Real-World Assets (RWA): Bridging the Gap Between DeFi and TradFi

DeFi was supposed to free us from the shackles of traditional finance. But then life happened. MakerDAO, the protocol behind DAI, the most popular decentralized stablecoin, now gets almost 60% of its revenues from real-world assets (RWAs):

Maker makes money on real-world assets like treasury bills, which is not very DeFi-like. DeFi protocols are leaning onto real-world assets, and companies are looking to tokenize them and bring them on-chain. So it's worth looking into real-world asset tokenization and its future:

What are real-world assets, and how do they work?
An analysis of the real-world asset sector
Real-world asset protocols
A case study of tokenized real-world assets
Future trends in the sector

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What Are Real-World Assets (RWA)?

Real World Assets are off-chain assets, which are tokenized and brought on-chain for use in DeFi. Tokenization involves converting an asset's value into a digital token for representation and transactions on the blockchain.

The most intuitive and widespread example of RWAs is stablecoins. They have tokenized representations of fiat currency. Other RWAs can represent tangible assets, such as gold or real estate, or intangible assets, such as government bonds or carbon credits.

But why do we need RWAs if we have them in the, well, real world?

Because the metaverse is cheap, but the meatverse (aka the "real world") is expensive and riddled with inefficiencies. DeFi cannot completely replace traditional finance, but it can rival it, thanks to significantly lower marginal costs:

DeFi aims to minimize or remove intermediation systems and save costs and improve efficiency in the process. Although DeFi has its own risk vectors, such as exploitable code, it makes up for it by drastically reducing intermediaries and increasing transaction transparency. As DeFi matures, asset holders may increasingly use RWAs to access the benefits of DeFi over TradFi.

How Do Real-World Assets Work?

So how do you tokenize a real-world asset?

There's a three-step process involved:

You formalize it off-chain.
You bridge the information on-chain.
You create a protocol connecting supply and demand.

To formalize an asset off-chain, you first determine the asset's worth, ownership and legal protection. The representation of its economic value includes factors like its fair market value, recent performance data, and, if applicable, physical condition.

Its ownership and legitimacy of title are formalized through documents like deeds, mortgages, or invoices. Legal backing involves a well-defined resolution process for any legal issues.

To tokenize the asset, you then convert the off-chain information into code and metadata for a digital token. Moreover, the legally challenging part happens here. Finally, an oracle supplies off-chain data to on-chain protocols.

The last part is finding or creating a DeFi protocol that connects supply with demand and facilitates asset trading.

The Real-World Asset Sector

The RWA market in DeFi is small but vibrant. It splits into equity-based, real asset-based, and fixed income-based DeFi protocols:

Equity and real asset-based markets are relatively small due to heavy regulation and operational complexity. Equities can often only be offered by regulated exchanges. They also tend to require physical ownership of the traded asset. For this reason, no stock-based or commodity-based trading of real-world assets has sprung up to date. The closest equivalent is synthetic assets, such as those offered by Synthetix.

Fixed income markets are the predominant RWA market, with an active transaction flow and diverse offerings and participation. Fixed-income markets are simply private credit offerings - loans backed by real-world collateral. However, the sector has been hit just as badly by 2022 as other parts of DeFi:

RWA loans can be divided into two groups:

Asset-backed (or secured) private credit: Centrifuge, Goldfinch, Credix
Unsecured private credit (undercollateralized or not collateralized): Maple, Clearpool, TrueFi

Asset-backed protocols have the benefit for borrowers that they provide access to cryptocurrency capital. This is a boon, especially for the protocols' target audience in emerging markets lacking native borrowing options.

Undercollateralized lending protocols rely, by design, on certain elements that are not to the liking of DeFi purists: centralized background checks, due diligence, and credit checks. However, over-collateralization doesn't allow those to participate who need credit the most: the capital-poor.

