Exploration on Real World Assets (RWAs) & Tokenization

In traditional asset management, the process of trading and investing entails the exchange of capital within a framework of strict regulations. This process faces various limitations, such as high entry barriers, restricted liquidity, and indivisible ownership.

From the perspective of investors and consumers, many investment opportunities require substantial amounts of capital to participate. This high upfront cost can make it difficult for individuals with limited financial resources to access these investment opportunities. For example, the initial cost of purchasing property is very high, so individuals who do not have an accumulation of capital are more likely to miss the chance of investing in real estate.

In addition, these types of investments are regulated and may necessitate individuals to adhere to certain regulatory criteria before participating. These rules and regulations not only prolong the investment process but also exclude many potential qualified investors and consumers.

From the perspective of owners, the only way to turn their physical assets into cash is to sell or lease the entire assets to other individuals. Yet, this procedure can be daunting because it may take months or even years for the owner to find suitable buyers or tenants at the desired price. The lengthy process involves negotiations, auctions, and so on. It’s not feasible to split ownership of the asset, selling a portion while retaining some for themselves [1]. For instance, the owner cannot sell only a portion of his/her real estate or artwork. This situation underscores the illiquidity of RWAs.

The introduction of RWA tokenization has had a significant impact on a variety of industries and is now widely used in both personal asset trading and public asset management. As shown in Fig. 1, similar to the fact that the utilization of the Internet enables the evolution of traditional documents, the application of blockchain is the digital upgrade of text-to-paper technology.

Blockchain technology provides a decentralized digital ledger which records transactions across many computers. Thus, the registered transactions can’t be altered retroactively. This technology lays a foundation for cryptocurrency systems and is valuable for the integrity and verifiability of data without a central authority.

Consensus mechanisms are protocols that make sure all participants in a blockchain network agree on the current state of the ledger. They are critical to maintaining the security and integrity of the blockchain. Common consensus mechanisms include Proof of Work (PoW) which involves complex computations to secure transactions. While Proof of Stake (PoS) selects validators based on their token holdings. Additionally, Delegated Proof of Stake (DPoS) makes token holders vote for delegates who manage the blockchain. These protocols are fundamental in maintaining the blockchain’s security and integrity and crucial for RWA tokenization.

Smart contracts are self-executing contracts with the terms of the agreement directly written into lines of code. They automatically enforce and execute the terms of a contract based on its code, which is publicly verifiable on the blockchain. This is instrumental in automating processes, reducing the need for intermediaries, and ensuring transparency and trust.

1. 1.

   Varied Jurisdictional Regulations: Different regions exhibit diverse approaches to the regulation of blockchain technologies and tokenized assets. For instance, the U.S. Securities and Exchange Commission (SEC) has been actively engaging in discussions around whether certain tokens qualify as securities, which would subject them to additional regulatory scrutiny and compliance requirements. Similarly, the European Union is working on frameworks like the Markets in Crypto-Assets (MiCA) to streamline regulatory approaches across its member states.

2. 2.

   Compliance and Legal Challenges: Token issuers must navigate a complex landscape of compliance issues, including but not limited to AML (Anti-Money Laundering) and KYC (Know Your Customer) protocols, and securities regulations. Ensuring compliance requires robust legal expertise and often, substantial resources, especially for platforms operating across multiple jurisdictions.

3. 3.

   Impact on Tokenization and Investor Protection: Regulations are intended to protect investors by ensuring that token issuers disclose adequate information about the risks and details of the investment, maintain fair trading practices, and operate within the bounds of the law. These protections help stabilize the market and build trust among investors, which is crucial for the adoption and growth of tokenization technologies.

The tokenization of RWAs into digital tokens is a multifaceted process that transforms physical and intangible assets into tradable digital representations on a blockchain. This process begins with the identification and selection of the asset to be tokenized. The chosen asset could be anything from a piece of real estate, or a work of art, to shares in a private company.

Following the selection of the asset, the asset undergoes a thorough valuation to determine its suitability for tokenization. This valuation not only determines the market value of the asset but also aids in defining the structure of the tokenization—how many tokens represent the asset and at what price each token should be offered. For tangible assets like real estate, this might involve a detailed property inspection and market comparison, whereas for assets like art, it might require authentication and historical significance evaluation.

The next step is the design and development of the token itself, which involves choosing the right blockchain platform that supports token standards such as ERC-20 or ERC-721 and deciding on the type of token—whether it should be fungible (identical and interchangeable) or non-fungible (unique). The token design includes defining what rights and benefits the token holders will have. For example, in the case of a building, this might include not only ownership shares but also potentially a share in the rental income. After the token design, the creation of a smart contract is imperative. This self-executing contract with the terms of the agreement written into code governs the functionality of the token. It defines the rules under which the tokens operate, including how they can be bought, sold, or transferred. The smart contract automates the execution of these rules, ensuring efficiency and compliance without manual intervention.

