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Tokenized real-world assets (RWAs) are digital tokens recorded on a blockchain that represent ownership or legal rights to physical or intangible assets. The scope of tokenization spans a wide range of asset classes, including real estate (residential, commercial properties, and REITs), commodities (gold, silver, oil, and agricultural products), art and collectibles (high-value artworks, rare stamps, and vintage wines), intellectual property (patents, trademarks, and copyrights), and financial instruments (bonds, mortgages, and insurance policies).
By enabling fractional ownership, tokenization enhances asset liquidity, democratizing access to investment opportunities once exclusive to high-net-worth individuals and institutional investors. Blockchain’s immutable ledger ensures transparent ownership records, reducing fraud risks, while tokenized assets traded on decentralized exchanges bring unprecedented levels of market accessibility and efficiency.
According to McKinsey's analysis, the market capitalization of tokenized assets across various classes (excluding cryptocurrencies and stablecoins) is projected to reach approximately $2 trillion by 2030, with scenarios ranging from $1 trillion in a pessimistic case to $4 trillion in an optimistic one. These estimates exclude stablecoins—including tokenized deposits, wholesale stablecoins, and central bank digital currencies (CBDCs)—to prevent double counting, as such instruments are often used as cash legs in the settlement of tokenized asset trades.
Tokenization of real-world assets means representing ownership rights of off-chain assets through digital tokens on a blockchain or similar distributed ledger. This process links an asset's characteristics, ownership rights, and value to its digital form. The token acts as a digital bearer instrument, allowing its owner to claim ownership of the underlying asset.
Historically, physical bearer certificates proved the ownership of assets. Though useful, these certificates were vulnerable to theft, loss, forgery, and money laundering. The 1980s saw the emergence of digital bearer instruments as a potential solution. However, limited computing power and cryptographic capabilities prevented their implementation. Instead, the financial industry turned to centralized electronic registries for digital asset records. While these dematerialized assets brought some efficiency gains, the centralized nature required multiple intermediaries—creating new costs and inefficiencies.
The development of Distributed Ledger Technology (DLT) has made it possible to revisit the concept of digital bearer securities, or tokens.
DLT consists of protocols and frameworks that allow computers to propose and validate transactions while maintaining synchronized records across a network. By decentralizing record-keeping, this technology shifts responsibility away from a single central authority. Such decentralization reduces administrative burden and minimizes the risk of system failure that comes with relying on a central entity, thus making the system more resilient.
Blockchain is a type of distributed ledger technology that operates across a decentralized network of computers. Tokens can be issued on two types of blockchains: private permissioned blockchains and public permissionless blockchains.
Private permissioned blockchains, such as Ripple, operate under a central entity's control and limit access to select users, creating a controlled ecosystem. Public permissionless blockchains, like Ethereum, function without central authority and provide open access to all users. When tokens are issued on public permissionless blockchains, they can integrate with Decentralized Finance (DeFi) protocols, such as decentralized exchanges, which enhances their utility and value.
The choice of blockchain—whether a private, controlled environment or a public, open network—determines the level of control a token issuer maintains. Public permissionless blockchains give issuers less control than private permissioned ones. The choice of blockchain structure should align with the issuer's goals and the token's intended functionality.
Asset tokenization's key advantage is automation through smart contracts—blockchain programs that execute when specific conditions are met by both parties. These contracts automate financial transactions and administrative tasks, reducing the need for manual work and intermediaries. This automation makes operations more streamlined and secure by removing counterparty risk, resulting in faster and cheaper transfers.
Real-world asset tokenization has traditionally used a simple binary classification: assets were either tokenized or not. As we enter the digital asset era, this oversimplified view no longer suffices. A more nuanced approach examines assets through two key properties: their representation and ownership rights.
Representation encompasses an asset's economic characteristics—its functionality, underlying assets, expiration dates, and interest rates. Alongside this, ownership verification requires a ledger, either off-chain or on-chain. Off-chain assets maintain their rights and representations through either physical certificates (like bearer bonds) or dematerialized forms (like electronic stock records), both operating within legal frameworks. On-chain assets, however, exist as either digitally enhanced or digitally native forms, governed by blockchain consensus mechanisms.
Understanding the distinction between digitally enabled and digitally native assets is crucial. Digitally enabled (or enhanced) assets maintain their ownership rights on an off-chain ledger that serves as the security, while using blockchain tokens for digital representation. For example, a stock title might exist on an electronic ledger but be tokenized on a blockchain for enhanced functionality. In contrast, digitally native assets—such as cryptocurrencies—are inherently digital, with their tokens directly representing both value and ownership. This means that while tokens of digitally enabled assets provide rights to claim title from an off-chain ledger, digitally native assets' tokens represent direct ownership without any off-chain component.
