<Exploring Tokenization of Real-World Assets: A Comprehensive Guide>
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# Introduction
Tokenized Real World Assets (RWAs) refer to tangible assets represented as tokens on a blockchain.
- Think of your car or house as an NFT on-chain.
- Your stocks could be represented as ERC20 tokens.
- Even personal items, like that nostalgic pair of socks from your mom, can be tokenized.
While the concept seems simple, the implementation is complex.
This article will explore:
- What are tokenized RWAs?
- How does backing function?
- Examples of current tokenized RWA projects.
- Steps to create tokenized RWAs.
- The primary challenges of tokenized RWAs.
- The future of tokenized RWAs.
You can also watch the accompanying video here.
# What are tokenized RWAs?
As previously mentioned, tokenized RWAs are tangible assets represented as tokens on the blockchain. This raises several questions:
- What qualifies as “real-world” assets?
- How are they deemed “tokenized”?
Real-world assets typically encompass anything that exists outside of the blockchain, including properties like houses, vehicles, stocks, bonds, and even fitness equipment.
Why is this important?
The key benefit is composability.
Trading and conducting business with tokens is significantly more efficient, faster, and easier.
What defines a "tokenized" asset?
Defining what makes an asset tokenized involves examining three main characteristics:
- Location of the asset: On-chain or off-chain.
- Location of the collateral: On-chain or off-chain.
- Type of backing: Direct (fully reserved) or indirect (synthetic).
For any asset to be classified as a tokenized RWA, it must be off-chain, allowing us to focus on the second and third characteristics.
Every tokenized asset requires some form of backing. There must be something tangible supporting the token for it to accurately represent the asset. Don’t worry; we'll delve deeper into this topic later. If you're eager, you can jump ahead to the section on “Current Tokenized RWA Projects” for real-life examples.
For now, consider the backing as a property ensuring that the tokenized RWA maintains the same value as the physical asset it represents. For instance, if the token is sold, the associated car must also be sold. We will elaborate on this "backing" issue later.
Example: Car as Off-chain Collateral, Directly Backed
Suppose you want to tokenize your car by creating a Car NFT. Using our aforementioned traits, here’s how we would proceed:
- Collateral Location: Off-chain — the car itself.
- Backing Type: Directly backed.
You might wonder, “Why wouldn’t the token be backed by the actual car?”
Example: Car as Off-chain Collateral, Indirectly Backed
Now, let’s say we want our Car NFT to reflect the car's market value rather than being tied directly to the physical vehicle. If we sell the token on-chain, we want to ensure it equates to the car's real-world dollar value.
Instead of backing the NFT with the car, we could base it on its dollar value, stating, “You can sell your Car NFT at any time for the car's market worth.” Thus, while the NFT retains the same value as the vehicle, it’s not directly backed by it; it’s backed by its dollar equivalent.
- Collateral Location: Off-chain — dollar equivalent of the car.
- Backing Type: Indirectly backed.
In this scenario, we have a Car NFT valued similarly to the car, but it is classified as a synthetic asset since it isn't directly backed 1:1.
Example: Car as On-chain Collateral, Indirectly Backed
We can further innovate by backing our Car NFT with cryptocurrency. For instance, we could state, “You can trade this Car NFT for its value in USDC or ETH at any time.” This setup results in a synthetic tokenized RWA supported by cryptocurrency.
- Collateral Location: On-chain — USDC or ETH.
- Backing Type: Indirectly backed.
Example: Car as On-chain Collateral, Directly Backed
It’s clear that a Car NFT cannot be directly backed by on-chain collateral since the car is off-chain.
You might speculate about a scenario where a Car NFT is backed by another NFT representing the car, but that's a separate conversation.
# How does backing work?
Each category of backing comes with unique methodologies, advantages, and drawbacks.
Off-chain Collateral, Directly Backed | Centralized Exchange
For off-chain collateral models, to back the Car NFT with the actual vehicle, a centralized link must exist between the blockchain and the asset's legal status. This approach often entails considerable centralized risk, as seen with tokens like USDC, which is a tokenized representation of real-world USD.
- Collateral Location: Off-chain — real dollars in a bank account.
- Backing Type: Directly backed — 1 USDC is equivalent to 1 USD.
- Backing Methodology: Centralized exchange.
