Innovation vs Regulation
Why have RWAs/Tokenized assets not gained wide adoption?
The concept of tokenizing real-world assets has been discussed for at least the last 5-7 years. Despite its long-standing popularity, it has not gained significant momentum in the blockchain world. The primary challenge is compliantly offering "securities" globally so that they can be easily traded on the blockchain using AMMs, integrated into other DeFi protocols like lending and borrowing, and used to create derivative productsâthis is akin to boiling an ocean.
Ethereum has come a long way in the last 3-4 years, enabling a level of composability in financial applications that has not been possible before. Technologically, enabling all the features mentioned above for simple real-world assets like stocks, ETFs, and bonds is now quite feasible on Ethereum. However, almost all the effort is related to navigating regulatory and compliance standards.
We can now send USD as USDC/USDT across borders instantly and at almost zero cost, a level of efficiency unmatched by traditional financial players or banks who have been in the financial domain for decades. We now have global friends, many of whom we have never met or will never meet in person, a scenario unprecedented before. Similarly, sending money or collaborating on incentives or investments now needs to be on a global level, yet financial systems have been designed with limitations to national borders.
Like sending USD, it is possible to instantly verify and settle any other asset. However, this has not been achieved due to the legal and compliance efforts required. Since USD is not a security, it can leverage technology without the burden of financial regulations.
The primary reason real assets are not as freely traded on the blockchain as meme coins is due to regulatory effort and cost. Founders looking to bring assets onto the blockchain globally to retail, should ensure they have a securities lawyer as one of the founders or possess in-depth regulatory experience to ensure the long-term health of the RWA project. Alternatively, keeping the asset offering limited to accredited investors allows projects to bypass many regulatory hurdles. This will be discussed in more detail in the next sections.
What is a Security?
A security is a broad term that encompasses a variety of financial instruments which investors can buy and sell. These instruments include stocks, bonds, options, notes, and derivatives, each serving different functions in financial markets.
Securities are essential tools for raising capital, both in public and private sectors, and they are generally:
Fungible: Each unit is the same as every other unit.
Tradable: They can be bought and sold in financial markets.
Regulatory Aspects
Securities are regulated primarily by federal laws, notably the Securities Act of 1933, which requires detailed disclosures to protect investors from fraud and misleading practices. The Securities and Exchange Commission (SEC), established by later legislation, plays a key role in regulation and enforcement.
Howey Test
The term "security" also includes investment contracts, as defined by the Supreme Court in the landmark case SEC vs. W.J. Howey Co. The Howey Test, which emerged from this decision, is a legal standard used to determine whether certain transactions qualify as investment contracts, and thereby fall under the securities regulatory regime.
The Howey Test specifies that an investment contract exists if:
There is an investment of money.
The investment is in a common enterprise.
There is an expectation of profit from the investment.
The profit is expected to come from the efforts of someone other than the investor.
This test also applies to a variety of non-traditional investments, including certain types of real estate deals and, cryptocurrencies and non-fungible tokens (NFTs).
Impact of Regulations
Regulations are essential for protecting users from malicious actors and play a critical role in safeguarding investors. They are designed with the best interests of the user in mind. However, when the government continuously adds new rules on top of existing ones, it can create an inefficient system. Even the best-designed systems need maintenance, fixes, and improvements, often involving the removal of outdated and inefficient parts and replacing them with more efficient alternatives. Unfortunately, there is typically no specific department within the government responsible for eliminating old rules and regulations.
The crypto market, while smaller compared to traditional markets, is still significant and often profitable for various projects in the blockchain domain. The rising demand for stablecoins (like USDC and USDT) and the recent growth of T-Bills in the crypto world highlight a strong interest in on-chain assets that are mapped to real off-chain assets. One of the key advantages of having assets on-chain is their global accessibility and the efficient issuance and transfer processes. Despite the strong demand and technological advantages, we have yet to see many crypto projects that offer deep liquidity for these real-world assets. The main deterrent for many developers in this space is the substantial effort and cost required to tokenize these assets.
