Basic Understanding of RWA Tokenization 【Basic Understanding of RWA Tokenization: Part 2】
This week we will discuss "Fundamentals of RWA Tokenization".
Good morning.
I am mitsui, a web3 researcher.
We update the web3 Basics Report every Saturday and Sunday at noon. This week we will discuss the "Basics of RWA Tokenization". Please read to the end!
1. Introduction
2. choice of legal instrument
3. Token Design
4. automation of cash flow and distribution
5.NAV calculation and Oracle
6. summary
1. introduction
Review of Part I: SPVs, Tranches, and Waterfalls
In the first part, we explained in detail the basic mechanics of securitization, explaining that three elements form the foundation of the modern securitization market: bankruptcy isolation through SPVs (special purpose vehicles), risk distribution through tranche structures, and mechanical allocation of funds through waterfalls.
The SPV acts as a legal vessel to insulate investors from the originator's credit risk and ensures certainty of asset transfer through a true sale (true sale).
The tranche structure is a mechanism that creates multiple securities with different risks and returns from a single pool of assets. The tiered structure of senior, mezzanine, and equity provides investment opportunities for both conservative and aggressive investors. Credit enhancement measures, which combine internal and external enhancements, ensure that each tranche is appropriately credit rated.
Waterfall is a mechanism for mechanically allocating collected funds according to a pre-determined order of priority. Allocations are made in the following order: expense payments, senior interest payments and principal redemptions, mezzanine, and equity, with trigger provisions, such as OC and IC tests, triggering automatic protective measures in response to changes in asset quality.
RWA Token is a challenge to code the "securitization idea" as it is
RWA Token is an initiative to digitize and automate the basic idea and structure of securitization, as we have explained, through blockchain technology and smart contracts. By not merely representing existing securities on the blockchain, but by encoding the entire securitization process, the goal is to create a more transparent and efficient capital market infrastructure.
In traditional securitization, transparency and automation have been achieved through complex contract documents and numerous intermediaries. However, written contracts leave room for interpretation, and human processing presents the risk of delays and mishandling. In addition, information asymmetries have sometimes made it difficult for investors to make informed investment decisions.
The RWA token attempts to solve these challenges through blockchain technology. The automatic execution of contracts through smart contracts, the immediate disclosure of information through transparent ledgers, and the unfalsifiability of transactions through cryptographic methods have the potential to further enhance the value of securitization.
2. choice of legal instrument
SPV (off-chain legal entity)
In RWA tokenization, as in traditional securitization, it is essential to have a legal instrumentality with bankruptcy isolation capabilities. This is because no matter how innovative blockchain technology is, under the current legal system, an entity with legal personality is required to hold physical assets and legal rights.
RWA token projects typically employ a structure in which an SPV established off-chain holds the underlying assets and tokenizes its equity or beneficial interest. This SPV performs essentially the same functions as those used in a traditional securitization, including purchasing assets from the originator, raising funds from investors, and distributing cash flows.
The choice of the region in which the SPV will be established is based on a comprehensive consideration of the regulatory environment, taxation, and legal stability. Delaware in the United States, the British Virgin Islands, Luxembourg, and Singapore are jurisdictions often chosen for RWA tokenization projects. These jurisdictions have well-developed legal systems for SPVs and provide a familiar legal environment for international investors.
The connection between SPVs and blockchain is usually realized in the form of digital securities or tokens issued by SPVs, which are linked to the value of assets held by the SPV and its earnings, and managed and traded on the blockchain, combining the benefits of traditional securitization with those of digital technology The SPVs can then use the tokens to manage and trade them on the blockchain.
Trust scheme/fund instrument
Trust schemes are also an important option in RWA tokenization. In particular, the legal characteristics of trusts offer significant advantages in the securitization of real estate and receivables, where segregation of assets is important. A system in which the trustee legally becomes the owner of the assets, but manages and operates the assets only for the benefit of the beneficiaries, is extremely effective in terms of investor protection.
In RWA tokenization using a trust scheme, the common structure is for the trustee to hold the underlying assets and tokenize the beneficial interest. The beneficial interest is a comprehensive right that includes the right to claim distribution of income and return of principal from the trust assets, and expressing this right in digital form allows for flexible investment product design.
