Grayscale Report: Public Chain and Tokenization Revolution

Author: Grayscale; Compiler: Golden Finance, Ke Dong

Abstract

• Tokenization of asset ownership refers to registering asset ownership on a blockchain infrastructure. Assets in tokenized form may benefit from the capabilities of blockchain, including more efficient settlement and the ability to interact with smart contracts.

• The modern financial system is already quite efficient in most cases, and tokenization itself may not lead to immediate efficiency gains. Instead, we believe that the main benefits may come from integrating users, assets, and applications onto a common global platform.

• From the perspective of the crypto market, while a variety of assets may benefit from the tokenization trend, the most potential may be protocols that can provide a universal global platform. Currently, Grayscale Research believes that the Ethereum blockchain has the greatest opportunity to play this role in the future.

Public chains can be viewed as general-purpose technologies with many potential use cases, from payments to video games to digital identity. Part of the value of this technology comes from bringing together diverse applications onto a platform with a permissionless and open architecture. When users, capital, and applications come together in one place, everyone in the ecosystem benefits from network effects.

Tokenization is just one of many applications for public blockchain technology. In some cases, if existing "back-office" processes are cumbersome, moving asset management to blockchain infrastructure may bring immediate efficiency gains. But for many types of assets, the effect of public chains is not obvious (except for public stocks, where the current digital infrastructure works quite smoothly). In these cases, the potential benefits of tokenization may come from network effects: by moving global assets to a common platform, we may create a more powerful, more accessible, and lower-cost financial system.

From the perspective of the crypto market, although various assets may benefit from the tokenization trend, the most potential may be protocols that can serve as a universal platform for tokenized assets, investors, and related applications. At present, Grayscale Research believes that the Ethereum blockchain has the greatest opportunity to play this role in the future.

System Upgrade

At some point in the future, when blockchain is more widely adopted, securities may be fully issued and tracked on the chain. But today, beneficial ownership of securities—as well as beneficial ownership of real assets such as real estate, physical commodities, and collectibles—is recorded on traditional off-chain ledgers (usually electronic accounts). Tokenization refers to registering asset ownership on a blockchain infrastructure so that market participants can benefit from the blockchain’s capabilities. By design, the price of a blockchain-based token should closely track the price of an underlying reference asset.

Some benefits of converting asset ownership into blockchain-based tokens may include:

1. Settlement efficiency: Blockchain transactions settle almost instantly and can be designed so that asset exchanges are subject to payment conditions, reducing the risk of settlement failures.

2. Programmability: Tokenized assets can be integrated into software applications to enable more functionality. For example, this could include conditional transfers based on off-chain information (such as compliance approvals) or using tokens as collateral in decentralized lending platforms.

3. Accessibility: Like the internet itself, blockchains are not limited by national borders. As a result, tokenizing assets could potentially give investors in more countries access to the world’s best capital markets. Blockchain can also help enable access to new asset types through asset fragmentation, giving more people new investment opportunities.

4. Reducing costs: By increasing automation and reducing the role of intermediaries, tokenized assets may reduce costs for issuers, including lower underwriting fees and lower interest rates.

Researchers at the Bank for International Settlements (BIS) have defined a tokenization "continuum" for considering how this process affects specific markets. On one side are markets that still require a lot of manual workflows, such as real estate or syndicated loans. These assets may be difficult to tokenize, but the process may provide substantial efficiency gains. On the other side are many other markets where current electronic ledger systems are quite efficient, such as public stocks, mutual funds, and exchange-listed derivatives. These assets may be easier to tokenize, but the process provides limited efficiency gains. The best candidates for tokenization may lie somewhere in the middle of the BIS continuum: those markets that benefit from slightly better electronic recordkeeping and smart contract capabilities. This list may include many types of fixed-income securities, such as government bonds and structured products. However, as discussed further below, the greatest gains may come from moving all assets onto a common global platform.

