Federal Reserve report details RWA: Benefits of tokenizing real assets are numerous, but financial stability risks remain

The Federal Reserve recently released a research report on tokenized assets, which provides detailed background information on tokenization and discusses its potential benefits as well as the risks it may pose to financial stability.

The Federal Reserve's Definition and Classification of Tokenized Assets

The Federal Reserve has outlined five elements of tokenized assets:

1. Blockchain
2. Reference assets - real-world assets
3. Mechanism for assessing the value of reference assets
4. Custody and/or storage methods for reference assets
5. Redemption mechanism for tokens and/or reference assets

The table below details current tokenization projects, categorized based on their reference asset type, redemption availability, and involvement of on-chain or off-chain references. Tokenization of physical/off-chain reference assets typically involves off-chain agents like banks to assess the value of reference assets and provide custody services. Tokenization involving other on-chain crypto assets may utilize smart contracts for custody and valuation assessments.

A Diverse Range of RWAs: Including Agricultural Commodities

Real World Assets (RWAs) may be more familiar to cryptocurrency enthusiasts. In a report released by Binance at the end of July, titled "Real World Assets: Market Overview," it is stated that RWAs are still in the early stages, with a current market value of approximately $1 billion. Quoting a report from the Boston Consulting Group, it is projected that the tokenized asset market will reach $16 trillion by 2030.

However, the Federal Reserve's report seems to list more RWA projects. As of May 2023, the value of tokenized assets issued on permissionless blockchains amounted to $2.15 billion. This includes various tokens issued by decentralized protocols like Centrifuge and traditional companies like Paxos Trust, with an estimated $700 million valuation in DeFi.

Table 2 lists examples of various RWAs, including tokenized U.S. Treasury markets, gold tokens, tokenization of real estate, and mentions examples of tokenized agricultural products.

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Agricultural tokens were launched as a pilot project in Argentina in March 2022 by a joint venture between Santander Bank and cryptocurrency company Agrotoken. Their SOYA, CORA, and WHEA tokens represent soybeans, corn, and wheat, respectively. Each token represents 1 ton of the commodity. The commodities can be tokenized for periods of 30, 60, or 90 days and can be renewed until the maximum contract date. Exporters or collectors are designated as "oracles" responsible for safeguarding the grain reserve certificates. The protocol runs on Ethereum, and the tokens automatically "de-tokenize" at the end of the term.

These tokens can also be used as collateral for loans at Santander Bank. Agrotoken has also partnered with Visa to issue a card accepted by 80 million stores and businesses involved in their tokenized grain program. The company effectively connects Argentine farmers and exporters with the global business network holding surplus grains.

Potential Benefits of Tokenizing Real Assets

The article mentions that tokenization may offer several advantages:

• Enabling investors to access markets that were previously inaccessible or cost-prohibitive, such as real estate tokenization, and enhancing asset liquidity
• The programmability of crypto tokens and the ability to embed additional functionalities using smart contracts allow for added features in tokenized assets
• Tokenization can facilitate lending by using tokens as collateral, as seen in the tokenization of grains discussed above
• On-chain settlement times are significantly faster than traditional finance

The Impact of Tokenizing Real Assets on Financial Stability

As tokenization evolves, the scale and scope of tokenized assets continue to expand, potentially posing financial stability risks to the traditional financial system. The interconnectedness between tokenized assets and the traditional financial system primarily lies in the redemption mechanisms of tokenized assets. For instance, if the liquidity of reference assets for tokenized assets is low, it could lead to pressure transmission risks. Additionally, the redemption of tokenized assets issuing institutions could pose a concern for financial stability. Differences in trading times between tokenized assets and traditional financial markets may also lead to unforeseen consequences.

Traditional financial institutions may increase their exposure to the crypto asset market by directly holding tokenized assets or using tokens as collateral for other financial instruments. For example, Santander Bank in Spain provides loans to farmers using tokenized grains. Moreover, Ondo Finance deploys tokenized ETFs on Ethereum, enabling users and DeFi protocols to freely deploy these tokens. As of May 2023, Ondo Finance's tokenized ETFs accounted for 32% of the market value of assets issued by decentralized protocols related to real-world assets, making it the largest project in this category. The OUSG issued by Ondo Finance can also be used as collateral in the lending protocol Flux Finance.

Lastly, akin to the role of securitization during the global financial crisis, tokenization may disguise riskier or illiquid reference assets as secure and easily tradable assets, encouraging higher leverage and risk-taking. Sudden reversals in these positions could potentially trigger systemic events.

Will RWAs of the Future Also Be Regulated?

In conclusion, this paper aims to provide background knowledge on tokenization, discussing its potential benefits and financial stability risks. While acknowledging that the development of tokenized assets may significantly impact the traditional financial system, requiring close monitoring by regulatory bodies and measures to mitigate potential financial stability risks, the paper also lists numerous advantages of tokenized assets, maintaining a neutral stance.

The detailed and clear observations by the Federal Reserve regarding the crypto market, especially in the realm of RWAs, may stem from the involvement of real-world asset prices and stability. Any issues could potentially transmit to traditional financial markets, causing headaches for regulatory authorities. This leads to the contemplation: will real-world assets also be subject to regulation in the future? Will companies or DeFi protocols issuing tokenized real-world assets need to report to regulatory authorities?