The way USDC maintains its value is by allowing users to exchange 1 USDC for 1 USD at any time, ensuring the tokens retain their worth.
Off-chain Collateral, Indirectly Backed | Centralized Exchange
The structure for off-chain collateral, indirectly backed tokenized RWAs mirrors that of their directly backed counterparts, but they are supported by “other assets.” USDT serves as a prime example of this.
- Collateral Location: Off-chain — it consists of “assets” valued at or above the total amount of USDT in circulation.
- Backing Type: Indirectly backed — 1 USDT is backed by other assets that equal or exceed 1 USD.
- Backing Methodology: Centralized exchange.
Similar to USDC, USDT allows users to swap 1 USDT for 1 USD.
The Issues with Centralized Exchange Backing
This reliance creates significant trust in the teams behind these tokens, such as Circle and Coinbase, and presents numerous legal challenges since they lack decentralization.
On-chain Collateral, Indirectly Backed | Price Feed Exchange
LUSD (liquidity) is an example of a synthetic tokenized RWA. Unlike others, its collateral is fully on-chain and decentralized.
- Collateral Location: On-chain — cryptocurrencies serve as collateral.
- Backing Type: Indirectly backed — 1 LUSD is backed by cryptocurrencies valued at or above 1 USD.
- Backing Methodology: Price feed exchange.
This method allows tokenized RWAs to maintain their value peg without centralization issues, using decentralized price feeds to determine the price of the collateral.
The Issues with Price Feed Exchange Backing
While this method avoids some legal complexities, it lacks the direct backing of the asset itself. Consequently, if the collateral's price fluctuates significantly, the value of the tokenized RWA may also rise or fall dramatically.
# Current Tokenized RWA Projects
Currently, popular tokenized RWA projects are widely used and in high demand. Stablecoins exemplify tokenized RWAs effectively.
- USDC
- USDT
- LUSD
These serve as tokenized RWAs where the underlying asset is the USD, but there are additional projects emerging as well.
Ondo Finance
Ondo Finance is working on tokenizing treasury bills, allowing users to access the yield of U.S. T-bills through an on-chain token.
Maple Finance
Maple Finance exemplifies a project focusing on tokenized borrowing and lending.
# How to Build Tokenized RWAs
To create tokenized RWAs, follow these steps:
- Understand the categories.
- Establish your backing methodologies.
I maintain an example repository named rwa-creator that demonstrates how to create tokenized RWAs using TSLA stock. Additionally, I have produced a walkthrough video available on Chainlink Labs' YouTube channel for those interested in learning more!
Chainlink Functions and Chainlink Price Feeds are the key components that facilitate the creation of these assets. Presently, price feeds are utilized to support decentralized stablecoins, while Chainlink Functions can be employed for more centralized setups, minimizing centralization risks. Explore the repository and video for a deeper understanding.
Chainlink price feeds enable seamless implementation of the “price feed exchange” backing method, allowing for API calls to off-chain services to facilitate the buying or selling of the underlying assets represented by the tokens.
# Major Challenges of Tokenized RWAs
Currently, the primary challenge lies in managing non-fungible tokens (NFTs). Two significant obstacles are present:
Legal Challenges
How can we ensure that when a token representing a physical asset is sold, the actual asset changes hands as well? For instance, if Bob digitizes his luxurious $10 million estate into an NFT and sells it to Fred, what happens if Bob refuses to relinquish the keys? At present, many would say “magic” — there’s no effective enforcement linking that token to the physical property.
Fungible assets, like USD, can sidestep this issue more easily because exchanges can facilitate the underlying value of the tokens. However, we have yet to see substantial advancements in addressing this challenge for non-fungible assets like houses and vehicles.
Value Retention
While price feeds are a valuable method for tokenized RWAs to maintain their value, achieving this for non-fungible tokens is much more challenging. Determining a fair price for a house can be complex since its worth is ultimately defined by what someone is willing to pay.
# Future of Tokenized RWAs
I anticipate that future projects will overcome many legal hurdles and develop advanced systems. Chainlink Functions will play a crucial role in this evolution, and I am excited to see the innovations that emerge.
# Summary
- Tokenized RWAs facilitate seamless trading of physical assets in a digital format.
- These assets are already thriving, especially in the form of stablecoins.
- You have the opportunity to create these RWAs, presenting a significant innovation potential.
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