When using a fund instrument, a tokenization of investment fund interests (units) is used. Funds have the advantage of being able to diversify their investments in a variety of assets and establish a professional asset management structure. It may also be advantageous in terms of regulatory compliance, as it can utilize the legal framework of existing mutual funds and private funds.
Designed for regulatory and investor attributes
The legal design of RWA tokens requires careful consideration of the demographics of the eligible investors and applicable regulations. There is more flexibility in product design for general investors and for the private market, which is limited to qualified investors. By utilizing systems such as Rule 506(c) in the U.S., the Enterprise Investment Scheme (EIS) in the U.K., and the Qualified Institutional Investor Special Practice in Japan, products for institutional investors and high net worth individuals can be offered while avoiding cumbersome registration procedures.
On the other hand, products for general investors are subject to strict disclosure requirements, compliance with the suitability principle, and explanation requirements at the time of sale. In particular, for securitized products with complex structures, explanatory materials must be prepared so that investors can fully understand them, and appropriate risk warnings must be provided.
In regulatory compliance, when a transaction spans multiple jurisdictions, the requirements of each jurisdiction must be met simultaneously. For example, for sales to investors in the U.S., the requirements of the Securities and Exchange Commission (SEC) rules must be met; for sales to investors in Europe, the requirements of MiFID II; and in Japan, the requirements of the Financial Instruments and Exchange Law must be met. For this reason, global products are often designed to meet the most stringent standards.
3. token design
Transfer Restrictions and White Lists
RWA tokens, like traditional securities, must be designed to be held only by appropriate investors. Strict transfer restrictions and whitelist features are essential to implement, especially for products that are limited to qualified investors or only for investors in certain geographic areas.
The implementation of transfer restrictions is done at the smart contract level. Before transferring tokens, the system automatically checks whether the transfer address is registered as an eligible investor and rejects the transaction if the conditions are not met. This feature technically prevents erroneous transfers to ineligible investors or sales to investors who violate regulations.
Only addresses of investors that have passed KYC and AML checks will be registered in the whitelist management. These investors are subject to periodic eligibility checks and are automatically removed from the white list if they no longer meet the requirements.
The same restrictions apply to transactions in the secondary market, as well as to DEX and OTC transactions, where regulatory compliance is ensured through automated checks using smart contracts.
Senior/Mezzanine Tokenization
The tranche structure in traditional securitization is also an important design element in RWA tokens. Issuing multiple token classes with different risk/return characteristics can address diverse investor needs and optimize funding costs.
Senior tokens are the safest token class, offering the most secure and stable yields. Coupons are typically paid at fixed or floating rates, and redemption of principal is also a top priority. Pension funds, insurance companies, and other institutional investors seeking stable cash flows are the primary holders. Smart contracts will incorporate a mechanism whereby allocations to senior tokens will take priority over other token classes.
Mezzanine tokens offer higher returns than seniors, but bear higher risk. They may be divided into multiple subclasses, each with a different interest rate and subordination. They are intended for investors with high risk-taking ability, such as hedge funds and private equity funds.
Equity tokens have the highest return potential in exchange for the highest risk. Often the originator itself holds a substantial portion and maintains an ongoing incentive for asset quality. Equity token holders typically have voting rights in key decisions and are also responsible for governance functions.
4. automation of cash flow and distribution
Servicer → Pooled Account → Smart Contract Distribution
Cash flow management in RWA tokens is an application of the traditional waterfall concept of securitization to the digital environment. It cleverly combines off-chain and on-chain mechanisms to efficiently and transparently distribute cash flows generated by the underlying assets to investors.
Similar to conventional securitization, servicers are responsible for the management and collection of underlying assets. The servicer collects repayments from borrowers, manages delinquent loans, and disposes of collateral, and consolidates the collected funds in a pooled account. Up to this stage, the process is off-chain and utilizes the same mechanisms as existing financial systems.
Funds accumulated in the pooled account are transferred to the smart contract on a regular basis (usually monthly). This remittance can be executed automatically based on predefined conditions or triggered by a trusted third party (Oracle). At the time of remittance, the smart contract is also provided with detailed breakdown information on principal collections, interest income, fees, and expenses.
Based on the funds and information received, the smart contract automatically executes the distribution process according to pre-coded waterfall rules. This process is transparent and all investors can see the distribution status in real time. The results of the process are permanently recorded on the blockchain, which can also be used as an audit trail.