With this foundation in asset types and tokenization, let's examine the four methods of tokenization. These methods differ in how directly they connect tokens to their underlying assets. We'll explore each method systematically, beginning with the most direct token-asset relationship and moving toward the least direct.
Direct title: In this method, the digital token itself serves as the official record of title, eliminating the need for custodians. This approach works only with digitally native assets (see Figure 2). The system uses a single ledger—which may be distributed—to record token ownership. For example, instead of issuing tokens backed by a share registry, the registry itself could be tokenized, making the tokens the actual ownership records. This streamlined approach eliminates the need for custodians or duplicate registries. While it can use a distributed ledger, the registry doesn't have to be distributed. However, legal frameworks for this tokenization method are still limited for most asset classes, and regulatory structures remain underdeveloped.
1:1 asset-backed tokens: In this approach, a custodian holds an asset and issues tokens that represent direct claims to that underlying asset. Each token can be redeemed for either the actual asset or its cash equivalent. For example, a financial institution might issue bond tokens against bonds held in its trust account, or a commercial bank might issue stablecoin tokens backed one-to-one by commercial bank money in a dedicated account.
Collateralized tokens: This method involves issuing an asset token backed by assets different from the intended represented asset or associated rights. Typically, the token is over-collateralized to account for potential fluctuations in the value of the asset backing relative to the token's intended asset value. For example, Tether, a stablecoin, is backed not only by cash but also by a mix of other assets like fixed-income securities. Similarly, one could create a government bond token backed by commercial bank bonds or an equity token backed by an over-collateralized portfolio of related stocks.
Under-collateralized tokens: This method involves issuing a token intended to track the value of an asset but is not fully collateralized. Similar to fractional reserve banking, maintaining the token value requires active management of the fractional reserve asset portfolio and open market operations. This is a riskier form of asset token, with historical instances of failures. For example, the collapsed Terra/Luna stablecoin had no independent asset backing but relied on algorithmic stabilization through supply control algorithms. Less extreme fractionally backed tokens have also been issued.
The tokenization of real-world assets delivers efficiency gains primarily through distributed ledger technology (DLT). This technology enhances transparency, automates processes, reduces operational costs, and removes intermediaries and counterparty risk. Compared to traditional financial systems, these benefits enable faster settlements and cost savings through a streamlined yet flexible market infrastructure.
Atomic settlement
The integration of distributed ledger technology and tokenized assets introduces the concept of atomic settlement. Presently, settlements are orchestrated through central counterparties, and the prevalent security settlement approach is a rolling cycle. In this approach, despite a trade being executed on a specific day, the actual settlement— transferring ownership based on a predetermined agreement—typically occurs one to three days later. This involves two legs or transfers: the delivery leg, transferring ownership from the seller to the buyer of the security, and the payment leg, transferring cash from the buyer to the seller. Atomic settlement, facilitated by smart contracts, involves programmable code that simultaneously executes either both legs of the transaction or neither if pre-specified conditions are not met. Consequently, atomic settlement eradicates counterparty risk, while significantly boosting transaction speed and efficiency. Furthermore, leveraging smart contracts for trade settlement eliminates the need for collateral margin requirements, as there is no risk of failed delivery and the subsequent trade reconciliation. This, in turn, releases the capital tied up in margin requirements, indirectly contributing to heightened liquidity in the financial markets.
Increased liquidity
Tokenization significantly enhances asset transferability, making previously non-tradable assets tradable. For instance, traditional real estate trading faces major obstacles—high transaction costs, complex legal processes, and inherent illiquidity. These barriers, combined with each property's unique characteristics (location, condition, legal status), make it impractical to trade individual properties on public exchanges like stocks or bonds.Tokenization solves these challenges through smart contracts, which streamline transactions by eliminating intermediaries, simplifying title transfers, and automating compliance checks. This dramatically reduces transaction costs. The same benefits extend to other traditionally illiquid assets like art, collectibles, infrastructure projects, and private equity stakes.Furthermore, tokenization enables new distributed markets through automated market makers (AMMs). These systems provide continuous liquidity by automatically matching buyers and sellers in asset pools managed by smart contracts. Unlike traditional markets with fixed trading hours, these blockchain-based systems operate 24/7. The increased accessibility is further enhanced through fractional ownership, lower investment minimums, and simplified trading processes.
Reduction in intermediation
The decentralized data structure allows smart contracts integrated into the blockchain to replace traditional middlemen who verify data. Smart contracts could also replace the Central Securities Depository, automating processes like asset ownership transfers, dividend payments, and interest distributions.
