A Blueprint for RWA Adoption

Many within crypto have a personal eureka story — the moment when they truly grasped the potential of blockchain technology. For me, it was when a good friend from graduate school was getting married in Asia. I couldn’t make the wedding but wanted to send a gift. I could have used the traditional banking system, but doing so would have incurred foreign exchange fees, wire fees, processing delays, etc. I didn’t take this path.

Instead, I sent USDC straight to his Ethereum wallet.

The funds arrived nearly instantaneously. My friend could easily swap the USDC and off-ramp the funds using his local exchange. I then imagined a not-too-distant future where enough merchants offered the ability to pay for goods and services in crypto that users wouldn’t want or need to off-ramp funds.

At that moment, I saw blockchain technology’s potential for revolutionizing finance. And it wasn’t through bitcoin, a Bored Ape NFT, or the millionth fork of some Ponzi such as OHM — but rather with a simple real-world asset — a digitized dollar, traveling on more efficient blockchain rails.

From then on, I saw tokenization powered by blockchains as finance’s future.

Real-world Assets

Real-world assets — or RWAs — are traditional financial assets (e.g., currency, private credit, art, real estate, stocks, bonds, etc.) represented (or tokenized) on a blockchain. Tokenization has existed since the earliest days of crypto as a concept but has been a growing trend in 2023. The typical arguments for tokenization are improved access, transparency, liquidity, and widespread efficiency — a wholesale revolution of financial markets.

Many can imagine that end state and how that world would be a step function change better than today’s status quo. To that end, reputable firms such as BCG, BlackRock, and S&P have estimated that trillions of dollars of value will be tokenized in the coming years.

However, there are a slew of obstacles that must be overcome on the road to that future. As a result, while there has been some early traction, the figures still pale in comparison to traditional global financial markets. As such, people working on RWA initiatives today talk about adoption over decades, not months or years.

Is there any way to accelerate this change?

In Switchpoint’s view, the pathway to meaningful RWA adoption necessarily involves compromise to realize the promise of tokenization. The purpose of this post is to outline the various issues holding back adoption and lay out a common-sense approach for RWA experimentation to overcome these roadblocks and ultimately unlock a wave of participation.

Let’s dig in.

Traction to Date

First, let’s review the current state of play. RWA traction to date has been a mixed bag.

Stablecoins — typically the 1-for-1 tokenization of a U.S. dollar — represent one of the most powerful innovations in crypto. The 3rd and 6th largest digital assets by market value are stablecoins USDT and USDC, which hold over $110bn in value, the vast majority of the $125bn+ stablecoin market.¹ Stablecoins allow for easy, fast payments, are ideal for cross-border activity, and unlock borrowing and savings opportunities in DeFi. Arguably, DeFi owes its existence today to these critical RWAs. Stablecoins have been a colossal success.

Outside of stablecoins, however, the adoption is still relatively nascent.

U.S. Treasuries. Once risk-free U.S. government rates surged higher than stablecoin rates in DeFi, a wave of tokenized U.S. Treasury offerings flooded the market from players such as Ondo, Matrixdock, Backed, Maple, and Open Eden, as well as traditional financial institutions such as Franklin Templeton and WisdomTree. The aggregate tokenized Treasury market is just shy of $700mm as of this writing.² Tokenized Treasuries allow holders to earn a yield they wouldn’t otherwise passively via popular stablecoins such as USDC (where yield is purposefully not passed along to tokenholders). DeFi platform Flux Finance allows Ondo $OUSG tokenholders to leverage their Treasury position to earn even more yield. These offerings often involve a KYC/AML check and incorporate traditional legal agreements and structures, such as special purpose vehicles. Only certain investors can participate; it is therefore permissioned, not permissionless.

Tokenized U.S. Treasury offerings with at least $1mm of TVL. Source: RWA.xyz as of October 30, 2023.

In the wake of early traction with tokenized Treasuries, other tokenized fixed income offerings are coming to the market, offering exposure to money market funds and short-duration bond instruments.

Private Credit. The third largest RWA bucket includes various lending protocols such as Maple, Credix, Centrifuge, and Goldfinch. These platforms vary in target borrower (institutional vs. retail) and lender segments (corporate, emerging market, etc.), as well as capital stack structuring. The common themes across these platforms are 1) harnessing smart contacts to create lending pool infrastructure and ABS-like tranches to slice risk and return more efficiently and 2) crowdsourcing capital from users via a blockchain. There have been over $4bn of originations to date, but active loans only total around $568mm,² due in part to adverse selection issues and the de-levering of the crypto economy since 2021.

