Detailed Explanation of RWA Asset Tokenization Sorting out the underlying logic and implementation path for mass adoption

Comprehensive Guide to RWA Asset Tokenization Unpacking the Underlying Logic and Path to Achieve Mass Adoption

Author:

Spinach Spinach: Head of Research, Ample FinTech

Annabella: zCloak Network CMO

Word Count: This research report contains over 28,000 words and covers a wide range of topics. Please read patiently.

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The most eye-catching topic in the field of blockchain in 2023 is undoubtedly Real World Asset Tokenization (RWA). This concept has not only sparked discussions in the Web3 world but also gained high attention from numerous traditional financial institutions and government regulatory bodies worldwide, being seen as a strategic development direction. For example, authoritative financial institutions such as Citibank, JPMorgan Chase, and Boston Consulting Group have successively released their own tokenization research reports and actively promoted related pilot projects.

At the same time, the Hong Kong Monetary Authority clearly stated in its 2023 annual report that tokenization will play a key role in Hong Kong’s financial future. In addition, the Monetary Authority of Singapore, the Financial Services Agency of Japan, JPMorgan Chase, DBS Bank, and many other financial giants jointly launched the “Project Guardian” initiative to deeply explore the enormous potential of asset tokenization.

Although RWA is a hot topic, there are differing opinions and controversial discussions within the industry regarding its feasibility and prospects.

On the one hand, some believe that RWA is just market hype and cannot withstand in-depth exploration;

On the other hand, there are also confident individuals who have high hopes for RWA’s future.

Meanwhile, articles analyzing different perspectives on RWA are emerging like mushrooms after the rain.

In this article, I hope to share a cognitive perspective on RWA and conduct a deeper exploration and analysis of its current state and future.

Due to personal understanding, the content of this article reflects my personal opinions. Please feel free to point out any issues for further discussion.

Key points:

• The logic of Crypto RWA mainly revolves around how to transfer the rights to income-generating assets (such as income rights of assets like US Treasury bonds, fixed income, and stocks) onto the blockchain, mortgage off-chain assets to obtain liquidity in on-chain assets, and trade various real-world assets on-chain (such as sand, minerals, real estate, gold, etc.). It reflects the one-sided demand of the crypto world for real-world assets, but faces many obstacles in terms of compliance.
• The future focus of Real World Asset Tokenization will be the establishment of a new financial system on a permissioned chain, using DeFi technology, driven by traditional financial institutions, regulatory bodies, and central banks as authoritative entities. To realize this system, it requires a computational system (blockchain technology) + a non-computational system (such as legal framework) + an on-chain identity system and privacy protection technology + on-chain fiat currency (CBDC, tokenized deposits, legal stablecoins) + robust infrastructure (user-friendly wallets, oracles, cross-chain technology, etc.).
• Blockchain, as a technology means that effectively supports the digitalization of contracts, is the first platform for digital contracts that emerged after the development of computers and networks. It can be said that blockchain is essentially a platform for digital contracts, and contracts are the basic form of asset expression, while tokens are the digital carriers of assets formed after the contract. Therefore, blockchain becomes the ideal infrastructure for digital asset/tokenized asset representation, which is the expression of digital assets/tokenized assets.
• As a distributed system maintained by multiple parties, blockchain supports the creation, verification, storage, circulation, execution, and other related operations of digital contracts, solving the problem of trust transmission. As a “computational system,” blockchain can meet the demand for “reproducible processes and verifiable results” in human society, making DeFi a type of “computational” innovation in the financial system, replacing the “computational” part of financial activities to achieve cost reduction and efficiency improvement, and also achieve programmability. However, the non-computational part, which is based on human cognition, cannot be replaced by blockchain. Therefore, the current DeFi system does not cover credit, and credit-based unsecured lending has not yet been realized in the current DeFi system. The reasons for this include the lack of an identity system to express “relational identities” on the blockchain and the absence of a legal system to protect the rights of both parties.
• In the context of traditional finance, the significance of Real World Asset Tokenization lies in creating digital representations of real-world assets (such as stocks, financial derivatives, currencies, equities, etc.) on the blockchain, extending the advantages of distributed ledger technology to a wide range of asset categories for exchange and settlement.
• Financial institutions can improve efficiency further by adopting DeFi technology, using smart contracts to replace the “computational” aspects of traditional finance and automatically executing various financial transactions according to predetermined rules and conditions, enhancing programmability. This not only reduces labor costs but also, in specific contexts, provides new possibilities for enterprises, especially innovative solutions for small and medium-sized enterprises (SMEs) facing financing problems, opening a door of immense potential for the financial system.
• With the increasing attention and recognition of blockchain and tokenization technologies by traditional financial fields and governments worldwide, as well as the continuous improvement of blockchain infrastructure technologies such as wallets, cross-chain protocols, oracles, various middleware, etc., along with the application of central bank digital currencies (CBDCs), which can express more complex asset types, and the continuous development of privacy protection technologies, especially zero-knowledge proof technology, as well as the maturing of on-chain identity systems, it seems that we are on the eve of the massive application of blockchain technology.

1. Introduction to Asset Tokenization

Asset tokenization refers to the process of expressing assets in the form of tokens on a programmable blockchain platform. Typically, tokenizable assets can be categorized into tangible assets (real estate, collectibles, etc.) and intangible assets (financial assets, carbon credits, etc.). This technology, which transfers assets recorded in traditional ledger systems to a shared programmable ledger platform, is a disruptive innovation for the traditional financial system and may even impact the future of the entire human financial and monetary system.

First, let’s address an observed phenomenon: “There are two distinct groups with different views on RWA asset tokenization.” I refer to them as Crypto’s RWA and TradFi’s RWA. In this article, we will discuss RWA from a TradFi perspective.

Crypto Perspective on RWA

Let’s talk about Crypto’s RWA first: Crypto’s RWA can be described as the one-sided demand of the Crypto world for real-world financial asset returns. The main background is that, against the backdrop of the Federal Reserve’s continuous interest rate hikes and balance sheet reduction, high interest rates significantly impact the valuation of the risk market, and balance sheet reduction heavily drains liquidity from the crypto market. As a result, the yields in the DeFi market have been declining. At this time, the risk-free yield of around 5% from US Treasuries has become a hot commodity in the crypto market. The most prominent example is MakerDAO’s significant purchase of US Treasuries. As of September 20, 2023, MakerDAO has purchased over $2.9 billion worth of real-world assets, including US Treasuries.

Data source: https://dune.com/steakhouse/makerdao

The significance of MakerDAO purchasing US Treasury bonds is that DAI can utilize external credit to diversify the backed assets. Additionally, the long-term extra income brought by US Treasuries can help stabilize the DAI exchange rate, increase the flexibility of its circulation, and reduce DAI’s dependence on USDC by incorporating US Treasuries into its balance sheet, thereby reducing single-point risks. Moreover, since all the income from US Treasuries flows into MakerDAO’s treasury, MakerDAO recently increased DAI’s demand by sharing a portion of the income from its US Treasuries, raising DAI’s interest rate to 8%.

It is evident that not all projects can replicate MakerDAO’s approach. With the skyrocketing price of MRK tokens and the market’s enthusiastic speculation on the RWA concept, various RWA concept projects have sprung up, trying various methods to tokenize real-world assets on blockchain for sale. Among them are some rather outlandish assets, leading to a mix of genuine and questionable projects in the RWA race track.

From the author’s point of view, the logic of Crypto’s RWA mainly revolves around how to transfer the ownership of revenue-generating assets (such as income rights to assets like US bonds, fixed income, stocks, etc.) to the blockchain, how to collateralize off-chain assets to obtain liquidity for on-chain assets, and how to trade various real-world assets on the blockchain (such as sand, minerals, real estate, gold, etc.).

Therefore, we can see that Crypto’s RWA reflects the one-sided demand of the crypto world for real-world assets. There are still many obstacles in terms of compliance. The approach taken by MakerDAO is actually for MakerDAO team to enter and exit funds through compliance channels (such as Coinbase, Circle), and to purchase US Treasury bonds through regular channels to obtain their profits, rather than selling these profits on the blockchain. It is worth noting that the so-called on-chain RWA US Treasury bonds are not the US Treasury bonds themselves, but rather their revenue rights. This process also involves converting the fiat currency earnings generated by US Treasury bonds into on-chain assets, which adds complexity and frictional costs to the operation.

The rapid rise of the RWA concept is not solely attributable to MakerDAO. In fact, a research report titled “Money, Tokens, and Games”, released by Citibank from the traditional financial industry, has also sparked strong reactions in the industry. This report reveals the strong interest of many traditional financial institutions in RWA, while also fueling the enthusiasm of speculators in the market. They have spread rumors about major financial institutions joining this field, further driving up market expectations and speculative atmosphere.