With the smart contract in place, the actual issuance of the tokens can occur. This involves the minting of tokens on the blockchain, which are then ready to be distributed to investors or purchasers. This step marks the transformation of the physical or intangible asset into a digital form that can be traded on blockchain platforms.

The final step in the tokenization process is the distribution of the tokens. Depending on the nature of the asset and the target investors, these tokens can be sold directly to known investors, offered through a public sale, or listed on digital asset exchanges for trading. This phase is critical as it not only involves the initial sale of the tokens but also sets up the framework for secondary trading, providing liquidity and accessibility to investors.

Here is an example token following the ERC-20 standard through an Open Zeppelin template.

Smart contracts are foundational to the functionality and security of blockchain technology, particularly in the context of asset tokenization. These autonomous contracts, once deployed on the blockchain, execute automatically when predefined conditions are met, ensuring the seamless management of digital tokens without the need for a centralized authority. Their capabilities revolutionize the way transactions are conducted and ownership rights are enforced in the realm of decentralized finance [11].

In the realm of ownership management, smart contracts are pivotal. They maintain a precise and immutable record of ownership on the blockchain. Every token has its ownership details coded into the smart contract, making each token’s provenance and ownership transparent and indisputable [12]. This level of transparency is crucial in markets where trust is paramount, eliminating the need for lengthy verification processes traditionally handled by third parties such as banks or legal teams.

When it comes to the transfer of tokens, smart contracts automate what was once a cumbersome and error-prone process [11]. Upon the execution of a transaction, the smart contract immediately updates the blockchain ledger with new ownership details. This automation ensures that transfers are not only secure but occur instantaneously, thereby enhancing liquidity and enabling real-time trading [13]. This feature is particularly transformative in markets like real estate or art, where sales and transfers traditionally involve multiple steps and can take considerable time to finalize.

Furthermore, in scenarios where tokens represent shares in a revenue-generating asset, such as rental properties, smart contracts facilitate the distribution of dividends [12]. They can be set to automatically distribute earnings to token holders according to their ownership stake, ensuring fairness and timeliness in profit-sharing. This feature not only simplifies the management of such assets but also enhances their attractiveness to investors by providing a clear, automated, and trustless dividend distribution mechanism.

Overall, the role of smart contracts in managing the ownership and transfer of tokens is transformative, offering unprecedented levels of efficiency, security, and compliance in the digital asset sphere. These contracts are the backbone of the decentralized finance (DeFi) ecosystem, providing the tools necessary to reshape the landscape of investment and asset management.

In this example, the smart contract defines a basic framework for asset tokenization:

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  The owner of the contract can issue shares (issueShares) to any address. The owner can transfer the contract’s ownership to another address using the transfer ownership function.

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  Shareholders can transfer their shares to others with the transferShares function.

This simplistic example illustrates how a smart contract can be used to manage ownership and transfer rights within the framework of tokenized assets.

The primary advantage of RWA tokenization is that through digitizing asset ownership, the RWA assets can be divided into smaller, more easily tradable units. Thus, compared the traditional entire ownership trading, the ownership can be divided. This property of fractionalization enhances liquidity because it lowers the entry barrier of the market and many partially qualified investors and buyers. Additionally, asset trading, involving the exchanging of digitalized tokens, is much easier because there is no need to submit redundant paper documents. The circulation on the secondary market makes the prices transparent to other sellers and buyers in this field, thus providing the platform to compare prices and stimulate market activity.

Unlike the traditional asset transaction, with the technique of RWA tokenization, various kinds of assets can be represented with digital tokens regardless of the location, form, or physical properties of the assets. The transaction with digital tokens overcomes the limitation of trading hours of the stock exchanges. As the transaction does not require the validation of an authenticated third party, the buyers and sellers can initiate a trade whenever they want. This is especially beneficial to the across-broader transaction in different time zones. This flexibility brings about the advantages of mitigating risks like geographic distance, shipment, and time differences.

In traditional asset management, especially in real estate transactions, it is often a tedious process to investigate any existing contracts, leases, or accuse associated with the property [14]. With a blockchain-based registry, these details could be recorded and updated transparently. All relevant information about the property’s legal status, previous ownership, and fundamental facts can be readily available on the blockchain. So the buyers can obtain sufficient information without extensive legal searches and document reviews.