Tokenization, the Present and Future

The first application of tokenization technology is to find product-market fit stablecoins that tokenize the simplest and most liquid asset: cash. The market capitalization of stablecoins has now reached $158 billion, led by Tether (USDT) and USDC (see Figure 1). Stablecoins come in different forms, but both USDT and USDC can be considered fiat-backed stablecoins. They operate similarly to other tokenized assets: the traditional asset is held off-chain, and a tokenized representation can be held in a blockchain wallet. This digital cash in tokenized form can be used for payments, benefiting from the potential of blockchain for nearly instant settlement, lower costs, and/or interaction with smart contracts.

Figure 1: Stablecoins Have Found Product-Market Fit

After stablecoins, the next tokenized asset to gain widespread adoption is gold (see Figure 2). The two largest projects, Tether Gold (XAUt) and PAX Gold (PAXG), have a combined market cap of approximately $1 billion. While there are many ways to invest in gold, these products offer blockchain features, including the ability to transfer risk outside of traditional trading hours, such as weekends. This feature has proven useful during recent geopolitical tensions in the Middle East: XAUt and PAXG saw significant volatility during the week of April 13-14, when other markets were closed.

Figure 2: Timeline of Selected Tokenized Projects

The latest wave of tokenization has focused on two different markets: U.S. Treasuries and related assets, and credit products.

Tokenized U.S. Treasury products are designed to function as cash equivalents and can be considered yield substitutes for stablecoins. According to data provider RWA.xyz, the weighted average maturity of all existing products offered today is less than two years. In other words, these products are designed to provide income and function like cash. When cash rates are close to zero, the opportunity cost of holding stablecoins is relatively low. But now that U.S. dollar rates are close to 5%, investors are more motivated to seek yield substitutes, which may have contributed to the growth of tokenized U.S. Treasury products.

Currently, there are already more than $1 billion in tokenized Treasury products on the market, led by Franklin OnChain U.S. Government Money Fund (FOBXX) and Blackstone U.S. Dollar Institutional Digital Liquidity Fund (BUIDL). Many existing products have been launched on the Ethereum network and appear to be geared toward crypto-native institutions, such as crypto-traded funds and DAOs (decentralized autonomous organizations). However, the largest fund, FOBXX, took a different approach: it launched on the Stellar blockchain and is available to retail investors through a mobile app. Overall, about 60% of tokenized Treasury fund AUM is on Ethereum, 30% on Stellar, and the rest on other blockchains.

Figure 3: About 60% of Tokenized Treasury Products Are on Ethereum

Many companies have also launched a variety of tokenized credit products. This is a diverse category that includes direct loans to individual counterparties, asset pools for structured credit products (e.g., ABS, CLOs), and loans to intermediaries in specific industries (e.g., real estate financing, emerging markets). Although these products can be risky and complex, and are currently designed only for institutional investors, their goal is simple and straightforward: to channel funds from lenders to borrowers through blockchain infrastructure. According to RWA.xyz, there are currently about $61.2 billion in loans in this category, with an average yield of about 10%.

Figure 4: Tokenized credit products cover a diverse borrower population

There are many other potential applications for tokenization technology, but only a few have moved beyond the experimental stage. For example, tokenized real estate platform RealT provides non-US investors with access to fractional ownership of real estate; the protocol currently has $10.3 million in total value locked. There is also hope that tokenized private funds will provide the alternative industry with a way to attract a wider range of investors. It is not yet clear whether these new distribution channels will have a substantial impact on the industry's AUM. Various fixed income securities have already been issued directly on-chain, from both public sector issuers (such as the European Investment Bank) and private sector issuers (such as Siemens). While tokenized equity securities have been attempted before, we suspect that these projects will require more regulatory clarity before they can move further.

If adoption continues, tokenization has the potential to drive a significant amount of blockchain activity and fee revenue because the addressable market is so large. In the U.S. alone, the Treasury securities market is $26 trillion, and total lending to the domestic non-financial sector is $36 trillion. Currently, the number of tokenized assets on-chain is a tiny fraction of these totals. However, for these products to take off beyond today’s crypto-native institutions, they will need to connect more effectively with existing pools of capital. This may require connecting to brokerage or bank accounts, or by providing sufficiently compelling reasons for investors to move their assets on-chain.