RWA from the perspective of TradFi

If we look at RWA from the perspective of Crypto, its main expression is the one-sided demand of the crypto world for the yield of traditional financial world assets. If we look from the perspective of traditional finance based on this logic, the scale of funds in the crypto market is basically negligible compared to the market with trillions of dollars in assets. Whether it’s US Treasury bonds or any other financial assets, it is unnecessary to have an additional sales channel on the blockchain. We can see the difference in scale between the crypto market and the traditional financial market from the visualized market size comparison chart below.

Therefore, from the perspective of traditional finance (TradFi), RWA represents a dual pursuit between traditional finance and decentralized finance (DeFi). For the traditional financial world, DeFi financial services based on smart contracts are innovative financial technology tools. The RWA in the traditional financial field focuses more on how to combine DeFi technology to achieve asset tokenization, empower the traditional financial system, achieve cost reduction, improve efficiency, and solve the pain points of traditional finance. The focus is on the benefits that tokenization brings to the traditional financial system, rather than just finding a new asset sales channel.

I believe it is necessary to differentiate the logic behind RWAs. Under different perspectives, RWAs have different underlying logics and implementation paths. Firstly, in terms of selecting the type of blockchain, the two have different implementation paths. Traditional finance RWAs are based on permission chains, while crypto RWAs are based on public chains.

Due to the characteristics of public chains such as no admission requirements, decentralization, and anonymity, crypto RWAs not only face significant compliance barriers for project parties, but also lack legal protection for users in the event of malicious incidents like rugs. Moreover, the prevalence of hacking activities requires users to have a high level of security awareness. Therefore, public chains may not be suitable for the tokenization issuance and trading of a large number of real-world assets.

On the other hand, traditional finance RWAs based on permission chains provide the basic prerequisites for legal compliance in different countries and regions. Establishing an on-chain identity system through KYC on the chain is a necessary prerequisite for implementing RWAs. Institutions holding assets in a legal system can issue/trade tokenized assets in compliance with the law. Unlike crypto RWAs, assets issued by institutions on permissioned chains can be native on-chain assets rather than mapped to existing off-chain assets. The transformative potential brought by native on-chain financial assets in RWAs will be enormous.

In summary, the core point of this article is that the future development direction of real-world asset tokenization will be driven by traditional financial institutions, regulatory authorities, and central banks, establishing a new financial system using DeFi technology on permissioned chains. Achieving this system requires a computational system (blockchain technology) + non-computational system (such as legal institutions) + on-chain identity system (DID, VC) + on-chain legal tender (CBDC, tokenized deposits, legal stablecoins) + sound infrastructure (user-friendly wallets, oracles, cross-chain technology, etc.).

In the following sections, we will start from the first principles of blockchain and provide detailed explanations on each aspect mentioned above, along with practical application examples to support the points made.

II. Starting from the first principles of blockchain, what problems does blockchain solve?

Blockchain is the ideal infrastructure for asset tokenization

Before discussing the first principles of blockchain, we need to have a clear understanding of the essence of blockchain. In the article “What are digital assets?” by Teacher Meng Yan [4], a comprehensive explanation is given regarding the definition of digital assets and the essence of blockchain. The article mentions that “Words and paper, as a technology, are considered one of the most important inventions in human history, with immeasurable driving force for human civilization. Their influence may exceed the sum of all other technologies.” Their main application scenarios are information dissemination and support for contracts/instructions.

In the application field of information dissemination, the recording of text allows for low-cost replication, editing, and dissemination of knowledge and information, promoting widespread knowledge transfer and the popularization of ideas. In the application field of supporting contracts/instructions, text can also record and convey various instructions, such as ancient emperors sending military orders and intelligence through documents, bureaucratic systems conveying instructions through text, and commercial activities forming contractual agreements and consensus through text, even forming legal provisions and preserving evidence for future regulatory arbitration.

There is a clear distinction between these two application scenarios. In the field of information dissemination, people seek the convenience of low-cost, lossless replication and editing. In the transmission of contracts and instructions, authenticity, non-repudiation, and tamper resistance are considered more important attributes. To meet these needs, people have developed various complex anti-counterfeiting printing technologies, and even today, handwritten signatures and other verification methods are widely used to ensure the reliability of information.

When the internet emerged and humanity entered the digital age, the internet as a modern information transmission system greatly satisfied the needs of information dissemination scenarios. The internet can achieve fast, low-cost, lossless, and convenient transmission of information, providing unprecedented possibilities for global knowledge and information sharing. At this time, information transmission and sharing became exceptionally simple and fast, allowing for the rapid dissemination and sharing of academic knowledge and daily information worldwide, greatly driving the progress and development of human society.

However, the internet encountered challenges when dealing with the contract/instruction system, especially in scenarios involving authority and trust, such as corporate operations, government decision-making, and military command. The credibility of information became crucial. In these situations, relying solely on internet-transmitted information may lead to significant risks and losses due to insufficient credibility. This is because the internet primarily developed around the first application scenario of information dissemination, emphasizing the fast, widespread, and convenient transmission of information but often neglecting its authenticity and accuracy.

In this context, people have tried to compensate for this deficiency by relying on centralized decision-making and trusted third parties as the main means of achieving trustworthy information transmission. However, centralized power structures can lead to the centralization and abuse of power, making information transmission opaque and unfair. The involvement of trusted third parties may also bring additional security risks and trust crises because the third party itself may become an untrustworthy source of information.

Therefore, the emergence of blockchain technology provides a new solution for dealing with the contract and instruction system. As a decentralized, transparent, and tamper-resistant distributed ledger, blockchain can ensure the authenticity and reliability of information, meaning that people no longer need to rely on centralized institutions or third parties to establish trust. This innovative technology brings new perspectives and solutions to the information transmission problem in the contract and instruction system, ensuring the authenticity, integrity, and consistency of information without the need for centralized verification.

If the Internet is the digital upgrade of text-paper technology in the context of information dissemination, then blockchain is undoubtedly the digital upgrade of text-paper technology in the context of supporting contracts/instructions. Therefore, we can identify blockchain as a distributed system maintained by multiple parties, which supports the creation, verification, storage, circulation, execution, and other related operations of digital contracts. It can be said that blockchain is the first technology means that effectively supports the digitization of contracts after the development of computers and networks. As blockchain is essentially a platform for digital contracts, and contracts are the basic expression of assets, tokens become the digital carriers of assets formed by contracts. Therefore, blockchain becomes the ideal infrastructure for digital asset representation/tokenization.

Image source: https://www.defidaonews.com/article/653729

Blockchain meets human demand for “computability”

Blockchain provides a basic infrastructure for asset tokenization for human beings, and smart contracts are the most basic form of digital asset representation. Ethereum’s Turing completeness provides smart contracts with the ability to express various types of assets. Therefore, token standards such as fungible tokens (FT), non-fungible tokens (NFT), and semi-fungible tokens (SFT) were born.

Perhaps someone may ask why only blockchain can achieve the digitization of assets? It is because blockchain solves the problem of “computability” under the premise of ensuring its non-manipulability, that is, “repeatable process, verifiable result.” The author considers “repeatable process, verifiable result” as the first principle of blockchain because the operation of blockchain is based on this principle: when a node records a transaction, many other nodes will re-execute the recording process (repeatable process); if the declared result is consistent with the result verified by the node itself, it will be regarded as an “established fact” in the blockchain world and be permanently recorded.

When we consider what problems blockchain can solve, decomposing the problems into “computational system” and “non-computational system” will help us gain a clearer insight into the essence. Blockchain can solve the problems of the “computational system,” which are transactions based on “repeatable process, verifiable result.” The “non-computational system” includes transactions that cannot achieve “repeatable process, verifiable result,” such as transactions influenced by human cognition. Because if human cognition, thinking, and judgment are all based on “repeatable process, verifiable result,” then humanity will become a group of robots who can only respond in the same way to the same stimulus.

Throughout history, humans have always had a demand for “repeatable process, verifiable result” in computation. It is just that due to insufficient technological development, humans could only simulate this “computability” process with their bodies and cognition. For example, they used stones for counting or ropes for record-keeping as the most primitive means. In ancient China, people invented calculation tools such as the abacus to meet the growing demand for “computability” at that time. However, due to human errors, humans could not achieve “repeatable process, verifiable result” very well. But with the birth of computers, the process of “repeatable process, verifiable result” can be solidified in computer programs. With the continuous iteration and upgrade of tools that satisfy the demand for “computability,” human productivity has made a qualitative leap and become an important driving force for the development of science, technology, and society.

But in this centralized “computational system” of the Internet, when human subjective consciousness interferes with this “computational system”, it will render “repeatable processes and verifiable results” ineffective. For example, hackers can manipulate programs to produce different outputs, thereby affecting the reliability and authenticity of information transmission, thus hindering the transfer and construction of trust.

With the birth of blockchain, a new tool that satisfies computational demands has emerged. When the blockchain system achieves decentralization, it becomes increasingly difficult for human subjective consciousness to interfere with this computational system. For example, if a hacker wants to tamper with the output of a smart contract, they would need to control over 50% of the nodes in the blockchain to achieve that, and such attacks often do not have a favorable cost-benefit ratio. Therefore, in non-extreme scenarios, blockchain can effectively meet human demands for “computation”.

