What Are Real-world Assets (RWAs)?

Real-world assets (RWAs) have long captured the imagination of cryptocurrency investors and developers alike due to the sheer size of global markets and easy improvements made possible with tokenization. Moreover, the challenges presented by these traditional markets, such as entry barriers and clunky trading mechanisms, make them ripe for revolution.

RWAs refer to any assets not inherently part of the blockchain on which they are tokenized e.g., they exist “off-chain.” Generally, conversations about RWAs are centered around traditional financial assets like government bonds, private debt, real estate, and even other non-blockchain-based holdings like art or collectibles. While fiat-collateralized stablecoins such as USDT and USDC technically fall under the category of RWAs, they are frequently considered separate and apart from other RWAs due to their relatively uncomplicated nature and use case as a stablecoin.

Yet, the narrative doesn't end with mere tokenization. Decentralized Finance (DeFi) brings another dimension to the table, broadening the financing avenues for RWAs. The combination of DeFi with RWAs can forge fresh investment yields, catering to participants keen on funding tangible assets.

In essence, the fusion of RWAs and crypto, spurred by tokenization and DeFi, has the potential to transform the landscape of asset trading and redefine our understanding of liquidity and inclusivity in the financial domain. The coming decade may well herald a paradigm shift, where tangible assets become seamlessly integrated into the digital world.

RWAs Continue to Grow

Incorporating real-world assets (RWAs) into blockchain platforms, commonly called "on-chain" assets, has achieved a new milestone. As per the latest research undertaken by Galaxy Research, the collective value of these on-chain assets has surpassed the $3 billion mark. A closer look into the constitution of these assets reveals an intriguing distribution. Gold and other precious metals emerge as dominant players, making up 37% of all real-world assets on-chain. Money market instruments, too, are gaining traction, with a representation of 23%. Interestingly, treasuries, accounting for 20.04%, and private credit at 13%, are significant contributors, with equities and carbon offsets constituting 1.6% and 0.43%, respectively.

Real World Assets (RWAs) have garnered significant attention in the decentralized finance (DeFi) and Web3 space, necessitating a comprehensive understanding of the term and its implications. RWAs refer to tangible assets present in the physical world, such as real estate and commodities. However, in the cryptocurrency context, the scope of RWAs expands to include tokenizable assets ranging from real estate and precious metals to stocks, bonds, and financial derivatives. This is made possible by employing blockchain technology and smart contracts to bring physical and financial assets on-chain, thereby bridging traditional financial markets (TradFi) and physical assets with cryptocurrencies. This connection creates more use cases and opportunities by offering increased liquidity, transparency, security, and availability through tokenized RWAs.

While the traditional asset class encompasses physical items with practical utility, such as infrastructure, machinery, and equipment, the crypto discourse includes various tokenizable assets as part of the RWA category. In traditional finance, these assets serve as valuable collateral for loans, a function that crypto protocols aim to replicate in the DeFi space.

One remarkable trend that has caught the attention of many in the industry is the growing allure of yield-bearing RWAs. As it stands, they encapsulate a staggering 61% of the RWA market capitalization on-chain. This surge can be attributed to the burgeoning demand for reliable yield sources, particularly ones that echo the familiar realms of traditional finance.

Given the prevailing atmosphere of high interest rates, assets like treasuries, money markets, and private credits have come to the forefront. Their promise? A blend of safety and consistent on-chain yield. It's clear that investors, in their quest for stability and returns, are increasingly turning their gaze towards these yield-bearing RWAs.

Advantages

The anticipated benefits of RWA digitalization span across multiple categories, including private capital markets, asset-backed securities, money market funds, ETFs, intellectual property, and fixed income. The Total Addressable Market (TAM) for tokenization is both staggering and continuously expanding. Private capital markets, which encompass company equity, debt, and real estate, face challenges such as illiquidity, outdated asset pricing data, and the presence of multiple intermediaries that affect price discovery and updates. These challenges make this sector particularly receptive to alternative financial solutions.

