Title: 《Tokenization and the New Market Cycle》

Authors: David Duong, David Han

Compiled by: Block unicorn

The progress, benefits, challenges, and future outlook of tokenization. Asset tokenization has been a long-standing effort in the crypto industry and is gradually gaining momentum and application among institutions.

Initially, in 2017, the hype around tokenization mainly revolved around creating digital assets on the blockchain that represented ownership of illiquid physical assets, such as real estate, commodities, art, or other collectibles. However, the current high-yield environment gives tokenization a different meaning, focusing on the digitization of financial assets like sovereign bonds, money market funds, and repurchase agreements.

We believe this could be an important use case for traditional financial institutions and may become a significant component of the new crypto market cycle, although full implementation may take another 1-2 years. Compared to 2017, when opportunity costs were around 1.0-1.5%, we believe that the current nominal interest rates above 5.0% make financial institutions more aware of the capital efficiency of instant (relative to T+2) settlement. Furthermore, we see the ability to operate around the clock, automate intermediary functions, and maintain transparent audit trails as making simple on-chain payments and settlements very powerful.

However, issues related to infrastructure and legal aspects remain core challenges. Most institutions rely on private blockchains due to concerns over smart contract vulnerabilities, oracle manipulation, and network failures, meaning they are wary of the risks associated with public networks. But we believe private networks may complicate interoperability in the future, with a possible outcome being the fragmentation of liquidity, making it harder to realize the full benefits of tokenization, such as having a functional secondary market.

Tokenization Fails to Deliver Initial Promises

During the crypto winter of 2017, tokenization seemed to fail to deliver on its initial promise of bringing trillions of dollars of real-world assets (RWA) onto the blockchain. The prevailing idea at the time was that token issuers would convert ownership of illiquid physical assets, such as real estate, commodities, art, and other collectibles, into digital tokens existing on a distributed ledger. The benefits included fractional ownership of these goods, allowing many people access to assets that would otherwise be difficult to reach, thus democratizing access to assets.

Even today, real estate still appears to be a particularly promising opportunity for tokenization, especially considering the ongoing reports about housing becoming increasingly unaffordable, particularly for younger generations. However, despite having clearly defined use cases, tokenization failed to gain substantial traction in 2017. Instead, the next crypto market cycle was driven by experimentation in decentralized finance (DeFi), while the disruptive promise of tokenization was clearly sidelined.

We believe the recent resurgence of interest in tokenization is partly due to the sell-off in the crypto market in 2022, as many proponents emphasized the fundamental value of blockchain technology rather than token speculation. This evokes the now well-known slogan "blockchain, not Bitcoin," which skeptics of tokenization in the crypto space often use to argue that the current enthusiasm for these projects may only last until crypto price action begins to recover.

What Has Changed in the Market?

While we believe there is some validity to this criticism, the current crypto cycle differs from previous bear markets in many significant ways. The most important of these is the global interest rate environment. From early 2017 to the end of 2018, the Federal Reserve gradually raised rates from 0.50-0.75% to 2.25-2.50%, while maintaining a relatively stable balance sheet. In contrast, in the current rate hike cycle (which began in March 2022), the Fed has raised rates by a full 525 basis points to 5.25-5.50% and has reduced its balance sheet by over $1 trillion in the past 18 months.

From a consumer perspective, higher short-term bond yields have led retail/individual investors to seek higher returns. This demand has been directed towards more protocols that seek to enter the tokenized U.S. Treasury market in a way that did not exist in 2017. (The two largest stablecoins—USDT and USDC—do not have native interest-earning capabilities.) The regional banking crisis in March 2023 also highlighted the low yield issue for existing customer deposits. Therefore, we believe tokenized products have the potential to drive on-chain activity, but regulatory issues may pose barriers to widespread development and adoption, potentially leaving U.S. consumers in a bind.

In the past year, the rise in interest rates has been reflected in the shift of RWA tokenization protocol allocations from private credit agreements to U.S. Treasuries (see Figure 1). Notably, the amount of RWA assets stored in Maker DAO's collateral has significantly increased, with over $3 billion worth of DAI stablecoins minted. As long-term and short-term yields in traditional finance rise, the relatively low borrowing rate of DAI (around 5.5%) appears increasingly competitive.

