Bridging TradFi and DeFi: The Role of RWAs in Modern Finance

Blockchain technology was intended to disrupt traditional finance (TradFi). In the midst of the bank crisis, a decentralized currency and payment system offered a transparent and secure alternative to TradFi. From there, Bitcoin and the other blockchains that have emerged since have evolved significantly to the systems that we know today. Beyond simply managing a digital ledger, blockchains now operate global, decentralized computers with rapidly-expanding capabilities.

However, Bitcoin, Ethereum, and other blockchains are not a replacement for traditional markets and asset classes. Instead, they operate as an alternative asset class that many traditional investors are skeptical about. They also have the potential to make traditional processes for investment and asset management more efficient, secure, and accessible.

Real world asset (RWA) tokenization offers a potential bridge between TradFi and decentralized finance (DeFi). RWA tokens track ownership of physical assets digitally on the blockchain in the form of non-fungible tokens (NFTs). By moving traditional assets onto the blockchain, they unlock new markets and take advantage of the numerous benefits of blockchain technology.

How Does RWA Tokenization Work?

RWA tokenization tracks ownership of real-world assets on the blockchain. The first step to accomplish this is to create a token that officially encodes ownership of the asset. This can only be accomplished by the asset owner, and proving that a token actually encodes ownership of a particular asset is one of the most significant challenges associated with RWA tokenization.

Once a token has been created for an RWA, it can be treated like any other token on the blockchain. Tokens can be bought, sold, transferred, and subdivided between multiple different owners. At all times, it’s apparent to any blockchain user who owns a particular token and, therefore, the RWA whose ownership it tracks.

RWA tokenization also enables the development of smart contracts to manage these tokens and the associated assets. These smart contracts can be used to implement traditional financial instruments (futures, etc.) or unlock novel use cases.

RWA Tokens and Financial Instruments

Traditionally, non-fungible tokens (NFTs) have been used to track ownership of digital assets, such as digital art. In the financial realm, there are numerous types of digital assets that an NFT can track ownership of, including stocks, bonds, and ETFs.

RWA tokens are used to track ownership of physical assets, which the financial industry has been doing for ages. Investors can indirectly own property, gold, art, and a variety of different physical assets. However, access to these investment opportunities is limited, which decreases the number of potential investors and the liquidity in the space.

With RWA tokenization, ownership of assets is tracked on-chain and much of the overhead of managing and securing these assets is handled automatically on the blockchain. Once an RWA token has been created, users can easily buy, sell, and trade them, and pricing is set by the market. Moving from localized markets to a global blockchain also dramatically expands the pool of potential investors in these assets.

Benefits of RWA Tokenization for TradFi

RWA tokenization enables blockchain systems to track ownership of real-world assets, expanding its reach beyond the digital world. By acting as a bridge between DeFi and the domains traditionally restricted to TradFi, RWA tokenization offers numerous potential benefits for TradFi, including the following:

• Simplified Transfers: In TradFi, transferring ownership of assets can be complex and requires numerous intermediaries. On the blockchain, transferring a token is as simple as submitting a transaction and having it added to the blockchain’s digital ledger as part of a block.

• Reduced Fees: TradFi often has significant fees due to the complexity of managing and securing various investments. By leveraging the blockchain’s built-in features and security to replace these processes, RWA tokenization can offer lower transaction fees than traditional alternatives.

• Improved Liquidity: The liquidity available in a market depends on the number of potential investors who have access to it. Blockchains’ global scope means that they have a much larger potential reach than TradFi, introducing additional liquidity into these markets.

• New Asset Classes: In TradFi, some types of assets are difficult to buy and sell, limiting investment and liquidity. RWA tokenization offers an alternative means to achieve this, unlocking new potential asset classes.

• Fractional Ownership: RWA tokenization uses NFTs, which can be easily subdivided for fractional ownership. This fractional ownership can make it easier for smaller investors to enter a market and can have a positive impact on asset pricing.

• Enhanced Security: Major blockchains have very strong security as the complexity of rewriting the digital ledger is significant and grows as each new block is added after the one containing a transaction. This means that asset transfers performed on the blockchain via RWA tokens have a high level of reliability and security.

• Increased Transparency: Many TradFi processes are a black box, making it difficult for investors to understand what is being done with their money and the source of the significant fees that they have to pay. On the blockchain, the digital ledger is visible to everyone, allowing independent verification of activity related to tokenized RWAs.

The Future of TradFi and DeFi

Historically, TradFi has been skeptical and distrustful of DeFi. While part of this might be caused by fear that DeFi will succeed in disrupting traditional financial systems, TradFi also has a legitimate basis for skepticism due to the large number of scams and hacks in the blockchain space.

However, in recent years, TradFi has become increasingly receptive to and interested in DeFi. The SEC’s approval of Bitcoin ETFs — and pending one for Ethereum ETFs — has created a TradFi asset class based on blockchain and crypto. These ETFs have performed beyond analysts’ expectations, indicating that widespread interest in DeFi and crypto exists for TradFi investors.

RWA tokenization has the potential to deepen these ties and has been growing rapidly in recent years. In the future, TradFi is likely to lean even more heavily on blockchain technology to streamline and secure its processes and to provide new investment opportunities that don’t exist in TradFi.