Pro Rata/Priority/Trigger Linked Distribution
The smart contract distribution process allows for flexible combinations of multiple distribution methods.
In the most basic pro rata distribution, funds are allocated proportionally according to the percentage of each investor's holdings. This ensures fair treatment and transparency among token holders of the same class.
In a priority distribution, the allocation is executed in the same order as in a traditional securitization waterfall: expenses, senior, mezzanine, and equity. In smart contracts, this order of priority is strictly coded, leaving no room for artificial decisions. After each stage of allocation is completed, allocation to the next priority is executed.
Trigger-linked distributions automatically change the distribution method in response to changes in asset quality; when indicators such as the Over-Collateralization Test (OC Test) or the Interest Coverage Test (IC Test) fall below thresholds, normal distributions are suspended and the funds in the equity portion are automatically applied to accelerate principal redemption. The process is automatically executed to apply the equity portion of the funds to the acceleration of principal redemption.
Automatic deduction of fees and credit enhancement costs
The automatic deduction of various fees and credit enhancement costs plays an important role in the RWA token system. In traditional securitizations, the treatment of these expenses can be complex and opaque, making it difficult for investors to understand the actual net return.
Servicer fees are usually set as a fixed percentage of the collection amount or as a fixed amount. With smart contracts, the commission amount is automatically calculated and transferred directly to the servicer's wallet as soon as the collection amount is determined. This process eliminates the risk of late payment or calculation errors.
Management company fees, trustee fees, audit fees, and legal fees are similarly automated. These expenses are typically set as fixed monthly or quarterly amounts and deducted at the beginning of the funds distribution. Synchronization of expense accruals and payments improves the efficiency of cash flow management.
The processing of credit enhancement costs is another important function. The cost of external guarantees and insurance, provision of reserve funds, and OC buildup are automatically executed according to predefined rules. These credit enhancement measures are essential for the protection of investors in the upper tranches, and the transparency and certainty of their execution is ensured by smart contracts.
5. nava calculations and oracle
Frequency and methods of asset valuation
Accurate determination of the Net Asset Value (NAV) of the underlying asset is extremely important in the calculation of the value of RWA tokens. In particular, reliable valuations must be provided for secondary market transactions and for periodic reporting to investors.
When real estate is the underlying asset, the frequency and methodology of valuation depends on the nature of the instrument. While highly liquid instruments may require monthly valuations, quarterly or semi-annual valuations are generally employed. A combination of the income capitalization method, the transaction case comparison method, and the cost method is used as the valuation method, and the average or median value of valuations by multiple real estate appraisers is often used.
When receivables are used as underlying assets, valuation is generally based on a cash flow model. Expected cash flows are calculated considering the borrower's credit status, delinquency rate, collection rate, and interest rate environment, and converted to present value using an appropriate discount rate. Methods that utilize machine learning models to predict credit risk from large amounts of data are also gaining popularity.
Detailed disclosure of the valuation process and results is important to enhance the transparency of the valuation. We will improve credibility by regularly providing investors with information on the independence of the valuation institution, the appropriateness of the valuation methodology, and an analysis of the differences from the previous valuation.
Bridging on- and off-chain
A key challenge for the RWA token system is how to reliably capture real-world information generated off-chain into the on-chain. The oracle function is a critical infrastructure that plays this bridging role.
The Price Oracle provides on-chain market data such as real estate prices, interest rates, exchange rates, and stock indices. It obtains information from multiple independent data providers and generates reliable pricing information by eliminating outliers and calculating weighted averages.
Event oracles provide critical event information such as defaults, collateral dispositions, and the initiation of legal proceedings. This information serves as a trigger for automated processing by smart contracts, enabling a quick response. To ensure reliability, multiple independent sources of information will be used to verify the information, and a system will be adopted to establish a certain verification period.
The KYC Oracle provides real-time investor eligibility information. It continuously monitors information such as changes in the investor's financial status, change of residence, and sanctions listings, and alerts the smart contractor as necessary. To protect privacy, a method is also being developed that utilizes zero-knowledge proof technology to only verify eligibility without disclosing detailed information.
Integration with audit trail
In an RWA token system, all transactions and decision-making processes must be recorded in a transparent and traceable manner. The blockchain's tamper-resistance and transparency can be leveraged to create a comprehensive audit trail that is difficult to achieve with traditional financial instruments.
