring immediate efficiency improvements. Instead, we believe that the main benefits may come from bringing together users, assets, and applications onto a common global platform;

· From the perspective of the crypto market, while various assets can benefit from the tokenization trend, the most potential may be the protocol that can provide this universal global platform. Grayscale research currently believes that the Ethereum blockchain is most likely to achieve this goal in the future;

Public blockchains can be seen as general-purpose technologies with many potential use cases, from payments to video games to digital identity systems. The value of this technology comes in part from bringing a variety of applications to a platform with a permissionless and open architecture. When users, capital, and applications are concentrated in one place, everyone in the ecosystem can benefit from network effects.

Tokenization is one of the many applications of public blockchain technology. In some cases, if the existing "back-office" process is very cumbersome, moving asset management to the blockchain infrastructure may immediately improve efficiency. But for many types of assets (such as listed stocks), the current digital infrastructure works quite well, and it is not obvious whether public blockchains can play a better role. In these cases, the potential benefits of tokenization may come from network effects: by moving global assets to a common platform, we have the potential to create a more powerful, more accessible, and lower-cost financial system.

From the perspective of the crypto market, while various assets can benefit from the tokenization trend, the most potential may be protocols that can serve as a unified platform for tokenized assets, investors, and related applications. At present, Grayscale Research believes that the Ethereum blockchain is most likely to achieve this goal in the future.

System Upgrade

When blockchain is more widely adopted, securities may be issued and tracked entirely on-chain. But today, ownership of securities benefits and ownership of physical assets such as real estate, physical commodities and collectibles are recorded on traditional off-chain ledgers (usually electronic bookkeeping accounts). Tokenization refers to the process of registering asset ownership on blockchain infrastructure so that market participants can benefit from the functionality of the blockchain. By design, the price of blockchain-based tokens should closely track the price of the underlying reference asset.

Some of the benefits of converting asset ownership into blockchain-based tokens may include:

· Settlement efficiency: Blockchain transactions can be settled almost instantly and can be set up to exchange assets under payment conditions, reducing the risk of settlement failure;

· Programmability: Tokenized assets can be integrated into software applications to allow for added functionality. For example, this could include conditional transfers based on off-chain information (such as compliance approvals), or using tokens as collateral on decentralized lending platforms;

· Accessibility: Like the Internet itself, blockchains are not limited by national borders, so tokenized assets can enable investors from a wider range of countries or regions to gain access to the world's best capital markets. Blockchains can also open up access to new asset types through segmentation;

· Reduced costs: By increasing automation and reducing the role of middlemen, tokenized assets can reduce costs for issuers by reducing underwriting fees and lowering interest rates;

Researchers at the Bank for International Settlements (BIS) have defined a tokenization "continuum" for considering how this process affects specific markets. On the one hand are markets that still require a lot of manual workflows, such as real estate or bank loans. These assets may be difficult to tokenize, but the process can create meaningful efficiency gains.

On the other hand, many other markets currently use electronic bookkeeping systems that are quite efficient, such as listed stocks, mutual funds and ETFs, and listed derivatives. These assets may be easier to tokenize, but the process offers more limited efficiency gains.

The best candidates for tokenization may lie somewhere in the middle of the BIS continuum: markets that could benefit from slightly better electronic recordkeeping and smart contract capabilities—a list that could include many types of fixed-income securities, such as government bonds and structured products.

However, as discussed further below, the greatest gains may come from moving all assets onto a unified global platform.

Tokenization Now and Tomorrow

The first application of tokenization technology to find product-market fit (PMF) was stablecoins, which tokenize the simplest and most liquid of all assets: cash.

The total market capitalization of stablecoins now stands at $158 billion, with Tether (USDT) and USDC leading the pack (Exhibit 1). Stablecoins come in many forms, but both USDT and USDC can be considered fiat-backed stablecoins.

They operate similarly to other tokenized assets: the traditional asset is held by an off-chain custodian, and the tokenized representation can be held in a blockchain wallet. This form of digital cash can then be used for payments, benefiting from blockchain’s near-instant settlement, lower costs, and/or potential for interaction with smart contracts.

