Putting Real-World Assets on-chain
Jan 12, 2022
A Multi-Trillion Dollar Opportunity Is Coming Our Way
Traditional financial markets can help to bring the over $20 trillion in debt denominated assets onto the blockchain and into the greater decentralized finance ecosystem.
Real-world assets on the blockchain enable greater transparency and capital efficiency, and allow for the fast, cheap transactions we’ve come to expect from DeFi.
The stability of these assets give DeFi protocols like Maker and Aave a way to back stablecoins with stable assets, creating a new world of DeFi and liquidity for both asset originators, credit facilities, and lenders.
Traditional businesses can leverage this technology to gain an economic edge over their competition and fuel faster growth.
Since the early days of crypto, the idea of bringing real-world asset (RWA) ownership rights to the blockchain has been a dream of many developers and financiers. In 2017, the first apartment was sold via the blockchain in Ukraine and in the following years more sophisticated assets like “collateralized debt positions,” music and movie royalty payments, payroll advances, and commercial real estate have been “tokenized” and brought onto the blockchain. In this article we will explore the basics of tokenizing a RWA, what it means for both traditional finance and decentralized finance, and demonstrate some use cases that your business can use today to access liquidity, reduce fees, and gain access to this growing sector.
Types of RWA Assets on-chain
What kinds of assets can be tokenized? Anything that can be owned can be tokenized. When you read “tokenization” it boils down to digital ownership rights represented on the blockchain through a token. That can be a unique ownership token represented through an NFT, or a fungible token that works similar to a share in a real estate syndicate or REIT.
Real estate titles as NFTs were the first use case for tokenizing real world assets, but since then the industry has added many new types of tokenized assets such as: Invoice Financing, Mortgages, Fix and Flip Loans (short term real estate financing), Royalty Payment Advances, Auto Financing, Art, and Small and Medium Size Business Financing.
How to Get an Asset onto the Blockchain With invoice Financing
Let us begin by going through the technical details to demonstrate how a RWA gets onto the blockchain in the first place. Many companies and protocols are building tools and methods to “tokenize” assets, but for our example we are going to demonstrate how Centrifuge gets assets onto the blockchain and how those assets are valued. We chose Centrifuge as they are currently leading the blockchain-enabled RWA origination movement and have integrations with two of the most battle-tested DeFi protocols: Aave and MakerDAO.
In our example of “invoice financing” a company we will call “Big Car Inc.” orders millions of tires from another company we will call “Tire LLC”. Tire LLC needs financing to purchase the rubber, electricity to run the plant, and capital to pay the employees who produce the tires. Tire LLC. sends the invoice to Centrifuge who in turn verifies all the particulars (price, delivery date, amount payable, credit worthiness of both parties). Once Centrifuge, Tire LLC, and Big Car Inc. are all in agreement the document is signed through a cryptographic hash, anchored to the blockchain, and then Tire LLC mints the invoice on-chain as an NFT that represents all the information verified. This NFT can now be used as collateral and capital can be borrowed against this asset.
What Is the Benefit of Tokenizing RWA?
Invoice financing is a common practice in traditional finance, as companies need capital to fulfill incoming orders, make payroll, pay rent, and continue operations. Typical invoice payment times can vary from 30 to 120 days to obtain payment after the order is delivered (that is not counting the amount of time needed to produce the product and fill the order).
To help businesses bridge the gap from order to payment, banks lend capital against the invoices they have in turn for interest, which can be quite high for a small or medium size enterprise (SME). SME financing can have rates higher than 15% to borrow capital while a top 2,000 company like Google can access capital for less than 1%. The difference in these rates is not commensurate with default rates as the SME industry has a less than 2% default rate on loans of this kind. Because of these high rates and low risk, the opportunity to bring these assets into the liquid world of decentralized finance is an attractive opportunity for lenders and borrowers alike. Fees for lenders in the RWA space on MakerDAO and Aave are between 4%-10%, and borrowers can get interest rates as low as 5% and upwards of 12% to access capital.
Bringing Real Estate On-Chain
If you have ever purchased a home, investment property, or a piece of commercial real estate, you know the painstaking process of filling out paperwork, dealing with multiple intermediary agencies like banks, title companies, and underwriters, along with the myriad fees charged by all of these intermediaries.
