Analysis of the Technical Mechanisms of Real-World Asset Tokenization

Tokenization of real-world assets ( RWAs ) refers to recording the ownership or legal rights of physical or intangible assets in the form of digital tokens on the blockchain. This tokenization encompasses a wide range of asset classes, including real estate, commodities, artworks, collectibles, intellectual property, and various financial instruments.

Tokenization increases the liquidity of assets by enabling fractional ownership, allowing more investors to participate in investment opportunities that were previously limited to high-net-worth individuals and institutions. The immutable characteristics of blockchain ensure the transparency of ownership records and reduce the risk of fraud. At the same time, tokenized assets traded on decentralized exchanges bring unprecedented market accessibility and efficiency.

According to the 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 $4 trillion. These estimates do not include stablecoins to avoid double counting.

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 ledgers. This process connects the characteristics, ownership, and value of the asset with its digital form. Tokens, as a digital holding tool, enable their holders to claim ownership of the underlying assets.

Historically, physical ownership certificates were used to prove asset ownership. While useful, these certificates were vulnerable to theft, loss, forgery, and money laundering threats. In the 1980s, digital holding tools began to emerge as a potential solution. However, limited 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 certain efficiency improvements, their centralized nature required the involvement of multiple intermediaries, which in turn introduced new costs and inefficiencies.

System based on distributed ledger technology

The development of distributed ledger technology ( DLT ) makes it possible to re-evaluate the concept of digital securities or tokens.

DLT consists of a series of protocols and frameworks that enable computers to propose and validate transactions over 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 decreases the risk of system failures associated with reliance on central entities, thereby making the system more resilient.

In traditional systems, multiple intermediary institutions handle transaction execution, clearing, and settlement. In contrast, 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.

A private permissioned blockchain is controlled by a central entity and restricts access to specific users, forming a controlled ecosystem. In contrast, a public permissionless blockchain does not require a central authority for control and provides open access to all users. When tokens are issued on a public permissionless blockchain, they can be integrated with decentralized finance ( DeFi ) protocols, thereby enhancing their utility and value.

The choice of blockchain determines the level of control that the token issuer can maintain. Compared to private permissioned chains, public permissionless chains grant the issuer less control. The choice of blockchain architecture should align with the issuer's goals and the intended functions of the token.

A key advantage of asset tokenization is the automation achieved through 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, enabling faster and cheaper transfers.

Tokenization Method

The tokenization of real-world assets can be analyzed through two key attributes of the asset: its form of representation and ownership.

The forms of expression include the economic characteristics of assets ------ their functions, underlying assets, maturity dates, and interest rates. Ownership verification requires a ledger, which can be off-chain or on-chain. Off-chain assets maintain their rights and forms of expression through physical certificates or paperless forms, all operating within a legal framework. On-chain assets exist in digitally enhanced or natively digital forms, managed by blockchain consensus mechanisms.

Digital enhanced assets maintain ownership through an off-chain ledger, which serves as their security guarantee, while using blockchain tokens as the digital representation. Digital native assets are essentially digitized, with their tokens directly representing value and ownership.

The four main methods of tokenization include:

1. Direct Ownership: Digital tokens themselves serve as official ownership records, eliminating the need for custodians. This method is applicable only to digital native assets.

2. 1:1 asset-backed Token: The custodian holds the assets and issues tokens that represent direct rights to the underlying assets. Each token can be exchanged for the actual assets or their cash equivalents.

3. Over-collateralized Tokens: Issuing asset tokens by using assets that are different from the expected representation of assets or related rights as collateral. Typically, to cope with the fluctuations in the value of collateral assets relative to the expected asset value of the tokens, the tokens are over-collateralized.

4. Insufficiently collateralized Tokens: The issued Tokens are intended to track the value of a certain asset, but are not fully collateralized. Maintaining the value of the Tokens requires active management of part of the reserve asset portfolio and public market operations.

The Advantages of Tokenization

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

The main advantages include:

1. Atomic settlement: Execute the two stages of a transaction simultaneously through smart contracts, eliminating counterparty risk and improving transaction speed and efficiency.

2. Liquidity Enhancement: Tokenization significantly increases the transferability of assets, making previously non-tradable assets tradable.

3. Reducing Intermediaries: The decentralized data structure allows smart contracts integrated on the blockchain to replace traditional intermediaries in verifying data.

4. Achieving Automation: Implement automation through smart contracts to simplify many manual tasks, especially in industries such as insurance.

5. Promoting Compliance: The underlying technology of tokenized assets enables more efficient and standardized compliance with regulatory requirements through standardization and automation processes.

6. Automated Market Makers ( AMMs ): Smart contracts are transforming traditional market-making mechanisms through automated market makers, reducing trading costs and improving performance.

Risks and Costs of RWA Tokenization

Despite the many advantages that tokenized assets bring, their adoption still faces significant challenges. The main risks stem from underlying technology and regulatory considerations. Concerns on the technical side include cybersecurity vulnerabilities, system scalability limitations, settlement processes, network stability, and efficiency issues. On the regulatory front, key issues involve anti-money laundering compliance, governance frameworks, identity verification, and data protection and privacy.

In addition, there are additional complexities brought about by investor behavior and market dynamics, such as speculative trading leading to the potential overvaluation of assets and increased price volatility. The high energy consumption of blockchain consensus mechanisms has also raised environmental concerns.

The transition to a tokenization financial system involves significant costs, including infrastructure changes, system integration, employee training, and educational activities. To fully realize the advantages of tokenization in the financial sector, these multifaceted challenges must be addressed.