Asset Tokenization for “Risk-Free” Yield in Crypto

The quest for “Risk-Free” yield in crypto lies with asset tokenization banner

Today’s underlying macroeconomic narrative is singularly driven by the direction of interest rates. As the market reels from ‘unknown unknown’ consequences with global liquidity shocks and banking disruptions, the nascent metaverse of digital assets has not been spared. 

Crypto has always been considered a high-risk alternative asset strategy in traditional finance and with good reason. A significant trust deficit pervades across the crypto industry in the wake of multiple insolvencies mired in bankruptcy courts, and the FTX implosion adding to the industry’s maleficence.

In this challenging market environment, finding viable investment options that offer attractive risk-adjusted returns can feel like an Indiana Jones adventure, full of unexpected twists and an uncertain outcome.

The appeal of crypto as an asset class is at a low ebb with treasury yields now besting previously attractive returns available in decentralised finance (DeFi), leaving investors mulling over a sole quest(ion) —  where should they invest their money next?

Quest for the Holy Grail 

With investors risk averse, the safe harbour of risk-free rates beckons and the most talked about approach is to own US Treasury Bills or T-bills.

Despite its risk-free label, owning T-bills is in practice not without potential hazards. As the demise of Silicon Valley Bank illustrated, owners are exposed to duration risk with price movements that may occur before the T-bill matures. 

However, with the recent interest rate hikes, short-term T-bills have become more attractive than ever before, touting yields close to 5% without credit risk. The best way to gain exposure to the true risk-free rate is via reverse repos collateralized with US government securities.

The closest proxy for a risk-free rate in digital assets lies with native staking on Ethereum but, of course, that comes with its own inherent risks. Afterall, it’s virtually not backed by tangible assets.

So where is the sweet spot? Perhaps this perennial search for the ‘holy grail’ of risk-free returns lies somewhere in the form of real-world asset tokenization. 

Navigating the Map

Digital tokens representing stocks and mortgages are not a new idea. In the post-FTX era, the discussion of tokenized real-world assets secured on the blockchain has gained renewed attention. It has immense potential to systematically improve the economics of finance while widening the pool of what can be collateralized.

Real estate tokenization offers increased liquidity and access to new investors, while tokenizing insurance policies could reduce costs for consumers by creating more industry stability through risk transfer. Combining real-world assets tokenization with DeFi will open up even more palatable high Shape ratio opportunities to diversify portfolios and while delivering investment returns at relatively low risk.

One of such pathways involves the marriage of T-bills and stablecoins. Tokenizing T-bills enable investors to diversify their stablecoin portfolios, gaining exposure to the attractive yields currently provided by T-bills through the use of smart contracts.

In the future, tokenized T-bills can be utilised for 24/7 token swapping or as prime collateral for DeFi lending protocols, allowing investors to access the broader DeFi ecosystem and generate additional returns beyond T-bill yields.

While these use cases are clearly attractive there is still work to be done towards 24/7 liquidity while maintaining yields close to the risk free rate. We also need to see progress on oracle pricing to ensure these stable tokens can be used as collateral.

In theory, such solutions are attractive propositions, holding the keys to unlocking the treasure chest of benefits that come with interplay of traditional and digital assets. The trove of real-world asset tokenization is sizable. Large institutions known for long term bets are already collaborating to explore new paradigms through Project Guardian

More DeFi Use Cases

Zooming in on tokenizing T-Bills alone, with over 130 billion dollars worth of stablecoins in circulation and a given standing 4.2% annual risk-free interest on offer, this single application of tokenized real-world assets alone holds the potential to capture a yield chest of up to 5.5 billion dollars. 

Indeed, tokenizing real-world assets allows DeFi to tap into some of the largest financial markets and in return, traditional capital markets and DeFi protocols are made more accessible for everyone — tangibly benefiting from greater capital efficiency and opportunities to trade previously illiquid assets. All immutably transacted with the enhanced security and transparency that blockchain technology bestows.

But even as the concept of asset tokenization picks up momentum, it’s too early to say how long it will take to reach the mainstream — a critical obstacle being regulatory and compliance. 

The recent crypto contagion sees regulators working against the tide in the industry’s tokenization quest; likely perpetuated by the fears of its systematic risks amplifying vulnerabilities of the entire financial system.

For this to work, asset managers and investors will need to ensure that they are engaging with sound counterparties and are familiar with regulatory and compliance issues. Progress has already been made by Asia-based DeFi solutions that have received compliance protecting umbrellas and regulatory approvals, but this will continue to play a critical role in getting investors to embrace such solutions in more ‘DeFi-shy’ jurisdictions like the US. 

On the Right Track 

While most might have deviated from the relatively high-risk investment that is crypto during the 2022 bear market, asset tokenization and its allure of “risk-free” returns are drawing investors back into the fold. The proposition? Stand to reap the benefits of continuous liquidity on-chain while simultaneously tapping into TradFi’s more favourable yields in this difficult climate. 

Today, most stablecoins are already backed by treasuries as part of their portfolio allocation with the spoils going solely to its issuer. Regulatory considerations aside, the evolution of this ‘holy grail’ investment will likely set the stage for a new era of finance where the worlds of TradFi and DeFi blend more seamlessly together to create a financial ecosystem that supports permissioned and permissionless assets, in unison.

Time will tell but one thing is for sure. We’re in for an adventure.