Still, these protocols use DeFi elements such as liquidity pools to operate debt offerings, smart contracts to automate the distribution of interest payments, and blockchains to make borrowing/lending dynamics completely transparent.

Real-World Asset Protocols

Since the RWA space is still emergent, no protocol has established itself as a runaway leader of the sector. However, three names that keep popping up in different research reports are Goldfinch, Centrifuge and Maple Finance.

Goldfinch

Goldfinch enables non-crypto businesses in emergent markets to access crypto-based lending by posting real-world collateral. Auditors, which are stakers of the GFI token, can vote on a borrower's creditworthiness and influence whether the project is granted a loan. So far, Goldfinch has procured over $120M worth of loans:

Investors can either provide capital to liquidity pools (at a lower return) or take riskier "junior tranches" and finance borrowers directly for a higher return.

The protocol has returned over 10% APY over the last few months and was only marginally impacted by the wider crypto downturn. It retains 10% interest payments and charges a 0.5% withdrawal fee.

Centrifuge

Centrifuge is a protocol for structured credit that mimics the TradFi securitization process. Similar assets, such as pooled mortgages, invoices, microlending, consumer finance, or others, are pooled together and used as collateral for the crypto-native debt. Centrifuge has natively integrated tranching, meaning that users can choose whether they want to invest in riskier "junior" tranches for a higher return or less risky "senior" tranches for a lower return. The assets are tokenized through NFTs.

Centrifuge is cooperating with Maker and Aave. In December 2022, it launched a $220M fund in cooperation with BlockTower Credit to bring institutional credit on-chain.

Maple Finance

Maple is an uncollateralized lending protocol. Its "pool delegates" are investment professionals assessing the creditworthiness of potential borrowers. After Maple Finance took a big hit from bad debt in 2022, it is increasingly shifting toward lending beyond crypto-native loans.

Tokenizing Real-World Assets: A Case Study

Asset tokenization is gathering steam, one way or another. Amazon announced it was rolling out the option for customers to purchase NFTs tied to real-world assets. On another front, banks have become increasingly interested in asset tokenization:

In their research piece about asset tokenization, The Block looked into several case studies of real-world assets being brought on-chain. For example, Propy is a real estate firm enabling digital property transactions. It tokenizes property as ERC-721 tokens and offers the transfer of ownership on its real estate NFT marketplace. The NFT acts as a proxy for ownership, as the land attached to it is owned by an LLC. When the NFT changes owners, it transfers the ownership of the LLC owning the land.

Even though there is no international standard for ownership rights of real estate, Propy has closed deals in different countries like the US, Portugal, Japan and the UAE. It has processed over $4 billion in transactions to date and aims to create a global marketplace for international real estate transactions. The PRO token is used for smart contract interactions and registry fees.

Future Trends

Binance sees several trends for RWA in its research report.

For one, dedicated RWA chains may spring up. Since RWA loans inevitably entail some form of KYC, public and permissionless blockchains are not a natural home for protocols dealing with them. Moreover, some aspects of RWA may necessitate privacy, such as ownership records. Token standards may also not always be suited to mirroring the payment logic of real-world assets. Custom-built L1s that cater to these needs and are only partly permissionless could be a solution.

Next, real-world assets inevitably run into the problem of regulation and securitization. Clearer guidelines are needed, together with better enforcement mechanisms to protect assets' values. Real-world assets are, by design, less liquid and harder to liquidate than on-chain assets. This need not be an obstacle that cannot be overcome. However, potential efficiency gains from tokenization are going to be moot without rules.

Finally, RWAs are - who would have thought - heavily influenced by real-world events. That is to say, if interest rates stay high and RWAs remain a source of revenue for DeFi protocols, this sector could grow significantly in the future. It has the potential to bridge TradFi and DeFi, although significant operational and regulatory obstacles remain.

But the RWA narrative shows the increasing interconnectedness between crypto and the physical world and the potential for crypto to drive positive change.

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