An audit trail at the transaction level records all issuance, transfers, redemptions, dividend payments, etc. for each token. Detailed information such as time stamps, parties involved, transaction amounts, and fees are permanently stored and can be used for later auditing and dispute resolution.
The audit trail of the valuation process records the data sources used in the NAV calculation, the calculation methodology, the person in charge of the valuation, and the approval process. If questions arise regarding the validity of the valuation, interested parties can refer to this information for verification. In addition, if any changes or special adjustments are made to the evaluation methodology, the reasons and approval process are clearly documented.
An audit trail of governance activities will record voting by investors, resolutions on important matters, contract changes, etc. In a decentralized governance system, proposal submissions, discussion processes, and voting results are all managed on-chain, making participants' actions transparent.
6. summary
Moving the basic elements of securitization on-chain, RWA token = "contract -> coded"
The essence of RWA tokens can be summed up as "coding the basic elements of securitization".
All three major elements of securitization, bankruptcy isolation through SPVs, risk distribution through tranches, and mechanical distribution of funds through waterfalls, which were explained in detail in the previous part, can be implemented as smart contracts.
In conventional securitization, complex contract documents define the rights and obligations between the parties and are managed through human interpretation and execution. However, by implementing these contractual conditions as program code, the room for interpretation is eliminated, and automatic and transparent execution becomes possible. By building on the simple logical structure of "if condition A is satisfied, then process B is executed," the operation of extremely complex financial instruments can be automated.
This "coding of contracts" allows many previously costly and time-consuming processes to be performed instantaneously, greatly reducing the risk of human error and conflicts of interest. For investors, it provides a more transparent and predictable investment environment, and for issuers, it reduces operating costs and improves efficiency.
What is important is that this coding will not merely improve operational efficiency, but will also enhance the value of the financial product as a financial product. Real-time information disclosure, 24/7 automated processing, and global access will create added value that has been difficult to achieve with conventional financial infrastructure.
Potential and Challenges for Next Generation Capital Markets Infrastructure
Beyond the mere digitization of existing products, RWA tokenization has the potential to bring structural innovation to the entire capital markets infrastructure. It is expected to move away from the traditional centralized financial system to a more decentralized, transparent, and efficient system.
The first technological possibility is a revolutionary increase in liquidity. Assets such as real estate and private equity, which previously had limited liquidity, will become accessible investments for more investors through the creation of smaller lots and secondary markets. In addition, 24-hour trading, immediate settlement, and low-cost operations will greatly enhance convenience for investors.
From the perspective of globalization, RWA tokens also have great value. Cross-border investments, which used to be complicated due to differences in regulations and payment systems in different countries, will be simplified with a unified protocol. Investors in emerging markets will be able to access high-quality assets in developed countries, while investors in developed countries will be able to tap into growth opportunities in emerging markets.
However, to realize these possibilities, a number of issues must be resolved.
On the regulatory front, it is important to harmonize with the financial regulations of each country, develop a regulatory framework that accommodates new technologies, and promote international regulatory coordination. In particular, in collaboration between existing financial institutions and new technology companies, it is necessary to establish appropriate risk management and investor protection frameworks.
On the technical side, the challenges include scalability, security, and interoperability. It is necessary to develop blockchain infrastructure that can efficiently process large volumes of transactions, address cybersecurity risks, and enable the transfer of assets between different blockchains. It is also important to develop technological bridging capabilities in the integration with traditional financial systems.
In addition, ensuring adequate liquidity is the most important issue in the development of the market. Since participants are limited in the early stages, it is necessary to promote the entry of market makers, establish appropriate price discovery mechanisms, and promote investor education. It is also important to promote standardization to increase comparability and interoperability among different projects.
Ultimately, the success of RWA tokenization will depend on the right blend of technological innovation and financial industry knowledge. By leveraging the full potential of blockchain technology, while at the same time inheriting the wealth of experience and knowledge accumulated in the securitization market, it is hoped that a truly valuable next-generation financial infrastructure will be created.
Disclaimer:I carefully examine and write the information that I research, but since it is personally operated and there are many parts with English sources, there may be some paraphrasing or incorrect information. Please understand. Also, there may be introductions of Dapps, NFTs, and tokens in the articles, but there is absolutely no solicitation purpose. Please purchase and use them at your own risk.
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mitsui
A web3 researcher. Operating the newsletter "web3 Research" delivered in five languages around the world.
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