DeFi is a “computational” financial innovation

Since the advent of Ethereum and smart contracts, blockchain has played a crucial role in the financial sector with its inherent financial attributes. This has led to decentralized finance (DeFi) emerging as one of the most widely used applications in the blockchain field.

DeFi is a new financial model that relies on distributed ledger technology to provide various financial services, such as lending, investing, or exchanging encrypted assets, without relying on traditional centralized financial institutions. DeFi protocols implement these financial services through a set of smart contracts, which are programmed to automatically execute traditional financial operational logic. Therefore, when trading in DeFi, users interact not with another party but with programs that can aggregate assets from other DeFi users to maintain control of their funds.

As a “computational system”, blockchain can be seen as an innovation in the “computation” aspect of the financial field. Smart contracts can replace certain “computation” processes in traditional finance, such as the repetitive steps that rely on human or mechanical means to “obtain a deterministic result by repeating a process,” such as clearing, settlement, transfers, and some repetitive tasks that do not rely on human cognition. In short, DeFi allows smart contracts to fully execute the time-consuming steps that require human involvement in traditional financial activities, significantly reducing transaction costs, eliminating settlement delays, and enabling automated execution and programmability.

The counterpart to the “computational system” is the “non-computational system,” which refers to human cognition. Blockchain is a purely computational system that can only solve computational problems, not cognitive-level problems. In the financial system, the cognitive system corresponds to the credit system, such as credit evaluation and risk control systems in credit granting. Despite having the same information, such as work income and bank statements, different banks may make different judgments regarding the specific credit limit to be granted.

For example, the same customer may get a credit limit of $10,000 from one bank, while they may get $20,000 from another bank. This difference is not based on repeatable, verifiable computational processes, but is heavily influenced by human cognition, experience, and subjective judgment. Each bank has its own risk control system, but in the specific credit decision-making process, human cognitive factors still play a decisive role. These cognitive-level decisions have the characteristics of being non-repeatable and non-comprehensively verifiable because they combine human subjectivity and interpretations of non-black-and-white issues.

Alternatively, for debt relationships, can the problem of defaulting be solved by putting debt contracts on the blockchain and automating repayment steps? To explore this issue, we first need to analyze the debt itself. Debt is not just a contract or a form, it is a relationship built on mutual cognition and trust among people. Essentially, the establishment of a debt relationship not only depends on the formation of a contract, but more on human cognition.

Blockchain technology can put the “entity” of a debt contract on the chain and program the contract with rules to achieve automation of repayment processes and debt transfers. This process is predictable and verifiable because it relies on fixed rules to ensure the “repeatability of processes and verifiability of results”. However, the operation of this system does not involve the cognitive level of humans.

Although the “entity” of a debt contract is objectively confirmed and guaranteed in terms of technology, the formation, modification, and termination of the debt relationship are built on human cognition. This cognition cannot be programmed or put on the chain. Human cognition is not a “repeatable, verifiable” process, it may change with the environment, emotions, and information. When the debtor’s cognition changes, they may choose not to fulfill the debt, which is called “defaulting”. Therefore, putting it on the chain cannot solve the problem of defaulting because it is a cognitive-level problem rather than a computational problem.

Some may ask, can’t the defaulting problem of borrowers be solved through smart contract liquidation in DeFi lending protocols? Isn’t lending on DeFi an act of a credit system? Jake Chervisnky, Compound’s legal counsel, has published an article discussing that DeFi lending protocols do not actually involve lending, but are rate agreements[7]. In simple terms, DeFi lending does not generate any credit itself, and most DeFi lending protocols rely on the same underlying mechanisms to function: overcollateralization and liquidation. That is, borrowers need to collateralize assets worth more than the borrowed amount in order to borrow, for example, borrowing $65 USDT by collateralizing $100 worth of ETH. This type of lending is essentially a form of “computational leverage” and does not generate any credit. Borrowers do not rely on any commitments for future payments, trust, or reputation.

Here’s a simple summary: Blockchain, as a distributed system maintained by multiple parties, supports the creation, verification, storage, circulation, and execution of digital contracts, solving the problem of trust. As a “computational system,” blockchain meets the demand for “repeatable processes and verifiable results” that humans have. Therefore, DeFi has become an “computational” innovation in the financial system, replacing the computational aspects of financial activities, automating processes to achieve cost reduction and efficiency while also enabling programmability. However, blockchain cannot replace the “non-computational” part based on human cognition, which includes credit. Currently, the DeFi system does not cover credit, and credit-based unsecured lending has not been implemented in the current DeFi system. The reasons for this phenomenon include the lack of an identity system that expresses “relationship identity” in blockchain and the absence of a legal system to protect the rights of both parties.

III. How does asset tokenization disrupt traditional finance?

Financial services are based on trust and empowered by information. This trust relies on financial intermediaries that maintain the integrity of records, covering aspects such as ownership, liabilities, conditions, and contracts. These records are typically dispersed across independently operating systems or ledgers, and these institutions maintain and verify financial data, allowing people to trust the accuracy and completeness of this data.

Due to each intermediary holding different puzzle pieces, the financial system requires a significant amount of post-coordination for reconciliation and settlement of transactions to ensure the consistency of all relevant financial data. This is an extremely complex and time-consuming process. For example, in the context of cross-border transactions, due to the need to comply with different regulations and standards in different countries, as well as involving multiple financial institutions and platforms, this process becomes even more complicated, resulting in longer settlement cycles that typically take one to four days, increasing transaction costs and reducing efficiency.

Blockchain, as a distributed ledger technology, demonstrates tremendous potential in addressing the efficiency issues prevalent in traditional financial systems. By providing a unified, shared ledger, it directly solves the problem of fragmented information caused by multiple independent ledgers, greatly improving transparency, consistency, and real-time updating capabilities. The application of smart contracts further enhances this advantage, allowing transaction conditions and contracts to be encoded and automatically executed when specific conditions are met, significantly improving transaction efficiency and reducing settlement time and costs, especially in complex multiparty or cross-border transaction scenarios.

As a result, asset tokenization has been increasingly accepted by traditional finance. According to a research report from the Bank of New York Mellon, 97% of the 271 financial institutions interviewed believe that tokenization will bring about a revolution in asset management, highlighting the potential of blockchain in the financial sector.

Image Source:

https://www.bnymellon.com/content/dam/bnymellon/documents/pdf/insights/migration-digital-assets-survey.pdf

Therefore, for the traditional financial system, the significance of Real World Asset Tokenization lies in creating digital representations of real-world assets (such as stocks, financial derivatives, currencies, equities, etc.) on the blockchain, extending the benefits of distributed ledger technology to a wide range of asset classes for exchange and settlement.

Financial institutions can further enhance efficiency by adopting DeFi technology, utilizing smart contracts to replace the “computational” aspects of traditional finance, and automatically executing various financial transactions according to predetermined rules and conditions, enhancing programmability. This not only reduces labor costs but also, in specific contexts, provides new possibilities for enterprises, especially for small and medium-sized enterprises (SMSE), offering innovative solutions to financing difficulties, thus opening a highly potential door for the financial system.

To delve into the potential transformative power of tokenization on the financial system, this article will present readers with a more in-depth analytical framework:

Establishing a Trusted Global Payment Platform, Reducing Costs and Increasing Efficiency

In various aspects of human daily life, financial activities, and trade activities, clearing and settlement are ubiquitous, becoming crucial links in maintaining economic flow. Although these two processes are very common in daily life, they often go unnoticed by the general public, yet they are the hidden forces that ensure smooth transactions.

In our daily activities such as shopping, receiving salaries, and sharing bills, clearing and settlement processes come into play. When sharing expenses with friends, we also engage in a simplified process of clearing and settlement by calculating the amount each person should pay and making transfers. Similarly, when using Alipay or WeChat for electronic payments, payment platforms go through a series of clearing processes to ensure that the payment amount is accurately and correctly transferred from our account to the merchant’s account. For users, it may seem like a simple payment action, but behind this simple payment action, there are many clearing and settlement processes involved (as shown in the following figure [10]).

Image Source: https://www.woshipm.com/pd/654045.html

According to the Committee on Payment and Settlement Systems (CPSS) definition of clearing and settlement, CPSS defines a clearing system as a series of arrangements that enable financial institutions to submit and exchange data and documents related to the transfer of funds or securities. It all starts with establishing a “net position” for the parties involved in the transaction, which means offsetting the debts of both parties. This step is called “netting” [11].

The subsequent settlement refers to the process of exchanging, negotiating, and confirming payment instructions or securities transfer instructions. Settlement occurs before the clearing process. Settlement involves the transfer of securities or other financial instruments from the seller to the buyer, as well as the transfer of funds from the buyer to the seller. It is the final step of the entire transaction. The settlement system ensures smooth transfer of funds and financial instruments.