At the same time, for institutional investors, the cost of capital in a high-interest environment is much higher than in a low-interest environment. Currently, most traditional securities trades settle within two business days (T+2), during which time funds are locked from the buyer to the seller, resulting in low utilization. In 2017, when nominal yields were close to 1.0-1.5%, market participants were effectively paying negative real interest rates for these funds. Today, nominal yields above 5% translate into an annualized real yield of 3% before inflation. Therefore, for a market with daily trading volumes ranging from hundreds of billions to over a trillion dollars, capital efficiency has become increasingly important. We believe that the value of instant settlement versus T+2 settlement is now clearer for traditional financial institutions, which may not have been the case previously.

Over the past six years, many misunderstandings about tokenization have also been clarified among senior leadership in major institutions. They now have a better understanding of the benefits of tokenization, including the ability to operate around the clock, automate intermediary functions, and maintain transparent audit and compliance records. Additionally, because transactions can be settled atomically in both delivery versus payment and delivery versus delivery scenarios, counterparty risk is minimized. Furthermore, it should be noted that many traditional market participants currently involved in tokenization have dedicated teams that both understand existing regulations and develop technology to ensure compliance with these regulations.

Tokenization Business Cases and Prospects

Therefore, we believe the business use cases for tokenization have shifted from placing real estate and other immovable properties on-chain to capital market instruments such as U.S. Treasuries, bank deposits, money market funds, and repurchase agreements (repos). In fact, in a 5% interest rate environment, we believe that JPMorgan's tokenized intraday repos (for example) are more attractive than when rates were close to zero two years ago. However, it is important to clarify that many of the benefits of tokenization (such as improved unit economics, reduced costs, and faster settlement speeds) are not new and still require large-scale distribution to be effective.

Predictions regarding the scale of tokenization opportunities vary, but according to Citigroup's forecasts, they range from $5 trillion to $16 trillion according to the Boston Consulting Group by 2030. These figures may not seem as exaggerated as they initially appear. First, they include projections for the growth of central bank digital currencies (CBDCs) and stablecoins. In fact, the key variable explaining these estimated differences is the potential percentage of the global money supply that tokenized assets may encompass.

Indeed, stablecoins are now one of the clearest potential cases for tokenization, and in the future, their reserve assets may include customer deposits and liquid cash alternatives. We believe that the liquidity of stablecoins may be one of the clearest ways for tokenization to intersect with the broader crypto economy in the next market cycle.

Legal and Regulatory Uncertainty

Nevertheless, the issue of legal clarity regarding the status of assets in the U.S. and their holders remains unresolved. Even outside the U.S., many laws pertaining to this field are still new, and numerous legal and regulatory hurdles continue to plague most tokenization efforts. Due to the nascent nature of the market, there are no widely recognized legal precedents and templates, making the establishment of these legal frameworks time-consuming and costly.

For example, Luxembourg was one of the first countries to adopt tokenization laws, enacting the first law allowing securities trading using blockchain in March 2019, and has since passed several laws, the most recent in March 2023, allowing for the tokenization of collateral. The EU's Distributed Ledger Technology (DLT) pilot program also only came into effect in March 2023, paving the way for broader tokenization efforts.

Due to this regulatory ambiguity, multiple platforms are often needed to handle asset tokenization across different jurisdictions. Many on-chain tokenization treasury platforms, including OpenEden, Backed, Matrixdock, and Ondo, restrict participants to accredited investors, and often only non-U.S. persons. An increasing number of U.S. Treasury token issuers are registering in non-U.S. jurisdictions (see Figure 3). The jurisdiction of the issuing entity is not always clear to end users, and there is a wide range from highly regulated jurisdictions like the U.S. and Switzerland to places like the British Virgin Islands, adding an additional layer of counterparty risk to existing smart contract risks.

The legal structures and investor requirements of private blockchains are equally complex and are just beginning to be addressed. The euro-denominated bond issued by the European Investment Bank (EIB) in November 2022 was the first digital bond issued under Luxembourg law, while the Hong Kong Monetary Authority (HKMA) bond issued in February 2023 was the first product regulated under Hong Kong law. The process of digitizing securities to distributed ledger technology varies across jurisdictions, and the interaction between crypto ownership, physically dispersed networks, and securities in specific jurisdictions is still in the early stages of exploration.

