Asset tokenization in DeFi brings real-world assets into the DeFi ecosystem, offering liquidity, accessibility, and efficiency.
Tokenization converts real-world assets into digital tokens, which can be traded, invested, and managed on blockchain networks. This technology can potentially revolutionize how we approach asset management, making it more efficient, transparent, and accessible.
In this article, we delve into asset tokenization and how to bring real-world assets into DeFi
What is DeFi
DeFi stands for Decentralized Finance. It refers to the concept of financial services and systems that are built on blockchain technology, decentralized networks, and open-source protocols.
DeFi is designed to provide financial services and tools that are more accessible, transparent, and secure than traditional financial systems.
DeFi aims to provide financial services to individuals and businesses that may not have access to traditional financial institutions.
This includes people in underserved communities, developing countries, and those who may not have a bank account or credit history.
What is Asset Tokenization?
Asset tokenization converts a traditional asset, such as a physical property, art, or company, into a digital token representing ownership or a claim on the underlying asset.
This allows for the creation of a new, tradable digital asset for decentralized finance (DeFi) applications, such as lending, borrowing, and trading.
Asset tokenization refers to recording the rights to a given asset into a digital token that can be held, sold, and traded on a blockchain.
The resulting tokens represent a stake of ownership in the underlying asset. Virtually any asset, whether physical like real estate or intangible like stock in a corporation, can theoretically be tokenized.
Turning these assets into digital tokens makes them more easily divisible, allowing for fractional ownership that enables more people to invest, making the markets for those assets more liquid.
How does Asset Tokenization work?
How does one convert a real-world asset into a digital token on a blockchain? The answer varies per project. Here’s an example of how it could work, using a piece of real estate as our example.
The process of asset tokenization typically involves the following steps:
- Create the Digital Tokens
- Smart Contract Implementation
- Token Distribution and Sale
- Asset Management and Governance
- Secondary Market Trading
Create the Digital Tokens
The first and most important step is creating the tokens representing shares in the real estate property.
To do this, one could create a legal entity that would exist solely to own the tokenized real estate.
The digital tokens would simply represent shares in the entity, thereby entitling holders to a portion of the real estate’s value and benefits, such as rental income or appreciation.
Smart Contract Implementation
The issuance, balance tracking, and payouts of benefits associated with the digital tokens representing a tokenized asset would all be governed by smart contracts.
Smart contracts are decentralized programs built on blockchains that fulfill specific functions and run based on transparent, auditable code.
In the case of a tokenized real estate property, the associated smart contracts could handle critical functions like the distribution of rental income, implementation of governance decisions voted on by token owners (similar to a DAO), and payment of expenses associated with maintaining the real estate.
Token Distribution and Sale
Once the digital tokens and necessary smart contracts have been created, the next step would be to sell the tokens to investors.
This could be done via private sales, an open sale to the public, or a combination of the two using a whitelist model, as many other crypto projects have done.
The efficient fractionalization of the asset enabled by tokenization could create a bigger, more liquid market for the asset.
Asset Management and Governance
As we alluded to earlier, holders can manage the underlying real estate once the tokens have been sold, including physical maintenance, tenant relations, property improvements, and more.
The exact level of control given to token holders and as a collective and the voting process would have to be laid out in the relevant legal entity’s charter and encoded into the smart contracts associated with the asset.
Secondary Market Trading
Tokens representing shares in the real estate property could also be traded on secondary markets after launch.
This is where the liquidity benefits come into play. Rather than being stuck with an unsellable property as so many real estate investors have over the years, token holders, in this example, would have greater flexibility and a potentially broader ecosystem of buyers with whom to explore price points.
Examples of Asset Tokenization
Real-world asset tokenization
Real-world assets like fiat currency, equities, T-bills, credit, commodities, carbon credits, intellectual property, and fine art can be tokenized and stored on a blockchain.
Gold bullion warrants and house deeds are bearer assets that give the holder a claim over a real-world asset.
The key difference from legacy bearer assets is that physical asset tokenization enables assets to be stored, traded, and used as collateral across blockchain networks.
Digital asset tokenization
Tokenizing assets that only exist in a digital form on a blockchain network is critical to Web3, especially for use cases such as representing DAO governance rights and cross-chain assets. Because they’re entirely digital, tokenized assets stored on a blockchain enable the owner to hold the asset outright rather than owning a claim on the underlying asset.
In-game asset tokenization
A subset of digital asset tokenization, in-game assets used in GameFi projects or metaverses, such as skins, weapons, or in-game currencies, can be represented as tokenized assets.
Popular Examples of DeFi Applications
Some popular examples of DeFi applications include:
Here are some popular examples of DeFi (Decentralized Finance) applications:
AAVE
Aave is a decentralized lending and borrowing platform that allows users to earn interest on their cryptocurrency holdings. It has a user-friendly interface and supports a wide range of cryptocurrencies and competitive interest rates. However, the platform’s fees can be high, and there is a risk of loss in the event of a smart contract failure.