In simple terms, clearing is the process where both parties send, receive, verify, and reach a final consensus on the payment instructions for the assets to be paid. Settlement, on the other hand, involves transferring assets based on the clearing results. Let’s explain this process through an example:

Clearing:

Imagine you and your friends decide to split the bill after having dinner at a restaurant. Everyone declares the amount they have consumed and collectively calculate each person’s share. In this scenario:

Amount determination: The consumption declared by each friend is similar to payment instructions.

Communication and verification: Everyone informs each other about their expenses and verifies the total amount. This step is equivalent to sending, receiving, and confirming payment instructions in clearing.

Total calculation: After calculating the total bill, each person’s share is determined. This action is equivalent to exchanging payment information and confirming the final settlement position (i.e., the amount each person has to pay).

Therefore, clearing is a “verification and preparation” stage where parties confirm the amount to be paid and prepare for the next step, which is settlement.

Settlement:

In the example, once everyone knows the amount they need to pay, the next step is to make the actual payment. Each person pays their respective share, and the sum is equal to the total bill of the restaurant. At this point:

Payment: The amount actually paid by each person is similar to the step of fund transfer.

Verification: Everyone confirms whether their payment is accurate and verifies if each member has paid the correct amount. This is similar to the step of confirming the correct transfer of funds in settlement.

Notification: If one friend is responsible for collecting all the amounts and paying the bill at once, they would notify others that the payment has been completed after making the payment. This notification step is similar to informing the parties after the settlement is completed.

Therefore, settlement refers to the actual transfer of funds from one party to another and the confirmation of the completion of the transaction.

As seen, in the traditional financial system, clearing and settlement are a “calculative” process of accounting and confirmation. Parties reach consensus through continuous verification and validation, and based on this, asset transfers take place. This process requires collaboration between multiple financial departments and significant manpower costs, and may face risks of operational errors and credit risks.

On June 28, 1974, a remarkable bank bankruptcy event attracted widespread attention from the international financial community. It was the collapse of Herstatt Bank, which exposed the credit risk in cross-border payments and its potential for significant damage. On that day, several German banks conducted a series of Deutsche Mark to US dollar foreign exchange transactions with the purpose of remitting dollars to New York, and the counterparty in these transactions was Herstatt Bank.

However, due to the different time zones between Germany and the United States, the process of trade settlement has encountered significant time delays. This time difference resulted in the US dollars not being transferred immediately to the counterparty’s bank account, but instead being “stuck” in Hesstat Bank. In short, the expected USD payment was not implemented as planned. During those crucial hours, Hesstat Bank received settlement orders from the German authorities.

Due to the lack of payment capability, it was unable to transfer the corresponding US dollar amount to New York, ultimately plunging into bankruptcy. The shockwaves caused by this sudden bankruptcy event resulted in varying degrees of losses for several German and American banks engaged in forex trading. The occurrence of this event also promoted the widespread application of real-time gross settlement systems in cross-border payments and the establishment of the Basel Banking Supervisory Committee, highlighting the importance of settlement and clearing in the international financial market.

By leveraging its distributed ledger characteristics and the immutability and traceability of data, blockchain provides a transaction method of atomic settlement through smart contracts. When one party pays a certain asset to another party, the counterparty will also simultaneously pay the corresponding asset to the payer. This eliminates the risks and costs brought by settlement and clearing while bringing significant transaction efficiency improvements through real-time settlement.

By incorporating blockchain technology into cross-border payment settlements, we reveal its profound significance: it constructs an efficient peer-to-peer payment network that alleviates the problem of lengthy clearing time in traditional cross-border payment methods. By excluding the involvement of third-party institutions, it achieves round-the-clock payments, instant receipts, easy withdrawals, and smoothly meets the convenience needs of cross-border e-commerce payment settlement services. In addition, it establishes a globally integrated cross-border payment trust platform at a lower cost, mitigating the funding risks brought by cross-border payment fraud.

The Mariana Project, a collaboration between the Bank for International Settlements Innovation Hub (BISIH), the Bank of France, the Monetary Authority of Singapore (MAS), and the Swiss National Bank, released a test report on September 28, 2023. The project successfully verified the technical feasibility of using automated market makers (AMM) for international cross-border transactions and settlements of tokenized central bank digital currencies (CBDCs).

Image source: https://www.bis.org/publ/othp75.htm

In summary, payment behavior in the traditional financial system often accompanies cumbersome clearing and settlement processes, resulting in additional costs, inefficient due to settlement delays, and facing issues such as human errors, credit risks, and stringent time window limits. However, the use of blockchain and DeFi technology provides an effective solution.

Through blockchain technology, transaction processes are optimized, reducing intermediary steps and significantly lowering associated costs. This technology eliminates the long waiting times of traditional financial settlements and enables true 24/7 market operations, particularly improving processing speed and accuracy in cross-border payments. What’s more important is that as transaction costs decrease, the potential increase in indirect profits may far exceed direct cost savings, thus promoting the vitality and efficiency of the financial market on a broader level.

Programmability and Transparency

For the traditional financial system, the programmability and transparency of real-world asset tokenization will bring disruptive changes. We can use financial derivatives as an example to illustrate the disruptive nature of programmability and transparency. Financial derivatives are an extremely large market in traditional financial markets, with an estimated nominal value exceeding billions of dollars [15]. The types of derivative markets are vast and complex, including stocks, fixed income, foreign exchange, credit, interest rates, commodities, and various types of contracts in other markets. These types of contracts include options (ordinary call options, put options, and exotic options), warrants, futures, forwards, and swaps, among others.

It is the huge potential of leverage in financial derivatives that allows them to create assets worth tens of times more than the underlying asset value. Among them, the 2008 financial crisis is a classic case of a global financial catastrophe triggered by financial derivatives. In this crisis, banks packaged a series of mortgage loans to form a special financial product – Mortgage-Backed Securities (MBS) – and sold them to investors. For banks, this practice could transfer the original loan risk, generate cash flow by selling these packaged mortgage loans, and earn interest rate spreads. For banks, every loan disbursement almost became a creation of profit, which carried huge risks.

The movie “The Big Short” vividly demonstrates this phenomenon: when a housing loan means profit and the risk is no longer associated with the bank, the bank tends to endlessly create mortgage contracts. When creditworthy homebuyers are depleted, banks tend to find other individuals with poor credit to continue this game, and even a person without any collateral can obtain a loan from the bank in the name of their dog. These poor-quality “subprime loans [16]” became the spark that subsequently triggered a financial tsunami.

Amid the backdrop of continuous increase in US real estate prices and loose monetary policies with low interest rates, banks kept releasing subprime loans, and Wall Street financial institutions invented various financial derivatives, such as Collateralized Debt Obligations (CDOs), which are financial instruments that package various types of MBS; and synthetic CDOs, which package various CDOs and credit default swaps (CDS).

Ultimately, an endless and convoluted array of financial derivatives emerged in the market, to the point where people couldn’t track the underlying assets supporting these products. In addition, a large number of subprime loans were mixed into financial derivatives that were rated as “low risk.” Due to the distortion of the ratings, high-risk assets only had to pay extremely low premiums. These layered and packaged derivatives were sold to various brokers and investors, causing the leverage ratio of the entire financial system to skyrocket and become extremely precarious.

Subsequently, the United States began raising interest rates, leading to a large number of borrowers defaulting due to the increase in loan interest. This problem first appeared in the subprime mortgage market but quickly spread to the entire financial market since subprime loans were packaged into asset-backed securities (ABS), mortgage-backed securities (MBS), and even collateralized debt obligations (CDOs). Numerous seemingly high-grade and low-risk financial derivatives suddenly revealed enormous default risk, and investors were almost completely unaware of the actual risks involved. Market confidence took a heavy blow, and the financial market experienced massive sell-offs, becoming a significant trigger for the 2008 financial crisis. All of this stemmed from the chaos, opacity, and overly complex structural system of the financial market.

From this, we can see how important transparency is for complex financial derivatives. We can imagine that if tokenization technology had been used before 2008, investors could easily penetrate and understand the underlying assets, and perhaps this financial crisis would not have occurred. Moreover, tokenizing financial derivatives can also improve the efficiency of multiple stages of the asset securitization process, such as servicing, financing, and structuring (i.e., tranching) stages.

For example, using the ERC-3525 semi-fungible token standard during the asset securitization process allows assets to be packaged into a standard set of divisible and combinable assets. Smart contracts can be used to stratify them (senior, mezzanine, subordinated tranches), and the cash flows of the assets can be programmed, reducing operational and third-party costs while greatly increasing asset transparency and settlement certainty.

When using blockchain, the monitoring role of regulatory agencies can be partially assumed by the platform. When critical information, such as documents submitted by sellers, past records, and updates, is visible to all key stakeholders on the blockchain platform, governance becomes a multi-party affair rather than a single-sided one. In other words, any party has the right to analyze data and detect anomalies, and this timely information disclosure can reduce transaction costs in the financial market.

