The RWA series

This is a publication in a series of articles on Real-World Assets (RWAs). Akira is a contributor to MakerDAO, the protocol that launched DAI, the world's first decentralized stablecoin, soft-pegged to the USD. In recent years, MakerDAO has significantly increased its investments in RWAs, further innovating and pushing the boundaries of what is possible within the blockchain. This article provides a breakdown of the tokenization process of RWAs. Throughout this series, MakerDAO serves as an example to showcase concepts and assist in understanding the practical applications of RWAs.

Introduction

Tokenizing RWAs as a concept is fairly easy to understand at a fundamental level. It is the process of creating a digital token on the blockchain that is linked to a real-world asset off-chain. But to fully understand a concept like RWA, you must also know the tokenization process. This article is about how to tokenize a real-world asset. I will throughout the article provide conceptual explanations alongside practical examples.

For those who need a quick primer on RWAs, check out my other article here:

First, I will outline some concepts that are necessary for understanding the tokenization process. Then I will provide a step-by-step breakdown of tokenizing an asset like a T-bill. Lastly, I will investigate the implications and future development of tokenization. I hope you will find this article helpful and informative.

Basic Concepts

To understand how tokenization works, we need to first cover some terms and concepts that we are gonna use later when we go further into the process of tokenization. If you already know these basic concepts, you can scroll down to the section: Tokenization Process. And for those that could use a recap, here is a quick rundown of the concepts and principles that are needed to understand the tokenization process.

RWA Categorization

We can differentiate between a RWA with these three traits:

1. Asset Location: On-Chain or Off-Chain

2. Collateral Location: On-Chain or Off-Chain

3. Backing type: Direct or Indirect

Source: QuillHash

Asset Location

This refers to whether the asset being tokenized is on-chain or off-chain. Since RWAs are typically off-chain, it generally makes sense to focus on assets with an off-chain location. An example of on-chain assets being tokenized are wrapped tokens like WBTC or WETH, though these are not considered RWAs.

There are rare cases where an asset's location is on-chain from the start, such as certain intellectual properties, patents, or copyrights. These assets hold intrinsic value and exist solely on-chain.

Collateral Location

Just like the asset location, collateral can also be either on-chain or off-chain.

• Off-chain collateral: USDT is a stablecoin pegged to the USD, with each USDT backed by 1 USD held in a collateral reserve, which is off-chain.

• On-chain collateral: DAI, a stablecoin issued by MakerDAO, is soft-pegged to the USD and uses other cryptocurrencies as collateral, making it on-chain collateral.

However, MakerDAO has also invested in RWAs and used these RWAs as collateral, which makes the collateral for DAI a bit meta. Because the collateral for one RWA is more RWAs you might wonder, what is the true collateral then. Here is a breakdown of the DAI collateral.

This makes the collateral for DAI a mix of on-chain and off-chain. While RWAs are tokenized and represented on-chain, their intrinsic value is tied to off-chain assets, making the collateral location partially off-chain as well.

Backing type

While Collateral Location is about where the collateral is stored, the backing type is about what the collateral is. It distinguishes whether the token is directly backed by the asset it represents (direct backing) or by other assets that indirectly support its value (synthetic/indirect backing).

• Direct backing: Tokenized T-bills are an example of direct backing since the collateral is the actual government issued T-bill that the token represents.

• Indirect backing: DAI is again used as example, since the DAI is backed by other tokens that are not directly tied to the value of USD, which is the underlying asset DAI is soft-pegged to.

Considering these three traits with two different states of each, there must be eight total types of RWAs as seen below in the cubic graph.

You can use the cube to identify the different types of RWAs. For instance, DAI is an off-chain asset with on-chain collateral that is indirectly backed, which positions it at number 4 in the cube. You could also argue it could be in between position 4 and 5, since the collateral location is a mix of on-chain cryptocurrencies and off-chain t-bills that are tokenized on-chain.

Smart Contracts

Smart contracts are exactly what their name suggests, contracts that are smart. Unlike traditional contracts, smart contracts are written in code, typically using the Solidity programming language. These contracts are stored on the blockchain, ensuring they are secure, transparent, and immutable.

To create a smart contract, developers often use an Integrated Development Environment (IDE). Once deployed, a smart contract functions as a set of predefined actions that automatically execute when certain conditions are met. This process eliminates the need for third-party intermediaries, making the contract fully transparent and accessible for anyone to verify.

