The RWA Cycle: This Time It’s Different
The next crypto cycle will be the RWA (Real World Asset) cycle. Back in 2019, after the ICO boom dissolved into an 80–90% crash in prices, legacy financial institutions had more or less written off crypto as a passing fad. The dream of replacing the clunky and byzantine infrastructure built up for legacy finance over the past 200 years for settlement, transfer, and compliance with sleek new crypto rails seemed largely dead. This time, in the 2022–23 bear market, traditional institutions have instead continued building.
After watching from the sidelines during DeFi summer, institutions saw smooth operation of on-chain lending infrastructure even during the stress test of the 2021–22 crash. Early proof-of-concepts for traditional financial products on-chain like Franklin Templeton’s BENJI money market fund have demonstrated immense cost savings and simplified workflows. It also doesn’t hurt that borrowing rates on-chain are often below the RFR. Bear market or not, institutions are as interested as ever and significantly more educated about blockchain technology than they’ve been in previous cycles.
And yet, while the RWA space has ground its way up to about a $1B market size, we haven’t seen the kind of explosive exponential growth we might have expected.
Why?
The fundamental problem holding back the RWA space is the challenge of building compliant, safe infrastructure in a non-compliant, unsafe environment. This basic problem raises its head in different ways for different players.
Institutions may have an interest in building on blockchains, but their compliance departments have no interest in holding capital in a wallet that can get dusted with OFAC sanctioned ETH from Tornado Cash. They may have an interest in borrowing stablecoins for sub 3% on Aave, but they certainly have no interest in borrowing from a pool of non-KYC’ed anonymous counterparties. They may want to access the composability of assets afforded by DeFi, but they cannot deploy capital on a chain where even “safe” protocols get drained by anonymous hackers. They are, in spite of all this, still interested enough in using blockchain technology that they are deploying products on the only networks that feel safe: private, white-listed chains. However, these private chains lack the activity, innovation, infrastructure, and existing pools of capital that live on the open networks.
RWA protocols have done excellent work creating pockets of compliance in a non-compliant environment. However, there still exists an oil and water separation between them and the other protocols available on these open networks. The problem with having your own isolated pool of KYC’ed capital is that the pool has lost the main benefits of being on an open network: free access and composability.
If you’re issuing an asset that cannot be transferred to a non-accredited investor, then that asset cannot be used as collateral on a lending protocol with open and anonymous liquidation auctions. To make matters worse, you’ve also created an onerous KYC onboarding funnel that most prospective users leave before completing.
At this point, you have sacrificed the primary benefits of being on a blockchain in order to achieve a certain degree of compliance. And yet, you have failed to solve the fundamental problems: you are no less susceptible to hacks than anyone else, and institutions are still not comfortable deploying capital into your protocol. Institutions could still get dusted by a sanctioned entity at any time in the wallet they would use to hold your asset.
The growth we’ve had so far in RWAs is only made more remarkable by all of these barriers. We’re building products that lack the benefits of being on a blockchain (easy access, composability), have a miserable onboarding flow, and haven’t even solved the things that most concern institutional investors: compliance and exploit risk. Yet still, we’ve slowly grown up to around $1B.
RWA Trends
There are two promising trends that will drive some incremental gains in the space. These two trends are a diversification of available RWAs and the development of RWA-dedicated on-chain financial infrastructure protocols allowing for collateralization, trading, et cetera for RWAs.
There are two important dimensions of that first trend of diversification. The first real tokenized RWA asset class was private credit.
Pre-2021, that was almost completely dominated by loans to crypto funds and market makers, whereas now it is moving into other spaces (e.g. Blocktower/Centrifuge Tinlake Pool or web2 fintech startup loans on Atlendis). We have to give institutional capital the ability to experience the benefits of on-chain infrastructure without necessarily carrying an exposure to the crypto cycle. The second dimension is the growth of on-chain treasuries, which have gone from nothing to constituting half of all RWAs over the past year alone.
Liquid, fungible, RWAs with reliable oracles are the first step to on-chain RWA composability, and composability is one of the main benefits of building on blockchain networks. This brings me to the second promising trend: dedicated RWA financial infrastructure on-chain.
One of the first examples of real RWA composability on-chain (MakerDAO notwithstanding) is the Flux product from Ondo, and the rapid growth OUSG has experienced in the past 6 months is a great proof of concept for the promise of borrowing against RWAs.
With that said, it’s not open (only qualified purchasers KYC’ed individually by Ondo/Flux can hold the collateral), and the arbitrage between low borrowing rates for stables on Aave and high treasury rates can only be closed via two separate legs (qualified purchasers borrowing against on-chain treasuries, and non-QPs borrowing on Aave and lending to them). Despite the fact that it’s still a relatively closed system, and restricted to QPs who also have no counterparty requirements, it’s grown to ~$150M TVL in the depths of a bear market.
The success of both these trends are held back by the same problems. These new RWAs and these new attempts at infrastructure are siloed, handicapped by the fundamental problem of building compliant, safe financial products on non-compliant, unsafe networks. The problem is a network problem, and the solution has to be a network solution. Specifically, a fully KYC’ed L2 designed for compliant financial products and infrastructure: Kinto.
First generation layer 2 networks have largely been undifferentiated from each other from a user/builder perspective — they are all cheaper, faster EVMs settling to the Ethereum blockchain. But the real promise of L2s lies in the ability to build custom networks for specific use cases while remaining connected to Ethereum L1: the beating heart of on-chain activity, capital, infrastructure, and innovation.
By building a fully KYC’ed layer 2 network, we can solve the fundamental network problems holding back the RWA space. Institutions can operate in a fully compliant environment without resorting to empty, private L1s. Governance can reveal the identity of attackers and reduce the risk of on-chain exploits. RWAs can perform user-friendly on-chain KYC checks during onboarding, and enable composability by checking recipient information directly on-chain. The RWA space has been trying to grow on networks that provide an inherently detrimental environment to their success, but now can finally build on a decentralized network suited to their needs.
Kinto will enable the RWA cycle.
Author Bio:
Alan Keegan is the CSO of Kinto, a KYC’ed Layer 2 launching mainnet in Q1 2024. Find him on twitter @misterkeegan.