To further understand the benefits that programmability and transparency bring to the traditional financial system, the “Digital Invoice Tokenization” project based on the ERC-3525 standard, developed by Australian startup Unizon, is an excellent example in the Australian central bank’s CBDC pilot program [18]. In supply chain finance, factoring is a common business model for accounts receivable. It allows companies to sell accounts receivable to a third party (usually a factoring company) at a discounted price, thereby obtaining necessary financing and improving their cash flow.

However, due to the difficulty of proving the authenticity of bills, small and medium-sized enterprises generally lack sufficient credit support, making it difficult for investors to conduct reasonable risk control on a large number of small and medium-sized enterprises. This results in widespread financing difficulties for small and medium-sized enterprises in reality. If small and medium-sized enterprises cannot accept delayed payment terms, it is difficult for them to receive orders from large enterprises. However, accepting orders from large enterprises will lead to a tight flow of funds for the company and increase the risk of cash flow interruption.

By tokenizing bills, we can add a confirmation step during the invoicing process using a private key signature. Once confirmed, the bill will be generated with the confirmation signatures of both parties, ensuring that the bill is generated in a state confirmed by both parties. Considering that delayed payment terms are actually equivalent to a form of loan provided by the seller to the buyer, if the issue of the authenticity of the bill can be effectively resolved, the seller can sell this account receivable to a factoring institution at a certain discount rate based on the buyer’s reputation and obtain discount funds.

Benefiting from the programmability of cash flows using ERC-3525, the payment bills are tokenized in the “tokenization of digital invoices” scenario. A pair of accounts are created using ERC-3525: the payment account (LianGuaiyable) and the accounts receivable account (Receivable). These two accounts form a payment channel similar to quantum entanglement, where funds will be automatically distributed to the accounts receivable account through a smart contract as long as the buyer remits money to the payment account. This means that no matter how many portions the accounts receivable are divided into and no matter whose hands they finally fall into, they will be transferred to the accounts receivable account according to the predetermined proportion. This operation is costly and difficult to achieve in the traditional financial system, but tokenization technology greatly increases the liquidity and composability of supply chain finance factoring businesses and reduces operational costs.

Image source: https://mirror.xyz/bocaibocai.eth/q3s_DhjFj6DETb5xX1NRirr7St1e2xha6uG9x3V2D-A

In summary, the programmability and transparency of tokenization have a huge impact on the traditional financial system. The transparency brought by blockchain platforms can not only reduce financial risks and information asymmetry in the traditional financial system, but also the programmability of tokenization opens up a door for us, making many operations that are difficult to achieve in the traditional financial system possible. This greatly reduces the cost of manual intervention and third-party participation. It not only significantly enhances the liquidity and composability of financial services, but also creates space for innovation, potentially giving birth to unprecedented types of financial products.

4. What else is needed for the Mass Adoption of Asset Tokenization?

Tokenization undoubtedly brings revolutionary innovation to the traditional financial system. However, in order for this innovation to be truly applied in real-life scenarios, we still face many challenges and difficulties. Below are some key factors to consider for the widespread adoption of asset tokenization:

A sound legal system and permissioned chains

Blockchain, as a purely “computational system,” can only address people’s demands for “computational” things (lowering friction costs, programmability, traceability, etc.). However, demands for relationship confirmation, moral judgments, and rights protection require a cognitive, non-computational system, such as a well-established legal regulatory system. This is because legal and regulatory systems cannot rely on a fixed set of procedures for execution. Execution, judgment, risk assessment, and control are all based on human cognition, which is something public blockchains cannot satisfy.

In the application of tokenization of real-world assets in the traditional financial sector, there are numerous operations involved, such as asset issuance and trading. For financial institutions that hold core assets, compliance and security are the main concerns. Imagine a situation where a financial institution issues tokenized financial assets worth billions of dollars on a public blockchain, only for all of those assets to be stolen by a hacker organization in North Korea. In such a case, the assets cannot be recovered, and there is no legal recourse against the criminals. Clearly, this is unacceptable.

Therefore, the financial industry needs to rely on a series of legal safeguards to protect investors from fraud, abuse, financial crimes, and illegal activities in the online world. These safeguards should also ensure that industry participants meet certain minimum standards and provide a mechanism for recourse in case of problems. Thus, only permissioned chains can satisfy both “computational” and “non-computational” demands. It is imaginable that in the future, each country or region may have different legal regulatory systems, and each region will have a permissioned chain that complies with the legal regulatory system of that region to support the tokenization of real assets.

Identity system and privacy protection

Relational identity vs contractual identity

If blockchain wants to tightly integrate with the real world and achieve widespread adoption, a complete on-chain identity system is crucially important. For a long time, blockchain has been difficult to reveal the true identity of wallet holders due to its anonymity, and a system lacking identity authentication naturally finds it difficult to establish trust. Yet, trust is a product of human social cognition, relying on deep social connections between individuals. In fact, the blockchain world has always lacked a “relational identity” system based on interpersonal relationships. This system is not simply an identity label, but a complex structure that reflects the various roles and relationships of individuals in the social network.

As early as over 150 years ago, the ancient British legal scholar Henry Maine inspired people to think deeply about the nature of identity [30]. He proposed two main types of identity: “relational identity,” which stems from an individual’s role and interpersonal relationships in society, such as being a father, having a nationality, or having a profession as a civil servant or military personnel. This type of identity represents social attributes and emphasizes a person’s position in the social structure and their connections with others.

The other type of identity is based on a “contractual” or “contract-based identity” system, such as labor agreements, company organizational structures, and contract terms. In the blockchain field, this can be compared to the “identity” attributes formed by interactions with smart contracts, such as wallet balances, interaction histories with smart contracts, and the states generated by smart contracts.

Image source: Holding up the "pillar" of "Web3 III": information, contracts, identity, "centralization" is still indispensable

For many years, blockchain has fundamentally been a purely “computational system,” within which only “contract-based identity” exists. Specifically, the information on the chain is limited to anonymous wallet addresses, their balances, transaction histories, and other data. Although people have tried to use these data elements to construct a “relational identity” system on the chain, the contract-based identity system lacks the ability to express social interpersonal relationships, and cannot fully capture or replicate the social dimensions and human interactions covered by “relational identity.”

This limitation is a significant factor hindering the development of the blockchain field, especially decentralized finance (DeFi), such as the lack of credit-based unsecured lending systems. Purely contract-based identity verification cannot capture an individual’s reputation and trustworthiness, as credit is built upon complex human social relationships rather than just the history of smart contracts or account balances. To achieve such a credit system, what is needed is not just a technical solution but also a mechanism that can understand and reflect the complex network of human social relationships.

Currently, the state of the identity system in the blockchain world is far from meeting the requirements for supporting the large-scale application of asset tokenization in the real world. In addition to the “contract-based identity” system, the blockchain also needs a “relational identity” system that can carry human social relationships and credit systems because in human society, credit is built upon deep, multidimensional social interactions. It is not an attribute that individuals can unilaterally attribute to themselves but is collectively shaped by individuals’ behavior, reputation, and recognition from others in the social network. Furthermore, such credit systems often require authoritative third-party institutions to certify and endorse them to ensure their credibility and authority. For example, in the real world, identification documents and related certificates issued by governments or other authoritative institutions are important signs of individual identity and reputation.

To sum up, in order for blockchain to achieve mass adoption in the real world, it needs to combine the “relational identity” system and the “contractual identity” system. To implement the “relational identity” system, it is necessary to introduce authoritative third parties (such as government agencies and regulatory bodies) to validate individual social relationships and credibility and perform operations such as granting, authenticating, and endorsing identities on the blockchain. Technological innovation is also needed to ensure the security, privacy, and immutability of identity data.

The DID+VC identity system based on W3C standards

In order to achieve mass adoption and implementation of asset tokenization in the real world, a set of optimal identity solutions is needed to achieve a dynamic balance between data sovereignty, privacy protection, regulatory compliance, and interoperability. The DID+VC system under the W3C standard may be part of the solution to this unresolved problem.

In order to achieve the tokenization and widespread application of real-world assets, a comprehensive identity solution is urgently needed at the technological level. This solution needs to find a dynamic balance between data sovereignty, privacy protection, regulatory compliance, and interoperability. The Decentralized Identifiers (DID) and Verifiable Credentials (VC) system developed by W3C may provide partial solutions to this complex problem.

In the development process of digital identity, we have witnessed several important transition stages: from centralized identity management, where identity information is completely controlled by a single authoritative institution; to federated identity authentication, which allows users’ identity data to be somewhat portable and enables cross-platform login, such as one-click login through WeChat or Google accounts; then to a decentralized identity system based on authorization and permission, as demonstrated by OpenID; and finally to self-sovereign identity (SSI), in which ownership and control of data truly return to individuals. However, this mechanism, such as the zkID decentralized identity system launched by zCloak Network, has not been widely adopted.