In short, smart contracts are self-executing agreements where the terms are embedded in code, ensuring that they are enforced and executed automatically without the need for intermediaries.

Token Standards

Token standards are a set of rules or protocols that dictate how tokens are created, issued, and behave on a blockchain. These standards ensure that tokens can interact seamlessly with smart contracts, wallets, and other applications within the same ecosystem. Each blockchain may have its own token standards, but the most well-known ones are from the Ethereum blockchain, where the concept of token standards became widely popular.

• ERC-20: The most widely used standard for fungible tokens, which are interchangeable and support basic functions like transfers and balance checks. For example, each DAI token is identical in value and function to another DAI.

• ERC-721: The standard for non-fungible tokens (NFTs), which represent unique assets like digital art or collectibles. Each token has a distinct value and cannot be exchanged on a one-to-one basis with another token.

• ERC-1155: A versatile standard that supports both fungible and non-fungible tokens within the same contract, commonly used in gaming for managing various token types, such as in-game currency and unique items.

• ERC-1400: A standard designed for security tokens, representing traditional financial assets like stocks and bonds. It includes features for regulatory compliance, such as restricting transfers to authorized users.

• ERC-3643: An evolution of ERC-1400, ERC-3643 is a standard specifically tailored for regulated security tokens. It enhances compliance features, including more sophisticated access controls and automated compliance checks, making it ideal for institutional and regulated markets. This standard is often used for RWAs.

Oracles

Oracles are used to bring real-world information onto the blockchain securely. Since blockchains operate as isolated systems, they can't access data outside their network on their own. Oracles serve as the bridge between the blockchain and the outside world, enabling smart contracts to interact with external information, such as real-world events, asset prices, or other data feeds.

Tokenization Process

Now that we’ve covered the fundamental concepts, let’s explore the practical steps involved in tokenizing a RWA, using the example of a U.S. Treasury Bond (T-bill). This process will demonstrate how a T-bill can be accurately represented on the blockchain, legally compliant, and ready for trading or investment.

When tokenizing an RWA, an entity first purchases the asset and holds it in reserve. The entity then develops and issues tokens that represent the RWA. These tokens can be transferred and traded on blockchain platforms. As a result, the tokens not only reflect the value of the underlying RWA but also gain the inherent benefits of blockchain technology, such as transparency, transaction speed, and immutability.

As I aim to cover the whole process of tokenization, I will not deep dive into each step but rather provide a concise and to-the-point overview of the process. For a more in depth analysis of a specific step, I will publish new articles to cover these areas. If you have any subject recommendation you want me to cover, feel free to write to Akira1924445 on X.com.

1. Asset Identification

The first step in the tokenization process is choosing the right asset, with careful consideration of its asset location. When selecting an asset, it’s important to consider factors such as stability, liquidity, market demand, and the asset’s potential for generating returns. T-bills, with their off-chain location, are often selected for tokenization due to their high security, backed by the U.S. government, and predictable returns.

Key factors to consider when choosing a T-Bill for tokenization include:

• Maturity Period: T-Bills come with varying maturities, typically ranging from a few days to one year. Longer maturities generally offer higher returns but may involve greater exposure to interest rate changes.

• Interest Rate Environment: The current interest rate environment influences the purchase price of T-Bills. An inverse relationship exists where rising interest rates generally lead to lower T-Bill prices. Selecting T-Bills during favorable interest rate conditions can enhance the attractiveness of the tokenized product.

• Liquidity: "On-the-run" T-Bills, which are the most recently issued, tend to be more liquid and are typically preferred for tokenization. Higher liquidity ensures that the tokenized T-Bills are easier to trade on secondary markets.

• Market Demand: Understanding the demand for T-Bills in the market is crucial. High demand for these secure, short-term investments can make the tokenized product more appealing to investors.

2. Legal and Regulatory Compliance

It's essential that the tokenization of RWAs adheres to both local and international financial regulations. This requires establishing a legal framework that officially recognizes digital tokens as legitimate representations of the underlying RWA. For T-bills, compliance with SEC regulations, including Know Your Customer (KYC) and Anti-Money Laundering (AML) protocols, is paramount.

3. Choosing the Blockchain Platform

Selecting the appropriate blockchain platform is crucial for the success of the tokenization project. The chosen platform must support the type of tokens being issued and offer the necessary scalability, security, and community support. Ethereum is often selected due to its extensive support for financial instruments and smart contract functionality, making it a strong choice for tokenizing T-bills, especially in projects requiring a robust ecosystem and liquidity.