Innovation vs. Regulations
Historically, many startups have operated in regulatory grey areas where clear guidelines were absent. Stringent regulations could have stifled many startups that are now significant contributors to Western economies, which generally strike a balance allowing startups to innovate within these grey areas. Here are some examples:
Adoption of the Internet in the 1990s: The internet has been a transformative invention, enabling entrepreneurs to create valuable products and fostering competition that has led to high-quality, low-cost products. Today, anyone can access courses from prestigious institutions like MIT, Stanford, and Harvard for free. Social media has democratized content creation, allowing individuals to compete with major media outlets. However, the internet is also rife with scams and bad actors. Would this level of innovation have been possible if the government had imposed complex incorporation processes costing each tech company $200K-$500K?
Uber: Uber has often operated without proper licenses, disrupting small taxi businesses. However, the government provided Uber with enough leeway to grow into the world's leading ride-hailing service and expand into new ventures like Uber Eats for food delivery. Airbnb has similarly operated in a gray area.
Generative AI: This recent technological breakthrough generates derivative content by learning from scraped articles, news, websites, videos, and audios. While generative AI has revolutionized content creation, it has also disadvantaged original content creators by using their work without credit. Existing copyright laws could drastically impede innovation if applied stringently to generative AI.
These examples illustrate how Western governments provide space for innovative startups to operate in grey areas, allowing regulation of bad actors while fostering good innovation.
Regulations and Crypto
The approach to crypto, however, seems more restrictive. While the SEC has effectively tackled many bad actors, its aggressive stance makes it feel as though they want to eliminate the entire crypto industry. Most honest projects in the crypto domain, such as Coinbase, Uniswap, OpenSea, and others, have been summoned by the SEC for various reasons. At the same time, many bad anonymous actors have not been tracked down by the SEC.
The options left for builders are either to restrict themselves to traditional financial systems, which are both inefficient and expensive, or to spend $500Kâ$2 million and 12â18 months obtaining licenses for a Broker-Dealer, Transfer Agent, Alternative Trading System, and then consider developing any product in the blockchain world.
At DoDAO, we are a team of builders and a bootstrapped company. We do not want to raise capital before we actually need it. We wanted to develop in the RWA world and have attempted several times to have conversations with traditional solution providers about how integration and trading between traditional and on-chain systems would work. In almost all these conversations, the first question asked was how much money we had raised. When we answered "none," most conversations ended there.
If you operate in the grey area of crypto and even if you focus on education and user safety, and your project becomes widely used and adopted, you should expect some form of legal litigation from the SEC. At the same time, if you remain anonymous and potentially exploit your users, the SEC currently has no way to reach you. This behaviour by the SEC favours bad actors and is detrimental to good players.
Investor or User Protection
While the SEC has adopted a "Regulation by Enforcement" approach, it's crucial that the crypto industry also takes significant responsibility for this situation. A key distinction between blockchain and prior innovations is that earlier technologies primarily benefited the common person without exposing them to scams.
In contrast, terms like "Pump and Dump" and "Rug Pull" are prevalent in the crypto space, indicating a lack of concern for end-user and investor protection in many crypto projects. The community often hides behind the phrase "Not your keys, not your coins," without considering the real-world implications for users. What happens when someone loses their private keys, potentially jeopardizing their family's financial security? Who in the community steps up to help?
Another common phrase is "don't trust, but verify." Your grandma might be interested in investing for your future, but she may not have the skills to verify where the yield is coming from or understand the risks of the investment. Currently, there is no one working in the crypto community to help users understand the risks and sustainability of their investments.
Note for builders
Real world Assets qualify directly as securities, and one rule of thumb every build should have is to always act in the best interest of investor and ensuring investor protection. On-chain adoption still has UX issues and requires investor education. We can only expect users to spend the extra effort to use blockchain wallets or systems, if we can think of offering 10x better selection of assets on-chain, or make the issuance or exchange 10x efficient in a traditionally compliant way, or 10x more information or trust for the assets.
This also means the effort which on-chain builders have to spend is much more than the effort that is needed by Fintech startups.
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