Currently, the on-chain identity system has enhanced the anonymity and openness of identity to some extent by utilizing the cryptographic mechanisms built into the blockchain. However, due to the use of closed or relatively independent data systems in different ecosystems and application systems, users’ identity information is still fragmented and stored in isolated and uncommunicative systems. Therefore, the key challenge ahead is to break down these silos and build an identity verification ecosystem that not only ensures individual data sovereignty and privacy but also meets regulatory requirements and has extensive interoperability. This requires not only technological innovation but also deep cooperation among stakeholders and support from policymakers.

W3C (World Wide Web Consortium), the organization responsible for developing international internet standards such as HTML and CSS, released the first formal standard for decentralized identifiers (DID) in 2022 and published a detailed definition and standard framework for verifiable credentials (VC) in 2019.

In W3C’s specification, DID is defined as a string that guarantees global uniqueness, high availability, resolvability, and encrypted verification (e.g., did:example:123). This identifier can be used to identify any form of entity, whether it be an individual, organization, or object. Each DID is generated according to a specific algorithm and controlled independently by its owner, rather than authorized by a single institution.

DID can be resolved into a DID document, which contains information such as Authentication Key, Agreement Key, Delegation Key, Assertion Key, and service endpoints for interacting with the DID entity. These keys are similar to different types of documents we use to sign in different life scenarios, such as confidentiality agreements, delegations, or authorizations.

VC, a verifiable credential associated with DID, is essentially an endorsed declaration from one DID to another regarding certain attributes, aimed at verifying the identity, abilities, or qualifications of the DID subject. For example, VC can be a digital certificate issued by an organization, government department, or business entity, generated and verified through cryptographic methods to confirm that the owner possesses certain specific attributes, and that these attributes are trustworthy. VC can contain various information and data types, such as ID, type, timestamp, and supports various settings for the status of the credential, including valid, expired, revoked, frozen, etc., to reflect the issuer’s declaration of the validity of the credential.

In the ecosystem of VC, W3C standards define three roles: issuer/attester, holder/claimer, and verifier. These roles participate together in the circulation of a credential: the issuer verifies and issues the credential to the holder, the holder decides how and to which verifiers to present these credentials, and the verifiers confirm the information they need to verify, thereby completing the entire verification process.

Image source: https://support.huaweicloud.com/intl/en-us/devg-bcs/bcs_devg_4005.html

On this basis, multiple projects and development teams have integrated privacy protection technologies beyond traditional cryptography into identity verification systems, including the widely recognized Zero Knowledge Proof (ZKP) technology in the Web3 field. Zero Knowledge Proof is a unique method that allows one party (prover) to prove to another party (verifier) that they indeed know a certain information without revealing any specific content about that information.

To illustrate with a simple analogy, let’s say Alice wants to prove to Bob that she knows how to solve a specific scrambled state of a Rubik’s Cube but doesn’t want to reveal the specific solving steps. In this case, Alice can use an opaque box to solve the Rubik’s Cube without showing Bob the specific steps. She only needs to take out the solved Rubik’s Cube from the box to prove that she has mastered the solving technique while keeping the specific steps a secret. The same principle applies to the technology of Zero Knowledge Proof, which can encrypt the true content of the information in the “box” while proving a certain fact.

In the digital identity verification scenario, ZKP technology is particularly useful because it allows individuals to prove their own information without publicly disclosing private details. Typically, identity verification may require the disclosure of a large amount of personal information, which, once collected and analyzed by multiple parties, can pose a threat to personal privacy. However, systems that adopt ZKP technology, such as zkID developed by zCloak, combine DID and VC to provide users with richer privacy protection options.

Through the zkID system, users can flexibly control the amount of information they are willing to share during the verification process after receiving a VC with a issuer’s digital signature. Users can independently choose the granularity of information display, such as ZKP Disclosure, Digest Disclosure, Selective Disclosure, or Full Disclosure. Especially through ZKP Disclosure, users can demonstrate information under the “minimal knowledge principle”, only providing results of “compliance” or “non-compliance” without exposing any specific private information.

For example, users can prove to relevant institutions that they meet the conditions for a valid visa, loan eligibility, voting rights, or compliance with transaction norms by only displaying locally processed data results with zero knowledge proofs. Throughout this process, the user’s privacy data is always stored and processed on their local device, without revealing any specific content, ensuring that the data usage rights are completely controlled by the user.

To summarize, in the process of promoting the widespread application of tokenization of real-world assets, privacy protection and compliance in identity verification have become indispensable cornerstones. By adopting the DID and VC identity verification system based on W3C standards and integrating zero-knowledge proofs (ZKP) technology, we can safeguard identity privacy on the blockchain while meeting compliance requirements. This not only provides implementation guidelines for a “sound legal system” but also potentially addresses the key link between bridging the gap between on-chain and off-chain, balancing privacy and regulatory needs.

Central Bank Digital Currency (CBDC)

Blockchain applications are fundamentally about solving trust issues, and in the business field, 99% of application scenarios related to trust are related to money [19]. Therefore, for tokenization of real-world assets to be widely applied, an on-chain legal tender is necessary. The tokenization of currency on the blockchain is itself an application scenario of tokenization of real-world assets. Only by introducing Central Bank Digital Currency (CBDC), tokenized deposits, and compliant stablecoins can we unleash the full potential of tokenization of real-world assets.

Currently, the blockchain world lacks a currency trust anchor provided by central banks [20]. Although stablecoins have emerged in large numbers to fill this void by mapping to legal tender, the fact that stablecoins have continuously decoupled from their peg in the volatile cryptocurrency market demonstrates that stablecoins cannot replace the role of legal tender on the blockchain. Essentially, stablecoins are only “vouchers” for off-chain legal tender on the blockchain, even if the stablecoin issuing institutions have fully collateralized assets, stablecoins may still experience price deviations due to market panic. However, if the tokens on the blockchain are the “essence” of legal tender, there will be no situation of price detachment.

Compared to the current stablecoin system, using tokenized fiat currency is not only more convenient and easily accessible, but its application scenarios are also more significant, providing greater programmable space for financial innovation. First of all, on-chain fiat currency, combined with a consortium blockchain architecture regulated by national laws, can directly integrate with payment scenarios in our daily lives. It seamlessly blends into our daily lives, whether it’s in salary payments, commercial activities, or other areas. This means that people can directly obtain on-chain fiat currency through their regular activities, bypassing some complex and time-consuming steps in the current crypto system, such as the need to acquire gas fees before using wallets and stablecoins.

In the Bank for International Settlements’ (BIS) annual report for 2023, titled “Blueprint for the Future of the Monetary System: Improving the Old, Enabling the New,” the section on tokenization mentioned the potential revolutionary impact of tokenization on the existing monetary system, exploring unprecedented opportunities for the current system. This vision describes a new type of financial market infrastructure called the “Unified Ledger,” which combines central bank digital currencies (CBDCs), tokenized deposits, and tokenized debts of other financial and physical assets.

The Unified Ledger has two key advantages. First, it provides a unified platform where broader emergency measures and financial transactions can seamlessly integrate and automatically execute. This enables transactions to be synchronized and settled instantly. In contrast to the world of cryptocurrencies, settlements using central bank currencies ensure uniqueness and finality of payments. Second, by centralizing everything in one place, it will foster new types of smart contracts (contracts that depend on specific circumstances or conditions) that better serve the public interest by addressing issues related to information and incentives.

To further explain the importance of on-chain fiat currency, I will provide definitions and differences for CBDCs, tokenized deposits, and legal stablecoins, which will be widely used on-chain in the future:

Central Bank Digital Currency (CBDC): A digital form of base money directly issued by a central bank. Whenever a transaction involving CBDC occurs, it directly reflects changes on the central bank’s balance sheet and can exist in tokenized form on a blockchain platform.

Tokenized Deposits: Deposits are a form of credit money created by commercial banks. Whenever relevant transactions occur, they directly affect changes in commercial banks’ balance sheets. Tokenized deposits refer to their tokenized expression on the blockchain.

Legal Stablecoins: In this context, legal stablecoins refer to stablecoins issued by regulated institutions, such as ANZ’s Australian dollar stablecoin A$DC. Whenever relevant transactions occur, since stablecoins are anonymous instruments, they do not reflect changes in the issuing institution’s balance sheet but transfer within different individuals’ wallets.

If you want to further understand the differences between base currency and credit currency, as well as the process of currency creation, you can read my other article: “MakerDAO from the Perspective of Currency: Understanding the Deep Meaning of Introducing RWA Treasury Assets”. Next, let’s further discuss the application scenarios that on-chain fiat currency can bring:

Programmable digital currency:

One of the advantages of tokenization is programmability. For tokenized fiat currency, programmable currency opens up an imaginative realm. For example, the Monetary Authority of Singapore (MAS) released a technical white paper on Purpose-Bound Money (PBM) in 2023. This is a kind of programmable digital currency standard that can use “wrapper contracts” technology to programmatically define the purpose of currency usage while preserving its fungibility. For more details, you can read the PBM white paper. The core idea is to use a “wrapper contract” to wrap and manage the universal digital currency, and put the payment logic in this “wrapper contract” to manage the digital currency within it. For different application scenarios, we can choose different “wrapper contracts” to constraint and manage the wrapped digital currency, thereby achieving the effect of programming the payment process and conditions. However, these wrapped digital currencies themselves are uniform, neutral, free, and fungible. Once the conditions are met, the recipient can withdraw the digital currency from the wrapper and restore the “unconditional” nature of the digital currency itself [21].