Private credit protocols with at least $1mm of TVL. Source: RWA.xyz as of October 30, 2023.

Other Assets. Proponents of tokenization — including BCG in its 2022 report — often point to more illiquid or esoteric assets like real estate, art, royalties, funds, etc., as targets for tokenization. The truth is that not much has taken place in this bucket outside of a few one-off experiments. We don’t expect that to change anytime soon. Making an illiquid asset slightly less illiquid doesn’t remove its illiquidity risk. No one is buying a fractionalized apartment, even if a blockchain provides a technical avenue to do so. In 2023, this type of tokenization activity is still a pipe dream.

Roadblocks to RWA Adoption

Many of these issues facing greater RWA adoption fall under the umbrella of switching costs. Imagine that we could create and agree upon the most perfect replacement for the traditional financial system. Even then, it would still take an incredible effort to convince the current financial system to move en masse to this “perfect” alternative, not to mention training front-line workers who are used to legacy systems on our new perfect alternative. Now consider the practical reality that the state of blockchain technology today is far from perfect. The switching costs are only magnified because there is greater risk.

Meaningful cost considerations, barriers, and risks include, but are not limited to:

• Lack of Regulatory Clarity. This is the greatest impediment to adoption. Blockchains like Ethereum may have established a technological standard, but to unlock meaningful institutional adoption, we will also need to see more consensus around a complementary regulatory standard to provide firms with the clarity that they are not risking major legal liability through experimentation. Europe’s MiCA regulation and Switzerland’s DLT Act offer the beginnings of a regulatory framework. By contrast, the United States has taken an antagonistic stance, and sadly, that weighs heavily on the minds of institutions interested in RWA innovation. In addition, without a defining legal standard, it’s unclear how tokenized representations of ownership will be honored by various jurisdictions when issues inevitably arise.
• Liquidity Risk. It sounds innovative to take an illiquid asset like art, real estate, and apparently, even uranium — and tokenize it to potentially increase access and liquidity. However, the level of liquidity to get most institutional buyers comfortable is far greater than the liquidity we see in these secondary markets today.
• Education Gap. “Going down the rabbit hole” to learn about crypto and blockchain is not an evenly distributed experience. The crypto rabbit hole is deep, and many — particularly institutions — don’t get far enough down it to feel comfortable enough with new considerations like wallet security and smart contract risk.
• Adverse Selection. The earliest RWA experiments have been prone to adverse selection. As Switchpoint wrote here, the Goldfinch platform has notably suffered from recent borrower defaults. This was unsurprising, at least to anyone who has worked in credit. There are enough risks with utilizing a new technology. Adding meaningful credit risk only complicates matters, and the ecosystem hasn’t earned the trust that it knows how to assess these financial risks to the standard that institutions demand.
• User Experience. Blockchain technology today makes some things better but also introduces novel risks and is still clunky to use. A popular startup tenet is that a new product needs to be 10x better than the existing solutions to overcome switching costs. Well, if we’re being honest with ourselves, crypto today is better in some ways, but while it holds the promise to be vastly better in the future, it is not a 10x better experience in 2023. Institutions must shoulder new operational issues (wallet & key management, smart contract risks, extra reporting, disaster recovery, etc.) that they do not have in TradFi. We’re still (too) early on this front.
• Ideological Rigidity. Too many people in crypto espouse a religious zeal for certain deeply held tenets, at times mocking anything resembling compromise. Purity tests are not helpful for attracting mainstream adoption and can appear out-of-touch to anyone outside crypto. It’s not just the laser-eyed Bitcoiners but highly credible people in the DeFi ecosystem (see below from the founder of DYDX). Purely decentralized, crypto-native apps and solutions can co-exist with tokenized real-world assets. Experimentation, even when the experiment doesn’t perfectly conform to ecosystem ideals, should be encouraged.

• Public Narrative. 2020–2022 was something to behold. We witnessed Ponzi schemes, mismanagement, and outright fraud from the likes of FTX, 3AC, Terra, etc. Those in the space rightfully saw those events as the same centralization-gone-amok that has plagued traditional finance forever. Unfortunately, the industry did not win the PR war, and too many outside of crypto today associate decentralized technology with these centralized frauds. This may tragically be SBF’s enduring gift to the space, and it will take a long time to regain trust, particularly among institutions.