Exhibit 1: Stablecoins have found product-market fit

After stablecoins, the next tokenized asset to gain widespread adoption is gold (Exhibit 2). The two largest projects, Tether Gold (XAUt) and PAX Gold (PAXG), have a combined market cap of around $1 billion. While there are many ways to invest in gold, these products offer some blockchain features, such as the ability to transfer risk over weekends or outside of traditional market hours. This feature has shown its utility during recent geopolitical tensions in the Middle East: XAUt and PAXG both saw notable gains during the week of April 13-14, when other markets were closed.

Chart 2: Timeline of Selected Tokenized Projects

The latest wave of tokenization has focused on two distinct markets: U.S. Treasuries and their closely related assets, and credit products.

Tokenized U.S. Treasury products are designed to be cash equivalents and can be considered a stablecoin alternative with a yield. According to data provider RWA.xyz, the weighted average maturity of all existing products currently on offer is less than two years.

In other words, these products are designed to provide yield and perform cash-like functions. When cash rates are close to zero, the opportunity cost of holding stablecoins is relatively low. But now that U.S. interest rates are approaching 5%, investors are more motivated to look for yield-generating alternatives, which could boost the development of tokenized Treasury products.

Currently, there is more than $1 billion in outstanding tokenized Treasury funds, led by Franklin On-Chain U.S. Government Money Fund (FOBXX) and BlackRock USD Institutional Digital Liquidity Fund (BUIDL) (Exhibit 3). Many of the existing products have been launched on the Ethereum network and appear to be geared toward crypto-native institutions, such as cryptocurrency exchange-traded funds and DAOs (decentralized autonomous organizations).

However, the largest fund, FOBXX, has taken a different approach: it was launched on the Stellar chain and is available to retail investors via a mobile app. All in all, about 60% of tokenized Treasury fund AUM is on Ethereum, 30% on Stellar, and the rest on other blockchains.

Exhibit 3: About 60% of Tokenized Treasury Products Are on Ethereum

Individual companies have also launched tokenized credit products. This is a diverse category that includes direct lending to a single counterparty, pools of structured credit products (e.g., ABS, CLOs), and lending to intermediaries in specific industries (e.g., real estate financing, emerging markets). While these products can be risky and complex, and are currently designed only for institutional investors, their goal is simple - to channel capital from lenders to borrowers through blockchain infrastructure. According to RWA.xyz, there are currently $612 million in active loans in this category, with an average yield of about 10% (Exhibit 4).

Exhibit 4: Tokenized credit products cover a diverse mix of borrowers

There are many other potential applications for tokenization, but few have made it past the experimental stage. For example, tokenized real estate platform RealT offers investors outside the United States a way to fractionalize property ownership; the protocol currently has $103 million in total value locked. There are also hopes that tokenized private equity will provide the alternative investment industry with access to a wider range of investors, and it remains to be seen whether these new issuance channels will contribute significantly to the industry’s AUM.

A variety of fixed income securities have been issued directly on-chain, by both public sector issuers (e.g., the European Investment Bank) and private sector issuers (e.g., Siemens). While tokenized equities have been tried before, we suspect that these projects will require greater regulatory clarity before they can make further progress.

Tokenization has the potential to drive a significant amount of blockchain activity and fee revenue if adoption continues, given the sheer size of the potential market—In the U.S. alone, U.S. Treasuries represent a $26 trillion market, and total domestic non-financial sector lending is $36 trillion. The current size of on-chain tokenized assets represents a minuscule fraction of these totals. However, in order for these products to grow beyond today’s crypto-native institutions, they will need to connect more effectively with existing pools of capital. This may require building connections to brokerage or bank accounts, or by providing investors with sufficiently compelling reasons to move their assets on-chain.