Enabling automation
A major advantage of asset tokenization is automation through smart contracts—coded programs on the blockchain that execute when predetermined conditions are met. Smart contracts can streamline many manual tasks, particularly in sectors like insurance. For example, they can automate policy issuance and claims payouts. If a flight is delayed or cancelled, a smart contract could automatically trigger a travel insurance payout without manual processing.The effectiveness of such automation depends heavily on the integration and real-time monitoring of relevant data. Third-party services called oracles provide smart contracts with external data, acting as bridges between the blockchain and the outside world since smart contracts cannot directly access external data.Automation is most feasible in asset classes where data can be quantified, standardized, and accessed reliably through oracles. Equities, bonds, and derivatives are prime examples, as their market data is readily available and easily integrated into smart contracts. However, sectors with subjective or hard-to-quantify data face greater challenges. Real estate, for instance, involves complex transactions requiring manual verification of legal documents, subjective property evaluations, and compliance with diverse regulatory frameworks—making full automation through smart contracts more difficult.
Facilitating Compliance
Compliance is a crucial aspect of tokenized assets. The development of know-your-customer (KYC), anti-money laundering (AML), and terrorism financing regulatory frameworks has created a secure environment for digital finance and transactions. Tokenized assets' underlying technology enables more streamlined and uniform compliance with these requirements through standardized and automated processes. KYC and AML regulations can be encoded directly on the blockchain or within individual asset transfer rules, enabling more efficient interactions. For example, when a customer begins a relationship with a new financial institution, their identity information can be automatically transferred with their consent. Research on tokenization's impact on banking infrastructure shows promising results. After analyzing over 50 operational cost metrics, studies indicate that improved auditability and transaction transparency could reduce total compliance costs by 30% to 50%.
Automated Market Makers
Smart contracts are transforming traditional market making through automated market makers (AMMs). While conventional market makers act as both buyers and sellers of securities to provide liquidity, AMMs offer a different approach. They use smart contracts to automatically match buyers and sellers through asset pools provided by liquidity providers. These blockchain-embedded smart contracts algorithmically determine asset prices and manage the pools. The automated nature of AMMs leads to significant cost savings and improved performance. Research shows that AMM transaction costs are notably lower than traditional systems, particularly for assets with high trading volumes and either low or medium volatility.
Despite its numerous benefits, the adoption of tokenized assets comes with significant challenges. The primary risks stem from both the underlying technology and regulatory considerations. Technical concerns include cybersecurity vulnerabilities, system scalability limitations, settlement processes, network stability, and efficiency. On the regulatory front, key issues involve anti-money laundering compliance, governance frameworks, identity verification, and data protection and privacy. Researchers suggest that addressing digital asset regulations shouldn't focus on fitting new technologies into existing frameworks. Instead, we should explore how blockchain technology and smart contracts can enhance regulatory compliance.
Beyond technical and regulatory challenges, investor behavior and market dynamics present additional complexities. Widespread adoption requires extensive education and awareness-building efforts. Market risks include potential asset overvaluation through speculative trading and increased price volatility due to the digital nature of these assets. The high energy consumption of blockchain consensus mechanisms also raises environmental concerns. These multifaceted challenges must be addressed to fully realize tokenization's benefits in the financial sector.
Transitioning to a tokenized financial system involves substantial costs. The most significant expenses come from infrastructure changes needed to support blockchain and tokenization technologies. Organizations must invest in secure, scalable blockchain platforms, acquire specialized software for managing tokenized assets, and train staff to handle these new systems. Integration costs are also considerable—connecting these new systems with existing financial infrastructure while maintaining security and operational integrity. Educational initiatives to build understanding and overcome skepticism represent significant direct and opportunity costs for governments. Finally, the high electricity consumption of blockchain consensus mechanisms presents both financial and environmental challenges.
Disclaimer: This post is for general informational purposes only and does not constitute investment advice, recommendations, or a solicitation to buy or sell any securities. It should not be used as the basis for making any investment decision and should not be relied upon for accounting, legal, tax advice, or investment recommendations. You are encouraged to consult your own advisers regarding legal, business, tax, or other related matters concerning any investment decisions. Certain information included here may have been obtained from third-party sources, including portfolio companies of funds managed by Aquarius. The opinions expressed in this post are those of the authors and do not necessarily reflect the views of Aquarius or its affiliates. These opinions are subject to change without notice and may not be updated.
Reference:
https://pages.stern.nyu.edu/~lpederse/courses/LAP/papers/TransactionCosts/AmihudMendelson86.pdf
https://cryptoeconomicsystems.pubpub.org/pub/auer-embedded-supervision
https://cepr.org/publications/dp14095
https://www.scribd.com/document/807508629/06-Baltais-Sondore
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