Uniswap
Uniswap is a decentralized exchange that enables users to trade cryptocurrencies without intermediaries. The platform uses an automated market maker (AMM) system, allowing more efficient price discovery and liquidity provision. Uniswap is known for its ease of use, low fees, and transparency. However, the platform can be susceptible to front-running attacks, and some users may find the AMM system confusing.
MakerDAO
MakerDAO is a decentralized stablecoin platform that allows users to create and trade stablecoins backed by cryptocurrency collateral. The platform is known for its stability and reliability, and its stablecoin, DAI, is widely used in the DeFi ecosystem. However, the platform can be complex to use, and there is a risk of liquidation in the event of a price crash.
What are Real-World Assets?
Real-world assets are tangible assets that have value in the physical world, such as:
- Real Estate: Properties, buildings, and land.
- Art: Artworks, collectibles, and other unique items.
- Commodities: Oil, gas, gold, and other physical commodities.
- Debt: Bonds, loans, and other debt instruments.
- Intellectual Property: Patents, trademarks, and copyrights.
After having an inkling of real-world assets, we’ll need to look at why it should be brought into the DeFi space before looking at how it should be brought.
How to Bring Real-World Assets to DeFi?
Bringing real-world assets to DeFi, also known as “on-chain” or “tokenized” assets, is a process that enables the integration of traditional financial assets with blockchain technology.
This allows for creation of new financial products and services that leverage the benefits of both worlds.
Here are some steps to help you bring real-world assets to DeFi:
- Identify the assets
- Understand the asset’s underlying characteristics
- Choose a tokenization platform
- Tokenize the asset
- Develop a smart contract
- Integrate with DeFi protocols
- List on exchanges
- Educate users and market participant
- Monitor and maintain
Identify the asset
Choose a real-world asset that you want to bring to DeFi. This could be a stock, bond, commodity, currency, or even a physical asset like a piece of art or a car.
Understand the asset’s underlying characteristics
Study the asset’s underlying characteristics, such as its value, volatility, and liquidity. This will help you determine the best approach for tokenizing the asset.
Choose a tokenization platform
Select a tokenization platform that supports your chosen asset type. Popular platforms include:
- Tokenization protocols like Compound, MakerDAO, and SushiSwap.
- Digital asset platforms like Paxos, Tether, and Circle.
- Blockchain-based marketplaces like OpenSea and Rarible.
Tokenize the asset
Use the chosen platform to tokenize the asset. This typically involves creating a digital representation of the asset (e.g., a token) backed by the underlying asset. The token is then traded on a blockchain-based exchange.
Develop a smart contract
Create a smart contract that governs the behavior of the tokenized asset. This contract should define rules for trading, settlement, and token redemption.
Integrate with DeFi protocols
Integrate the tokenized asset with DeFi protocols, such as lending platforms, yield farming protocols, or decentralized exchanges (DEXs).
List on exchanges
List the tokenized asset on various exchanges, including DEXs, centralized exchanges (CEXs), or peer-to-peer lending platforms.
Educate users and market participants
Educate users and market participants about the benefits and risks associated with tokenized assets. This includes explaining their work, use cases, and potential risks.
Monitor and maintain
Continuously monitor the performance of the tokenized asset and maintain its underlying infrastructure to ensure stability and security.
Challenges in Asset Tokenization
Asset tokenization, the process of converting rights to an asset into a digital token on a blockchain, holds significant promise for transforming traditional finance.
However, this innovation faces several challenges:
- Regulatory Uncertainty
- Lack of Standardization
- Limited Liquidity
- Counterparty Risk
- Security Risks
- Market Volatility
- Scaling Issues
Regulatory Uncertainty
The regulatory landscape for asset tokenization is still evolving, and governments and regulatory bodies lack clear guidelines and oversight. This uncertainty can create entry barriers and limit asset tokenization adoption.
Lack of Standardization
There is no standardized framework for asset tokenization, which can lead to fragmentation and complexity in the market. This makes it challenging for investors and issuers to navigate the process.
Limited Liquidity
The liquidity of asset tokens is often limited, making it difficult for investors to buy and sell them quickly and efficiently. This can result in reduced investor demand and lower valuations.
Counterparty Risk
Asset tokenization involves using intermediaries, such as exchanges, custodians, and brokers, which can introduce counterparty risk. This risk can be mitigated through smart contracts and other technologies, but it remains a concern.
Security Risks
Asset tokens can be vulnerable to hacking and other cyber threats, compromising the security of the underlying assets.
Market Volatility
The market value of asset tokens can fluctuate rapidly, making it challenging for investors to predict their returns.
Scaling Issues
As the asset tokenization market grows, it may face scaling issues, such as increased transaction costs, decreased network effects, and reduced scalability.
Conclusion
Asset tokenization in DeFi is a critical step in unlocking the full potential of decentralized finance.
By tokenizing real-world assets, we can increase accessibility, liquidity, transparency, and efficiency while offering new investment opportunities and diversification strategies.
While tokenization has challenges and limitations, the benefits are undeniable. As the regulatory environment continues to evolve, we expect to see more widespread adoption of tokenization in various industries and markets.