In simple terms, after using PBM technology to program currency, it can be used for specific purposes and automatically restored to a fungible currency form after meeting certain conditions. For example, the government may distribute dedicated funds to the public for the purpose of stimulating a specific market, such as the peach market, and this fund can only be used to purchase peaches. Alternatively, parents can set up a fund lock for their children, ensuring that only a certain amount is unlocked each month to regulate expenses. However, this technology may be controversial because although it provides governments with more precise currency control means, it also means greater regulatory authority, which may lead to the loss of privacy and freedom.

Real-world application scenarios:

In the past, blockchain technology has encountered many obstacles in practical industrial applications, resulting in some blockchain projects without tokens becoming expensive and inefficient database systems. Even blockchain projects with tokens cannot fully realize their potential due to legal regulation and the disconnect between on-chain and off-chain. The lack of on-chain fiat currency is one of the reasons. We can take an RWA case as an example.

In the world of crypto, we can see some RWA projects attempting to tokenize real-world rental income rights and sell their shares on the blockchain. To achieve this operation, there are barriers between on-chain and off-chain, for example, tenants pay rent in off-chain fiat currency, and the project needs to convert the tenant’s rent into on-chain stable coins, and then distribute the rental income to the shareholders. In addition to the friction costs involved in converting off-chain currency to on-chain stable coins, there are also issues of information opacity, such as whether the tenant has actually paid the rent, as well as compliance and regulatory issues. For example, how to handle disputes? How to deal with the project running away?

And if it is built on a legally regulated permissioned chain system with a central bank digital currency, tenants can naturally use the digital currency on the blockchain to directly pay the corresponding smart contract. The smart contract will automatically allocate the income from the financial product to all investors who hold shares, and using token standards like ERC-3525, issuers can easily package multiple non-standard rental income assets into a standardized financial product. The transparency also allows investors to know whether tenants have actually paid rent, and issuers can even package multiple financial products into one.

To summarize, the widespread adoption of digital currencies on the blockchain, especially the application of central bank digital currencies (CBDCs), will inject powerful momentum into the mass tokenization of real-world assets. This not only creates practical scenarios for the application of tokenization technology in our daily lives and various industries, but also brings broader development prospects and possibilities, which may have a significant impact on all aspects of our daily lives.

Oracles and Cross-Chain Protocols

Although the application of blockchain and tokenization technology has revolutionary potential, the deterministic nature of blockchain’s operation mechanism poses challenges. Each node must perform deterministic operations, meaning that for the same input data, all nodes will get the same output results. However, when nodes retrieve and process external data, they face uncertain operations. This inherent uncertainty can cause data inconsistency among nodes, affecting the consensus process. Therefore, blockchain itself cannot actively obtain external data, which is known as the “oracle problem”.

The vast majority of potential use cases for smart contracts require connectivity to off-chain data and systems. For example, in the financial sector, smart contracts rely on external market price data for execution. In the insurance industry, smart contracts require IoT and network data to make claims judgments. Smart contracts in trade finance require access to relevant documents and digital signatures to confirm and execute lending operations. In addition, many smart contracts in settlement require interaction with traditional payment networks for fiat currency transactions. However, a large amount of necessary data is generated off-chain and cannot be directly transmitted to the blockchain.

In addition, blockchain itself is an isolated ecosystem, leading to the fragmentation of users, assets, liquidity, applications, and data. In order to achieve mass tokenization of real-world assets, it is crucial to connect different blockchains together, transforming the “islands” into a “mainland” to fully unleash the potential of blockchain and achieve interoperability among different blockchains. Whether it is oracles or cross-chain bridges, their essence is to facilitate information transfer between blockchains and the external world. As the leader in the oracle space, Chainlink will play a crucial role in the mass tokenization of real-world assets in the future.

In 2023, Chainlink introduced two heavyweight features, Chainlink Function and CCIP. I believe they have milestone significance for the mass tokenization of real-world assets because as financial institutions explore more applications involving tokenized assets, they believe in the long-term value of blockchain technology and/or digital assets. However, since central banks or financial institutions in different regions will issue their own central bank digital currencies or financial assets on different private chains/permissioned chains in the future, this will result in a highly fragmented global blockchain platform, isolating tokenized assets and related services between different blockchains and limiting their interoperability. This cross-chain communication problem restricts the application of tokenized assets, making them inaccessible with inadequate liquidity and complicating the integration process of financial institutions.

In order to achieve widespread adoption, people need to be able to freely use these tokenized currencies to purchase assets on other blockchain ecosystems. Although there are many cross-chain protocols in the market, the frequent security incidents in the past have made cross-chain protocols a high-risk security area, resulting in countless asset losses. Such “dangerous bridges” are obviously unable to fulfill the mission of connecting “islands” into a “continent”. Therefore, the security of cross-chain protocols has become a top priority for people. The CCIP introduced by Chainlink may change this situation and become a widely adopted universal interoperability layer (note: the reason I chose Chainlink is because of its close cooperation with the traditional financial world).

CCIP is an abstraction layer and cross-chain messaging protocol that allows existing infrastructure to connect to blockchain and instruct smart contracts to send arbitrary data and achieve token transfers between public and private blockchains. In simple terms, CCIP can link any blockchains together (such as permissioned chains and public chains), solving the problem of interoperability and liquidity fragmentation caused by blockchain islands.

Image Source:

https://zh.chain.link/resources/cross-chain-tokenized-asset-settlement

CCIP provides financial institutions with a way to meet customer needs without making major modifications to existing infrastructure [26], allowing financial institutions to interact directly with tokenized assets in existing infrastructures, such as through Swift messages, APIs, mainframes, and other traditional formats. Financial institutions can interact with any protocol on any blockchain through CCIP using on-chain CBDC.

Image Source:

How Chainlink Unlocks the Full Capabilities of Tokenization for Capital Markets

On August 31, 2023, the international fund clearing system SWIFT released a report [27]. SWIFT collaborated with several major financial institutions, including ANZ, BNP Paribas, BNY Mellon, Citibank, Clearstream, Euroclear, Lloyds Banking Group, SIX Digital Exchange, and Depository Trust & Clearing Corporation (DTCC), for experimentation. Using Chainlink’s CCIP, Swift’s network was securely connected to the Ethereum Sepolia network, achieving full interoperability between source and target chains and successfully realizing cross-jurisdictional and cross-chain interoperability of blockchains.

Image Source:

How Chainlink Unlocks the Full Capabilities of Tokenization for Capital Markets

In addition, Chainlink has also partnered with ANZ Bank to participate in a comprehensive case study of CCIP. They plan to deploy CCIP in the legal stablecoin issued by ANZ Bank to promote institutional adoption of tokenized assets. They have also published a case study[25] demonstrating how financial institutions can use Chainlink CCIP to provide the ability for clients to trade and settle tokenized assets on both public and private blockchains. Therefore, we can expect that tokenized assets will exist on both public blockchains and regulated permissioned blockchains operated by financial institutions in the future, and CCIP can be used to achieve interoperability by connecting tokenized assets on any blockchain. This will enable seamless connectivity among various blockchains.

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In order for blockchain and smart contracts to realize their full potential, it is extremely important to establish a connection with the real world, in addition to achieving interoperability between blockchains. In the past, the main application of oracles was price feeds, which involved reliably transmitting real-world price information to the blockchain through specific data supply chains, providing necessary triggering conditions or parameters for smart contracts. With the introduction of Chainlink Function in 2023, smart contracts can now be linked to any API in the world for conditional triggers or information transfer, and can utilize Chainlink’s decentralized oracle network for custom computations.

Whether it’s CCIP or Function, Chainlink’s decentralized oracle network, DON, plays a crucial role. Its purpose is to ensure the security, reliability, and tamper resistance of data by introducing multiple independent and reliable data provider nodes. This design reduces the risk of a single point of failure and makes data manipulation more difficult. Therefore, in critical application scenarios, decentralized oracles can provide a higher level of trust and reliability.

Image Source: https://research.web3caff.com/zh/archives/8102?ref=W3110

Chainlink Function achieves custom computations at the DON level of the decentralized oracle network, which can be called decentralized off-chain computation. It combines the characteristics of centralized off-chain computation and on-chain computation, bridging the gap between the two. According to the official description, the oracle computation allows data transmitted to smart contracts to maintain security, reliability, and immutability while also possessing the advantages of centralized off-chain computation. This enables high performance, low cost, and scalability. Therefore, compared to pure on-chain computation and centralized server computation, Chainlink Function allows smart contracts to achieve functions that were previously difficult or inefficient, providing great potential for innovation.