4. Token Standards

The next step involves choosing or developing a token standard that best suits the characteristics of the asset being tokenized. For example, the ERC-3643 standard is commonly used for tokenizing assets on the Ethereum blockchain, particularly for RWAs.

5. Collateralization

While T-bills are already considered one of the safest financial instruments due to government backing, understanding the Backing Type is crucial in the tokenization process. In this case, the T-bills provide direct backing for the tokens, meaning each token represents a direct claim on the T-bill’s value. This direct backing type ensures that the tokens maintain their value, as they are directly tied to the government-issued T-bills. For instance, the smart contract might ensure that each token is redeemable for a portion of the T-bill’s face value upon maturity, maintaining a 1:1 ratio.

6. Smart Contract Development

Smart contract development is the next critical step in the tokenization process. The smart contract governs the creation, transfer, and management of the tokens. It mints digital tokens that represent fractional ownership of the T-bill, allowing multiple investors to hold parts of the same bill. The contract also defines the rules for token transfers, any ownership restrictions, and the distribution of interest payments to token holders. For example, for a T-bill with a $10,000 face value, the smart contract could issue 10,000 tokens, each representing $1 of the T-bill's value. As the T-bill matures and pays interest, the smart contract automatically distributes payments to token holders.

7. Oracles

Oracles play a crucial role in providing the smart contract with real-time data, ensuring that the tokenized T-bill accurately reflects its market value and any interest payments. An oracle service can provide real-time data on the current market value of T-bills, interest rate changes, and other relevant financial information. Continuous data feeds are essential for reflecting any changes in the T-bill's value or the issuance of interest payments, ensuring transparency and accuracy.

8. Token Distribution and Sale

Once the tokens are minted, they need to be distributed to investors or sold on a marketplace. Initial distribution might involve a private sale to institutional investors or a public Initial Token Offering (ITO) allowing retail investors to participate. After the initial sale, the tokens can be traded on secondary markets, providing liquidity to token holders. This allows investors to enter and exit positions as needed, without waiting for the T-bill's maturity. For instance, the tokenized T-bills could be listed on a decentralized exchange (DEX) where they can be traded like any other cryptocurrency, with the smart contract ensuring that the underlying value remains intact.

9. Security and Audits

Conducting security audits of smart contracts and the overall system architecture is essential to identify and mitigate potential vulnerabilities or attack vectors. Implementing best practices for secure smart contract development and deploying contracts on testnets for thorough testing are critical steps in ensuring the security and reliability of the tokenization process.

Implications and Future Developments

Tokenizing a T-bill represents just one example of how traditional financial instruments can be brought into the blockchain era. This not only democratizes access to government-backed securities but also opens up new avenues for trading and investment in these traditionally stable assets.

• Future Trends: As blockchain technology evolves, we might see the tokenization of a broader range of government securities and even cross-border trading of tokenized assets, creating a global market for T-bills.

• Potential Challenges: Regulatory compliance remains a significant challenge, particularly as governments and financial institutions adapt to the idea of blockchain-based securities. However, the ongoing development of legal frameworks should help mitigate these challenges over time.

Conclusion

Tokenizing RWAs like T-bills is a transformative process that bridges traditional financial instruments with the advantages of blockchain technology. By carefully selecting the right assets, ensuring legal compliance, and utilizing robust blockchain platforms and smart contracts, entities can create digital tokens that represent secure and liquid investments. The tokenization of T-bills not only offers enhanced transparency, speed, and accessibility but also opens up new opportunities for global investors and financial innovation.

As the tokenization process continues to evolve, the potential for broader adoption of blockchain-based securities is immense. However, navigating regulatory landscapes will be crucial in ensuring the successful integration of these digital assets into the global financial system. The future holds exciting possibilities for expanding the tokenization of government securities, potentially leading to a more inclusive and efficient financial ecosystem.

Vision

In Japanese, the name Akira signifies brightness, clarity, and truth, principles that guide my approach to exploring the complexities of crypto, blockchain, and RWAs. As I delve into these topics, my goal is to demystify the intricacies of decentralized finance and RWAs, making them accessible and understandable. Through this series of articles, I aim to shed light on these subjects, providing clear, actionable insights that contribute to our collective understanding of the future of finance.

Akira