Leveraging blockchain technology and tokenized RWAs can address several challenges the financial industry faces. By allowing each party to operate its node and validator and maintain its ledger, blockchain minimizes inconsistencies and automatically detects and raises special events. This setup ensures that every participant acts as an independent validator, creating a decentralized system across a network of financial institutions and companies. While this is the goal that many RWA protocols aspire to achieve, it is important to acknowledge that, at the time of writing, there is still a considerable journey ahead to establish such an international system. However, this remains the ultimate objective for tokenized real-world assets, aiming for a future where the entire market is interconnected and transparent, devoid of TradFi and DeFi divisions.

To encapsulate the unique properties and characteristics of non-fungible real-world assets, protocols employ Non-Fungible Tokens (NFTs). NFTs contain crucial information about specific assets, and by tokenizing these assets, their ownership and transaction history can be securely recorded on the blockchain. This includes a wide array of assets such as tokenized art, commodities, and real estate. Smart contracts facilitate the issuance and transfer of NFTs, ensuring transparent and automatic enforcement of real-world asset representations on the blockchain.

Maker RWAs

At its core, Maker's RWA initiative aims to diversify the protocol's collateral further in order to minimize risk and hedge against DAI's reliance on USDC (USDC makes up more than half of DAI's collateral). Initiative proponents emphasize the significance of RWA in expanding the scope of DAI, enhancing its stability, and increasing its decentralization.

Collateralization using Real World Assets (RWA) within MakerDAO has seen a remarkable uptick. From August 2022 through Q2 2023, DAI backed by RWA within MakerDAO experienced exponential growth. This meteoric rise can be attributed to strategic collaborations with entities such as Monetalis Clydesdale, Huntingdon Valley Bank, and BlockTower. Within the partnership framework of Monetalis Clydesdale, MakerDAO has the opportunity to allocate its dormant PSM USDC towards liquid bonds, thus optimizing the use of idle assets.

MakerDAO, a decentralized finance (DeFi) powerhouse, has been a prominent player in the real-world asset (RWA) arena, with $3.4 billion of its collateral base represented by RWAs, predominantly U.S. treasuries. This move has proven to be lucrative for Maker as RWA-related fees accounted for ~66% of the total fees generated up until July 2023. Despite the growing influence of centralized forces, which has often been a point of contention, the integration of RWAs into Maker’s portfolio has been a valuable addition. While the majority of Maker's exposure is towards assets considered 'risk-free,' the platform has also ventured into other asset classes, albeit on a smaller scale, which carry default risks.

Traditional finance addresses defaults through various means, including selling distressed loans at discounted rates, undergoing financial restructuring, or initiating liquidation processes. However, when the recoverable value is negligible, or a lender is too junior to receive any recovery versus what is available for distribution, the recovery is usually nil. Additionally, several external factors, such as legal claims, environmental issues, insufficient insurance, or intellectual property disputes, can also affect the token's value.

Challenges Faced by MakerDAO

Recently, MakerDAO encountered a default on one of their RWA loans, a tokenized loan facilitated through Centrifuge in a pool underwritten by ConsolFreight, a trade finance provider. The pool consisted of $2.7 million in loans, with the largest borrower having an outstanding balance of $1.84 million. ConsolFreight was responsible for originating the loans, while Centrifuge Tinlake's infrastructure financed the assets, and MakerDAO, along with other DeFi participants, acted as the lenders. A previous default occurred in April involving a 1.5 million DAI loan under the Harbor Trade pool.

Defaults are not inherently problematic unless they constitute a large portion of a broader portfolio. Effective risk management involves accepting that defaults are inevitable and ensuring that the default risk is acceptable relative to the portfolio and that there is a reasonable estimate of recoveries in the event of a default. However, the crypto space presents additional risk as the legal backing for crypto lenders/investors has not been thoroughly tested. Although the defaulted loans are relatively small compared to Maker's collateral base and do not pose a significant financial risk even if no capital is recovered, the handling of the situation could have long-term implications for managing investments and risks in more impactful scenarios.

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