The Revolution Will Not Be Private

There is a common misconception that tokenization may not be a boon for crypto assets because such activity will take place on private permissioned blockchains, rather than on public permissioned blockchains like Ethereum. However, the fact is that banks do experiment on private blockchain infrastructure (e.g. JPMorgan Onyx, HSBC Orion, and Goldman Sachs DAP), but this only reflects part of the current regulatory landscape—depository institutions are prohibited from interacting with public chains. But asset managers are not subject to similar restrictions: they have been building on public chains or a hybrid of public and private chains.

In fact, all successful applications of tokenization to date—such as stablecoins, tokenized treasuries, and tokenized credit products—have been launched on public chain infrastructure. The reason is simple: it’s where the users are.

We expect that moving certain assets onto blockchain infrastructure will bring efficiency gains. But the greater promise of tokenization comes from seamlessly connecting global assets and investors (or borrowers and lenders), and building richer experiences through interoperable applications. Public chains have many applications beyond tokenization, making them natural hubs for user assets and activities over time. For this reason, they are also likely to continue to be the main destination for asset issuers and developers building open finance applications. We believe that private permissioned blockchains — operated by companies or national governments — have little chance of providing the neutral global platform that the public needs to host the world’s tokenized assets.

Transactions, Fees, and Value Accumulation

Blockchain transactions typically generate fees that can flow directly to token holders (e.g., dividends) or indirectly through a reduction in token supply (e.g., buybacks). Therefore, if tokenization results in transaction activity and fees, value can be accumulated to blockchain-based tokens. However, the mechanism by which this occurs will vary depending on the protocol type and token properties (see Figure 5).

Figure 5: Crypto assets can benefit from tokenization

Certain components of the crypto sector should be most directly impacted by our smart contract platforms. Layer 1 blockchains in this market segment (and perhaps eventually components of the Layer 2 ecosystem) can serve as a common global platform for tokenized assets. The native tokens of these protocols are often used to pay transaction fees (“gas”) and may earn staking rewards and/or benefit from a reduction in token supply ((deflation)).

There is competition within the smart contract platform crypto sector, but the Ethereum ecosystem still dominates other chains in terms of users, assets (total locked value), and decentralized applications. In addition, in our view, Ethereum can be considered fairly decentralized and neutral among network participants, which may be a requirement for any global tokenized asset platform. Therefore, we believe that Ethereum is currently in the best position to benefit from the tokenization trend. Other smart contract platforms that may benefit from the tokenization trend include Avalanche (used by financial institutions in various proof-of-concept projects), Polygon and Stellar, as well as Layer 1 blockchains specifically designed for tokenization, such as Mantra and Polymesh.

The next group of beneficiaries includes the tokenized protocols themselves - platforms that provide software applications for transferring traditional assets onto the chain (see Figure 6). Many of these providers do not have governance tokens (e.g., Securitize, Superstate), but some do. For example, Ondo Finance is an issuer of tokenized U.S. Treasury products, and Centrifuge is a platform for tokenized credit products and is also an integral part of the financial crypto sector. Before considering these tokens, investors should consider the nature of the governance rights communicated by the project and the statements (if any) provided by the project regarding protocol revenue.

Figure 6: Annualized returns of selected tokenized protocols

Finally, increased blockchain activity resulting from tokenization may support other components of the crypto ecosystem. For example, Chainlink hopes that its Cross-Chain Interoperability Protocol (CCIP) will become core infrastructure for cross-blockchain messaging, both private and public. Similarly, the Biconomy protocol provides technologies that allow traditional financial institutions to interact with blockchain technology (e.g., a “paymaster” service — allowing users to pay for gas in tokens other than the blockchain’s native token). Both Chainlink and Biconomy are part of Grayscale’s “Utilities & Services Crypto Division.”

Tokenization Outlook

Grayscale believes that many aspects of digital commerce are moving away from closed platforms hosted by centralized intermediaries to open and decentralized platforms based on public blockchain infrastructure. Tokenization is one of many blockchain adoption trends, but it could be an important one given the size and scope of global capital markets. If public chains can bring together borrowers and lenders (or asset issuers and investors) and eliminate the intermediaries of existing financial technologies, then increased network activity should increase the value of the public chain’s token.