An Emerging Blueprint

That’s a lot of issues to work through. The good news is that the recent wave of tokenization has increasingly pursued Circle’s USDC playbook to create constructs that help to mitigate these concerns and spark greater RWA adoption by embracing:

• Simplicity. The more complex an RWA offering, the greater the switching costs involved because of the heightened due diligence burden. It shouldn’t be surprising that 1:1 USD stablecoins have meaningful traction or that Treasury-based offerings have seen the second-most traction. They’re simpler to understand for participants relative to, say, a multi-tranche emerging market loan securitization. RWA projects should deliberately tokenize simple, plain vanilla assets and achieve product-market fit there before focusing on more complex offerings that are less likely to gain traction today.
• Low-risk Assets. This is similar to simplicity. This industry will only get to the point of tokenizing illiquid, higher-risk assets if RWA models are first proven with the most liquid, well-understood markets in traditional finance. Institutions are professional risk managers. Asking them to take a technology risk (alone) is a much lower bar than asking them to participate in a construct that also includes substantive liquidity and/or credit risk. Earn the right to move into riskier, more illiquid asset classes by first getting tokenization right where burdensome liquidity and credit premia aren’t a holdup for participating.
• Compliance. Permissioned chains and compliant apps/solutions are not the end of decentralization. At Switchpoint, we believe institutional participation in any type of blockchain (private, permissioned, or public) is a rising tide that lifts all boats. Given the uncertain regulatory environment, a concerted effort to create a compliant structure (i.e., by incorporating KYC/AML) is a foundational requirement for institutional participation and not a sign our “hearts are not in it” (see below). These are regulated entities, and protocols need to be mindful of such user constraints to successfully target an institutional segment.

Compromise: The Ultimate Key to Greater RWA Adoption

Ultimately, the key unlock for greater RWA adoption is to make pragmatic trade-offs to gain traction and realize the promise of blockchain technology. RWA adoption will increase with more solutions that compromise where zealous fanatics will not:

• Not fully decentralized. Successful RWA efforts will carry some degree of centralization. For instance, today’s tokenized Treasury solutions set up special purpose vehicles — limited liability entities incorporated in a particular jurisdiction like the State of Delaware — that hold real-world assets like U.S. Treasuries in a bankruptcy remote fashion. This is a due diligence requirement for most institutions and, therefore, essential for onboarding more institutions.
• Not fully permissionless. This is where compliance comes in. As noted above, KYC/AML is table stakes for institutional adoption in many jurisdictions. By definition, this means there must be some degree of permissioning and (limited) privacy give-up.
• Recognition that TradFi isn’t always the enemy. There has been a sticky good vs. evil narrative in Crypto Twitter when it comes to TradFi. We should view TradFi not as a villain to eradicate but rather as potential partners and customers. That’s the mainstream market if we actually care about achieving product-market fit.
• Acknowledgement that regulation isn’t (all) evil. You could be forgiven thinking that all governments are on a mission to eradicate blockchain-based activity, given the United States' posture. At Switchpoint, we view the U.S. stance as a form of Innovator’s Dilemma — protecting a system that most benefits the incumbent (in this case, the U.S. and its financial sector). The Innovator’s Dilemma framing anticipates competitors coming to take a shot at the market leader by being more open to crypto, and that’s exactly what we’re fortunately seeing from others like Europe with its MiCA.

I can feel the hardliners’ heads exploding. This is short-sighted. If they’re right about open-source, permissionless transacting producing a better financial system, they shouldn’t fear institutions trying a different way to get their feet wet. Many with this concern aren’t truly afraid that institutions will co-opt a movement. Rather, they’re afraid that they’re wrong that these values are a necessity for an improved financial system.

As noted above, we believe more RWA adoption on permissioned chains/apps will bring more adoption across crypto, including on permissionless, fully decentralized finance. We’ve already seen this in practice with Circle and Tether, the centralized entities behind the RWAs largely powering decentralized finance.

The irony of making compromises to enable ring-fenced, permissioned RWA offerings is that subsequent adoption will inevitably lift activity that reflects the deeply held tenets of the crypto community and gives blockchain its best chance to realize the promise of a better financial system.

Let’s all be more open to that path.

Data sources:

1. DeFi Llama as of 10/30/23.
2. RWA.xyz as of 10/30/23.