Image source: https://research.web3caff.com/zh/archives/8102?ref=W3110

Through Chainlink Function, smart contracts can be linked to any device API in the real world. For example, when an emergency occurs on the chain, such as the risk of DeFi positions being liquidated, the smart contract can automatically send email reminders to users through the Chainlink Function connected to the email API. When a flight is delayed, the insurance smart contract on the chain can be automatically triggered through Chainlink Function. The status of off-chain assets can be updated on-chain through Function. Another example is a case combining with the Internet of Things implemented by AWS IoT Core. Chainlink Data Feeds are used to monitor the price of stablecoins, and then Chainlink Automation is used to monitor the Chainlink data sources that report the stablecoin prices. If a stablecoin deviation is detected, it will activate and call the Chainlink Function to send alerts to AWS IoT core, triggering alerts on real-world IoT devices.

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11 Ways To Use Chainlink Functions in Your Decentralized Applications

To sum it up, in the future with different jurisdictions and regulatory systems, cross-chain technology is particularly important for solving the problems of interoperability and fragmented liquidity. As new generations of more secure cross-chain protocols like Chainlink CCIP emerge and explorations in the traditional financial world continue, the foundation for the security and large-scale application of interconnection of tokenized assets across multiple chains in the future is laid. The continuous improvement of oracle functionality, such as the launch of Chainlink Function, has also opened a highly imaginative door for future applications combining with the real world.

Image source: https://www.youtube.com/watch?v=8qqy-8Oi8ww&t=24s

Low-threshold Wallet

As an entry point and passport to Web3, wallets not only serve the function of asset management in the traditional sense, but also are essential tools for circulation in the Web3 world. They bear the mission of interacting with blockchain and smart contracts. However, at this stage, the learning curve for using wallets is too high for new users, and coupled with rampant hacking and frequent asset theft incidents, many people are kept out. Therefore, reducing the threshold for wallets is necessary to bring in more fresh blood and promote the explosion of large-scale applications and ecosystems.

The current understanding of blockchain and wallets is relatively high for the general public. The high level of understanding, combined with the complexity of using wallets, such as the management method based on private keys, is a significant obstacle to the widespread adoption of Web3. For example, when users create a wallet, the storage and management of private keys become a huge challenge. Most people do not have a concept of managing private keys, making it easy to lose or leak them, resulting in permanent loss of assets. Therefore, low-threshold wallets have become an important factor in promoting the widespread application of blockchain.

The existing wallet system is mainly divided into two types: EOA (Externally Owned Accounts) and CA (Contract Account). The difference between the two is that an EOA wallet is controlled by a key pair consisting of a private key and a public key. It basically only has the functions of receiving, holding, sending tokens, and interacting with smart contracts. It does not have programmable functions, and executing each transaction requires paying gas fees. Creating an EOA wallet is cost-free, but can only be created by generating a private key.

On the other hand, a CA wallet refers to a wallet that exists in the form of a smart contract. It is not controlled by a private key and does not have a private key. Instead, it is implemented through code written in the form of a smart contract to achieve various functions, such as multi-signature wallets, safes, faucets, and other functions. A common use case is multi-signature wallets, which require multiple EOA wallets to authorize transactions and are usually used for enterprise wallet management. Creating a contract account wallet requires consuming gas fees. The contract account wallet itself cannot initiate transactions actively and needs to be invoked and paid gas fees by an EOA wallet to initiate transactions passively.

Each of these two wallet account types has its advantages, disadvantages, and limitations. EOA wallets can only be generated using the method of generating key pairs, lack programmability, require gas fees to operate, and cannot recover the private key if it is lost. Compared to CA wallets, although CA wallets can customize logic to achieve more possibilities, they cannot initiate transactions actively and need to be called by EOA wallets. Additionally, creating CA wallets has additional costs. Currently, both types of wallet account types cannot solve the problem of complex wallet user experience.

Existing wallet solutions include MPC wallets, smart contract wallets, custodial wallets, and other forms. However, ERC-4337’s Account Abstraction wallet is considered the ultimate form to achieve widespread wallet application. It combines the advantages of EOA wallets and CA wallets, allowing programmability while greatly reducing the learning curve, such as supporting wallet login and usage like Web2, gas payment delegation, social recovery, and aggregated wallets.

However, the mechanism of account abstraction has its complexity, resulting in challenges for widespread applications. Nevertheless, reducing the user learning curve is always a priority. Whether it is account abstraction or other types of wallets, simplifying the user experience is crucial. A wallet with low threshold and easy usability is undoubtedly the key infrastructure to propel blockchain towards widespread application.

5. Future Outlook

The foreseeable trend is that as the traditional financial sector and governments around the world increasingly focus on and recognize blockchain and tokenization technology, and as the blockchain infrastructure technology continues to improve, blockchain is moving towards integration with the traditional world and solving real pain points in real-world application scenarios. It aims to provide practical solutions for practical scenarios, rather than being limited to a “parallel world” disconnected from reality.

Although many people worship the so-called “blockchain revolution,” in the current industry environment, many projects claim to be decentralized but are actually highly centralized. However, most people do not care, much like the “elephant in the room.” Therefore, in the process of blockchain application in real-world scenarios, I believe that the emphasis on decentralization should be weakened, and it should not be forced in unsuitable environments.

Real World Asset Tokenization will be the killer application that leads blockchain to a trillion-dollar scale. Its potential could impact the entire human financial and monetary system. By tokenizing real-world assets and using tokens on blockchain platforms, it can significantly improve efficiency, reduce costs, operate 24/7, provide programmability, enable automatic execution, ensure transparency, enable traceability, allow composability, protect privacy, empower enterprises, enable global liquidity, solve trust issues, provide identity autonomy, and bring potential new application scenarios.

In the current stage, for the crypto world, the logic of RWA is the unilateral demand for real-world asset returns. In practice, there are challenges such as regulatory compliance and the disconnect between on-chain and off-chain. However, it is in the traditional financial world, TradFi, that can truly unleash the huge potential of tokenization. RWA’s logic for TradFi is bidirectional; the traditional financial world needs blockchain and DeFi technology as a new financial technology tool to empower the traditional financial system and address its pain points.

To achieve widespread application of real-world asset tokenization, legal and regulatory compliance is a necessary prerequisite. The majority of core assets for tokenization are in the hands of traditional financial institutions, and for institutions, compliance is a necessary requirement. They need a series of legal safeguards to protect investors from fraud and abuse, combat financial crimes and cybercrimes, safeguard investor privacy, ensure industry participants meet certain minimum standards, and provide recourse mechanisms in case of problems. With the legal framework in place, the use of permissioned/private chains can meet the requirements for effective enforcement of laws and regulations in different jurisdictions.

To achieve effective regulation, the concept of “relationship-based identity” plays a crucial role in the on-chain identity system. This combination of identity system and privacy protection technology is key to granting and managing digital identities under the authorization and supervision of governments and regulatory bodies. Within this framework, W3C’s DID (Decentralized Identifier) and VC (Verifiable Credentials) technologies can play an important role. These standards provide a way for individuals and entities to control their own identity information while ensuring the integrity and verifiability of information. In the future, the combination of zero-knowledge proof technology also offers new possibilities to enhance user privacy, security, compliance, and transparency.

To meet the regulatory and asset risk management requirements of regulatory agencies and financial institutions, the future will be a multi-chain landscape. Therefore, the interoperability between blockchains and the security of information transmission are particularly important. With the gradual improvement of new generation cross-chain technologies like Chainlink’s CCIP, coupled with their cooperation with traditional financial institutions, we can see that the foundation for the future multi-chain landscape and the widespread application of tokenization of real-world assets is being established.

If blockchain and smart contracts are to be widely used in real-world scenarios, the tokenization of legal tender on the blockchain, such as CBDC (Central Bank Digital Currency), and tokenized deposits are also indispensable. Unlike the current stablecoin system, stablecoins are not the currency itself but rather a blockchain “voucher” for currency. It is difficult for stablecoins to be widely used in real-world commercial activities. For example, merchants usually do not accept stablecoins as a means of payment when shopping or visiting convenience stores. Although some credit cards currently allow users to directly use cryptocurrencies for payment, the high transaction fees make it impractical for daily payment activities.

With the popularization of CBDC and the continuous development of tokenization technology, as well as the lowering of wallet adoption barriers, we can envision a future where people can easily own and manage their tokenized assets and seamlessly conduct transactions in daily life using on-chain legal tender. On-chain legal tender opens up a new gateway for the practical application of tokenization technology in real-world scenarios, providing it with a broader application space and practical value.

Currently, many countries around the world are actively promoting legal and regulatory frameworks related to blockchain. At the same time, the infrastructure of blockchain, such as wallets, cross-chain protocols, oracles, various middleware, etc., are rapidly being improved. CBDCs are also being implemented, and token standards that can express more complex asset types, such as ERC-3525, are constantly emerging. Furthermore, with the continuous development of privacy protection technologies, especially zero-knowledge proof, and the maturing of on-chain identity systems, it seems that we are on the eve of the large-scale application of blockchain technology.

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