Similarly, in commodity markets, the application of RWA tokenization provides a detailed document of the managing, tracking, and verification of assets. For instance, the blockchain can be utilized to authenticate the origin of rare jewelry, tracing from mining, cutting, and wholesale to retailing, which reduces the information asymmetry.

RWA tokenization can also improve security during asset registration and exchange. As traditional asset management often relies on physical registration certificates, the certificates can face risks of loss, theft, or destruction. Even if there may be digitized copies of the certificates, they may not be updated among different bureaucracies in different countries. The host servers are also vulnerable to risks of being hacked or destroyed. For instance, in 2010, an earthquake in Haiti destroyed the host server of the land registry database. This disaster led to a loss of sixty years’ worth of land registry records. Over a million citizens who suffered property loss in this disaster were unable to prove their assets [15]. In these cases, the property of immutability of RWA tokenization based on blockchain technology can help. It ensures that even if some nodes in the blockchain are destroyed, the complete ledger can still be kept because at least other intact full nodes also store copies of the data [16]. Therefore, the integrity and consistency of the data can be guaranteed.

During the trading process of the RWA, the security of the transaction can also be ensured even without an authenticated third party. The ownership of a property is represented by digital tokens recorded on the blockchain ledger. Only the legitimate owner of the asset can initiate a transaction due to the private key validation. Once the transaction is validated, it cannot be immutable. This process automatically avoids the risk of double-spending and fraud, adding an additional layer of trust to the transaction.

In traditional asset transactions, a legal trade process should involve the witness of intermediaries, like brokers, agencies, custodians, and so on. Their validation and paperwork can lead to additional high transaction costs. As tokenized RWA simplifies the whole transaction process and makes point-to-point trading possible on blockchain platforms, the transaction costs can be largely reduced. According to the research and estimation of Roland Berger in Figure 4, with the application of tokenized RWA, about €4.6 billion of the transaction costs in equity trading could be saved by 2030. This estimation only covers one asset type[17]. So in the general scenario, the cost savings will be significantly much greater than the expectation.

Real estate is defined as the land and any permanent structures, like a home, or improvements attached to the land, whether natural or man-made. Real estate is a form of real property. It differs from personal property, which is not permanently attached to the land, such as vehicles, boats, jewelry, furniture, and farm equipment.

NFT Trading cards are digital representations of collectible cards that are owned and traded on blockchain platforms. They leverage the unique properties of NFT’s such as scarcity, provable ownership, and immutability, to offer collectors a new way to engage with their digital assets.

One of the most significant technical challenges facing blockchains, especially those like Ethereum which are popular for tokenization, is scalability. The ability to process transactions quickly and cost-effectively is crucial as the volume of transactions on blockchain networks increases. Currently, networks such as Ethereum can become congested, leading to slower transaction times and higher costs. This limitation can be a significant barrier to the widespread adoption of blockchain for asset tokenization, where speed and efficiency are critical [18].

While blockchain technology enhances security, it also introduces new vulnerabilities, particularly in the rigid structure and execution of smart contracts. Unlike traditional contracts, which allow for amendments and adaptations to address real-life dynamics, smart contracts are inflexible once deployed, potentially leading to practical complications if changes are necessary. This rigidity can expose tokenization platforms to increased risks as programming errors or oversights become more challenging to rectify post-deployment [13]. The result is that amending a smart contract may not only complicate the modification process but also increase transaction costs and the likelihood of errors in reflecting intended changes accurately [19]. As tokenization platforms grow more complex, the potential for such vulnerabilities increases, necessitating rigorous security audits and updates to ensure the integrity of the platforms.

Cross-chain capabilities allow for tokenized assets to be traded, utilized, or moved freely among different blockchain environments, which further enhances liquidity and accessibility [18]. This expansion may facilitate a worldwide ecosystem for tokenized RWAs and minimize fragmentation within the ecosystem [21].

The potential for tokenizing new types of assets is vast, including areas such as intellectual property, personal data, or carbon credits, which could transform a multitude of industries [21]. For example, tokenizing intellectual property could streamline the licensing processes, making it easier for creators to monetize and protect their work. Similarly, personal data tokenization could give individuals more control over their data and the ability to monetize their personal information securely and transparently.

Widespread tokenization has the potential to dramatically reshape global financial markets and investment strategies. By making assets more liquid and accessible, blockchain could democratize access to investment opportunities, previously available only to select groups or individuals. Moreover, the increased transparency and efficiency provided by blockchain could lead to more robust and resilient financial systems, reducing the likelihood of fraud and increasing the ease of regulatory compliance.