What if we could use the ease and security of the blockchain to facilitate these types of transactions as well as unlock new functionality while simultaneously lowering counterparty risks? While it may sound too good to be true, the future is here and being tested by a variety of companies. Tokenized real estate unlocks a host of new features that can open up these markets to individuals and companies that have been left out of this ever-growing market.
Transparency and Ease of Blockchains
Imagine buying a property at 3am on a Sunday from the comfort of your own home. This is the future blockchain-enabled real estate is bringing to the table.
Currently real estate relies on multiple human intermediaries to complete a transaction that can take weeks if not months to effectuate. Thanks to the composability of smart contracts, the required facts and figures such as market value, ownership (past and present), and lien status are all verifiable instantaneously through smart contracts, allowing 24/7 transactions without all of the traditional title transfers, title insurance, real estate agent fees, appraisers, and underwriters.
Secondary Market Liquidity
Real estate is often touted as a vehicle for the wealthy to park capital that keeps pace with inflation and can produce a dividend in the form of rent payments. However, real estate is an illiquid asset and accessing capital locked in a property can be an expensive and cumbersome process.
With tokenized real estate, borrowing against a piece of property can be simple with DeFi marketplaces such as MakerDAO, Aave, and Compound. Perhaps you are part of a real estate syndication or group investment and have a financial emergency where you need to liquidate the asset; with tokenized real estate, secondary markets are created where these tokens can be traded to another investor looking to gain exposure to your type of asset.
Even more nuanced investment choices can be made in these markets. Perhaps you invested in growth markets where the value of the property was going up quickly, but rents were low; now as an older investor you would prefer the safety of a more stable market with the cash flows of a higher rental rate. You could use these secondary markets to change the composition of your portfolio to better adapt to your individual investment goals.
Using a smart contract, tokenization fractionalizes ownership of the asset. This is similar to the crowd funding model or to bundling multiple real estate assets into one pool, such as a real estate investment trust (REIT). For example, as a small retail investor I want exposure to commercial real estate in the city of Austin, TX. I only have $10,000, which is well short of owning my own property, and no real estate investment syndication will let me in on the deal for less than $100,000, meaning I have no way to access this market. With asset tokenization, ownership in a property can be split as large or as small as needed to allow investors the opportunity to unlock these capital markets. Similar to REITs, these tokens can be bundled into larger “vaults,” which could give investors access to a variety of investment strategies in asset class or location such as:
Commercial Real Estate in Austin, TX
Large Apartments in Fast Growing Cities
Green Energy Projects in Emerging Economies
Women-Owned Rental Real Estate
Vineyards in Europe
Public-Private Affordable Housing
The tokenization model enables asset organizations and fund managers to create a variety of new investment vehicles that can allow for more targeted investments, such as in underserved segments of the real estate market.
Getting DeFi Liquidity with MakerDAO
MakerDAO is the oldest and most battle-tested decentralized finance protocol in existence, and they continue to innovate and build new ways to democratize finance. Maker Vaults are an over-collateralized lending protocol, essentially you lock up an asset (typically crypto currency) and you can borrow DAI (a dollar-backed stablecoin) in the amount the vault will allow depending on the asset deposited (typically 50%-80% of the underlying value). Due to the overcollateralized nature of these loans, they are typically very stable and if the underlying collateral ever reaches the amount borrowed, the assets are automatically liquidated to repay the loan plus a liquidation fee. The Maker Vaults work the same with RWA as they do with crypto assets, allowing fund managers to lock up an investment type as collateral and to borrow against that asset.
Why Tokenizing Assets Will Change the Game
The cross section of traditional finance and decentralized finance continues to evolve. With what seems like almost daily news of a new use case of technological convergence, we are witnessing everything from carbon credits on-chain to tokenized ownership of commercial real estate.
Centrifuge and MakerDAO are continuing to work together to maintain and grow a robust marketplace for lenders and borrowers alike to gain exposure to the fast, secure, and transparent system DeFi offers users. Putting real-world assets on the blockchain enables greater transparency, easy access to liquidity, and fast, cheap transactions, while enabling a new generation of financial tools that can unlock financial freedom for all.
Joe King is a tokenomics designer and DeFi strategist with Bankless Consulting, where he helps clients build token models, incentive structures, and go-to-market strategies for DeFi protocols. A contributor to Tokenomics DAO, The Token Engineering Academy, and The Crypto Oracle Collective, when Joe King is not at his desk you can spy him in the sky flying his Paraglider around the Appalachian Mountains.