The Revolution Won’t Happen on Private Chains

A common misconception is that tokenization may not benefit crypto assets because the activity will occur on private permissioned blockchains, rather than public permissionless blockchains like Ethereum. While banks have certainly experimented with using private blockchain infrastructure (e.g., JPMorgan Onyx, HSBC Orion, and Goldman Sachs DAP), this is at least partly a reflection of current regulation that prevents depository institutions from interacting with public chains, and asset managers that are not subject to these restrictions have been operating on public chains or a hybrid of public and private chains.

In fact, almost all successful tokenized applications to date (e.g., stablecoins, tokenized treasuries, and tokenized credit products) have been launched on public blockchain infrastructure.

The reason is simple: that’s where the users are.

We expect there will be efficiency gains from moving certain assets onto blockchain infrastructure, but the bigger promise of tokenization is to seamlessly connect assets and investors (or borrowers and lenders) around the world and build richer experiences through interoperable applications.

Public blockchains have many applications beyond tokenization, making them natural hubs for user assets and activity over time. As such, they will likely continue to be the primary destination for asset issuers and developers building open finance applications. We believe that private permissioned blockchains operated by companies or national governments are unlikely to credibly provide the global, neutral platform needed to custody the world’s tokenized assets.

Transactions, Fees, and Value Added

Blockchain transactions typically generate fees that can flow to token holders directly (e.g., dividends) or indirectly through a reduction in token supply (e.g., buybacks). Tokenizing assets can therefore generate value added to blockchain-based tokens if they generate transaction activity and fees. However, the mechanism by which this occurs will depend on the protocol type and token properties (Exhibit 5).

Exhibit 5: Assets from across the crypto space could benefit from tokenization

Some components of our smart contract platform crypto should see the most immediate impact. L1 blockchains in this segment (and perhaps eventually some components of their L2 ecosystems) can serve as a universal global platform for tokenized assets. The native tokens of these protocols are often used to pay transaction fees, “gas,” and may receive staking rewards or benefit from a reduction in token supply.

There is intense competition in the smart contract platform crypto space, but the Ethereum ecosystem still dominates other blockchains in terms of users, assets (total value locked), and decentralized applications. In addition, we believe Ethereum can be considered very decentralized and neutral to network participants, which is likely a necessary condition for any global tokenized asset platform.

As a result, we believe Ethereum is currently best positioned among smart contract blockchains to benefit from the tokenization trend. Other smart contract platforms that may benefit from the tokenization trend include Avalanche (a platform used by financial institutions for various proof-of-concept projects), Polygon, and Stellar, as well as L1 blockchains designed specifically for tokenization, such as Mantra and Polymesh.

The next group of beneficiaries include the tokenized protocols themselves, which provide platforms for bringing traditional assets to on-chain software applications (Exhibit 6). Many of these providers do not have governance tokens (e.g., Securitize, Superstate), but some do.

For example, Ondo Finance, which issues tokenized treasury products, and Centrifuge, a tokenized credit product platform and part of the financial crypto space, investors should consider the nature of the governance rights they confer and whether they confer rights to any protocol revenue before considering these tokens.

Exhibit 6: Year-to-date returns of selected tokenized protocols

Finally, the increase in blockchain activity due to tokenization is likely to support many other components in the crypto ecosystem. For example, Chainlink hopes that its Cross-Chain Interoperability Protocol (CCIP) will provide core infrastructure for messaging data across blockchains, both private and public. Similarly, the Biconomy protocol provides certain technical processes that can help traditional financial institutions interact with blockchain technology (for example, a "paymaster" service that allows users to pay for gas fees in tokens other than the blockchain's native token).

Both Chainlink and Biconomy are part of our Utilities and Services crypto space.

Tokenization Vision

In summary, many digital commerce use cases are moving from closed platforms hosted by centralized middlemen to open and decentralized platforms based on public blockchain infrastructure, and tokenization is just one of many blockchain adoption trends.

But given the size and scope of global capital markets, it may be an important trend, and if public chains can match borrowers and lenders (or asset issuers and investors) and disintermediate existing fintechs, then the increase in network activity should bring value to public chain tokens.

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