Financial Fractures

The direct consequence of the aforementioned legal challenges is that liquidity in the secondary market is affected, as investors need to establish new trading channels for each different platform. This can be time-consuming, as customer due diligence (KYC) and anti-money laundering (AML) checks between various protocols and institutions are generally not shared.

As a result, many tokenized assets struggle to find transparent price discovery through decentralized finance (DeFi) channels, such as automated market makers (AMMs). Tokenized Treasury activity on Ethereum is weaker compared to similar non-KYC assets. See Figure 4. For example, the market cap of Curve's DeFi-native 3pool (3Crv) token shows no significant gap compared to Ondo Finance's institutional-grade OUSG tokenized Treasuries ($199 million vs. $140 million), despite the former having nearly 200 times the number of holders of the latter (i.e., while the former has a higher market cap, it only has 56 holders, whereas the latter, with a lower market cap, has 9,254 holders).

The 3Crv token has the highest daily trading volume, despite its lower yield (as of October 24, 2022), and according to Etherscan, it attracted over 100 independent daily trading participants in less than a month since its launch in 2020. In contrast, tokenized U.S. Treasuries on Ethereum have averaged fewer than ten transfers per day overall nearly a year after their launch. Therefore, we believe that investor barriers severely hinder the liquidity and adoption of these assets, although the controversial KYC measures introduced by Uniswap V4 may change the future adoption and liquidity paths of these assets.

Permissioned Chains and Private Tokens

Additionally, many institutions choose to build their own private blockchains for tokenization purposes due to concerns over risks such as smart contract vulnerabilities, oracle tampering, network disruptions, and key compromises—essentially the risks associated with public networks. Furthermore, private chains offer the benefits of private, fee-less transactions and KYC (Know Your Customer) for all network participants.

Technology providers in the private blockchain space seem to be consolidating around four main solutions: (1) Hyperledger's platform suite, (2) Consensys's Quorum, (3) Digital Asset's Canton, and (4) R3's Corda. Each platform has its unique ecosystem, but different projects built on the same technology stack do not automatically achieve interoperability due to the physical isolation of the networks. This isolation negatively impacts the ability to conduct atomic settlement transactions, which is one of the main advantages of tokenization.

In fact, it is worth noting that some platforms only record transaction details on the blockchain without involving cash settlement. That is to say, cash flows through traditional banking channels (thus still relying on independent interbank solutions), making the real-time settlement process incomplete. Moreover, using multiple platforms may disperse liquidity across various chains, similar to the issues that arise when using different public blockchain networks.

Our latest report discusses cross-chain interoperability technologies in detail, while many private blockchain providers are committed to advancing interoperability initiatives within their ecosystems. However, achieving inter-chain interoperability, especially between permissioned chains, is not just a technical issue; it also involves legal and business considerations. Therefore, we believe that interoperability and liquidity will continue to be pressing issues in the short to medium term as platforms consolidate and the field continues to gain legal clarity.

Conclusion: A Long Road Ahead

We expect institutional interest in tokenization to persist into the next crypto market cycle, as the benefits of tokenization (capital efficiency, faster settlement, increased liquidity, reduced transaction costs, improved risk management) are evident in a high-interest environment. However, there has been a shift in focus regarding the underlying assets being tokenized, with traditional financial institutions now looking at U.S. Treasuries, money market funds, and repurchase agreements.

How all this is implemented is crucial. We believe the next one to two years will be a period of platform consolidation around three aspects: (1) financial verticals, (2) jurisdictional boundaries, and (3) technology stacks. Integration and interoperability have also been focal points, as tokenizing secure assets on one chain while tokenizing payment currencies on another greatly increases complexity and risk, while exacerbating settlement times and reducing transparency. Without integration, the tokenization space will continue to face challenges of fragmented liquidity and investor entry, particularly in the secondary market.

However, traditional companies typically transform slowly, and many have already committed to building their own tokenization platforms. Therefore, we believe it is still too early to pick potential winners, although we believe that the flywheel effect of adoption will be driven by early network effects and the ability to flexibly respond to changing legal and technological environments.

Ultimately, we believe that the interest in tokenization reflects the industry's shift from a focus on pure decentralization to a practical combination of centralized entities and semi-decentralized networks that can accommodate more users. As more jurisdictions establish legal frameworks for tokenization, we expect a gradual unlocking of tokenization liquidity through integration and interoperability in the long term.