Asset Tokenization: A New Financial Paradigm in the Web3.0 Era (Part 1)

Similar to asset securitization, which packages and divides illiquid assets into liquid securities, asset tokenization involves packaging and dividing various encryption assets from the virtual digital world and financial and non-financial assets from the real physical world into tokens that are valued, stored, and traded on the Blockchain.

With the arrival of the Web 3.0 era, decentralized finance (DeFi) built on the foundation of asset tokenization will extend human finance, economy, and various social activities into the virtual digital world, integrating and expanding with the real physical world. At the same time, given the programmability, composability, and divisibility of tokens, as well as the 7X24 hours global peer-to-peer atomic settlement features, DeFi will be able to approach the ideal realm of Arrow–Debreu complete markets, thereby achieving a comprehensive replacement of the traditional financial system, including banking and capital markets, in terms of the fundamental financial function of resource time allocation.

The Genius Bill, Clarity Bill, and Anti-CBDC Bill passed by the U.S. House of Representatives in July 2025 establish a systematic strategic framework for the regulation and development of stablecoins and digital assets. Establishing this framework is fundamental to ensuring that the United States leads the Web 3.0 revolution. At the same time, it will also bring new strategic opportunities to support U.S. government debt, create a global unified capital market centered around the dollar, and maintain and enhance the dollar's hegemony.

For asset tokenization, we need to be aware of the risks and crisis origins it entails. Throughout human history, financial risks have always accompanied financial innovations. Significant financial innovation technologies usually need to withstand the baptism of financial crises to become widespread. However, we must also deeply recognize that in this new era of great navigation, where the virtual digital world and the real physical world merge and expand, promoting financial innovation is the fundamental priority.

To facilitate reading, this article is published in two parts: the upper part and the lower part. This is the upper part.

Asset Tokenization: A New Financial Paradigm in the Web 3.0 Era

###0****1 Introduction****: Arrow-Debreu Securities and Complete Markets****

Finance is essentially the allocation of resources over time in an uncertain environment. As Bodie and Merton (2000) stated, "Finance is the study of how people allocate resources over time in an uncertain environment." They pointed out that financial decisions are different from other resource allocation decisions because the costs and benefits of financial decisions are distributed over time, and no one can know the outcomes in advance. In the real world, the vast majority of financial decisions rely on a financial system that includes financial institutions, financial markets, and financial regulatory authorities.

So, how can we determine the efficiency of the financial system in allocating resources over time? The general equilibrium model of Arrow and Debreu (1954) provides a concise and powerful explanation: under conditions of perfect competition, a complete market that includes all future states must necessarily exist with an equilibrium price system, thus allowing resource allocation to reach a Pareto optimal state. The so-called "complete market" is such a market: for the future state space, there exist enough state-dependent (payment conditions triggered by certain future states), mutually exclusive (no correlation between different states), and complete (covering all future states) atomic securities—referred to as "Arrow-Debreu securities"—which allow any future state payment flows to be realized through linear combinations of these securities.

A simple example can illustrate the relationship between Arrow-Debreu securities and complete markets. Suppose today (t=0) there are two economic agents: a vendor who needs to set up a stall tomorrow (t=1) and a umbrella seller who hopes to sell umbrellas tomorrow. Tomorrow's state space consists of two states: rain and no rain. Assume there are two types of Arrow-Debreu securities in the market: one called "rain security," which pays a corresponding amount if it rains tomorrow; and another called "no rain security," which pays a corresponding amount if it does not rain tomorrow. Since tomorrow's state space includes two mutually exclusive states (rain and no rain), the market also has two mutually exclusive and complete securities, making the financial market a complete market. The vendor can purchase rain securities to hedge against the losses from rain, while the umbrella seller can buy no rain securities to hedge against the losses from no rain, thus hedging all economic agents' risks of facing losses in the future — this is optimal risk sharing. At the same time, the production activities of the vendor and the umbrella seller today (such as the vendor preparing ingredients for tomorrow's stall) and their consumption activities (like celebrating the prospect of earning money tomorrow with a big meal) can proceed without concern for the impact of tomorrow's weather — this is known as the "Fisher separation theorem."

Of course, in order to achieve a complete market, the number of atomic securities needs to change according to the state space. If the number of states increases and the state space expands, then the Arrow-Debreu securities need to be further refined in granularity and increased in number. For example, if the state of "raining" tomorrow changes to "light rain," "moderate rain," and "heavy rain," and the state of "not raining" tomorrow changes to "overcast," "cloudy," and "sunny," then the corresponding 6 types of Arrow-Debreu securities are needed to form a complete market.

A complete market clearly does not exist in reality. This is because there are many transaction costs in the real world, making it impossible to create an atomic security for every possible state. Any financial instrument (stocks, bonds, loans, derivatives, etc.) is a type of contract, and the entire process from contract signing to completion involves transaction costs (Yin Jianfeng, 2006): before signing, economic agents need to gather information (information search costs), in an asymmetric information environment, they need to identify trading counterparts (identification costs); the signing of the contract requires repeated negotiation (negotiation costs); after the contract is signed, in an asymmetric information environment, monitoring whether the trading counterpart is fulfilling the contract is necessary (monitoring costs); after the contract expires, it is necessary to verify the states that have occurred (verification costs); finally, payments and settlements need to be made based on the states (payment settlement costs).

Although a complete market does not exist, since the era of the Sumerians around 5000 BC (Gozman and Rovenhorst, 2010), humanity has been continuously advancing towards this ideal through various financial innovations. The wave of financial liberalization that began in the United States in the 1980s greatly accelerated the pace towards a complete market, with a large number of new native securities (such as over-the-counter Nasdaq stocks, junk bonds) and derivatives (options, futures, swaps, etc.) emerging. Among various financial innovations, asset securitization, which integrates numerous native securities and derivatives, can be regarded as the culmination.

Asset securitization, simply put, is the process of packaging and dividing previously non-tradable, non-standardized financial instruments (such as mortgage loans) into smaller standardized, tradable securities. Similar to asset securitization, the recently emerged asset tokenization (also known as "tokenization") involves packaging and dividing various encryption assets and real world assets (RWA) into tokens (also known as "tokens") that are priced, stored, and traded on the Blockchain. Compared to asset securitization, asset tokenization can approach the creation of various atomic Arrow-Debreu securities due to the programmability, composability, and divisibility of tokens, as well as the capability for atomic settlement, making it a more significant financial innovation towards a complete market.

Of course, looking back at thousands of years of financial innovation by humanity, each step toward a complete market, depending on the magnitude of the advance, may cause varying degrees of financial risks or even financial crises in its initial stages. For example, the significant development of the British stock market in the early 18th century led to the first stock market crisis in human history—the South Sea Bubble crisis of 1720; the emergence of money market funds in the 1980s exacerbated the disintermediation of the American banking sector, leading to the bankruptcy of numerous banking institutions; asset securitization evolved into a massive wave of structured finance at the beginning of this century, which laid the groundwork for the subprime mortgage crisis in the U.S. in 2007 and the subsequent global financial crisis. In short, the greater the financial innovation that advances toward a complete market, the more it requires supporting financial regulatory measures and risk disposal plans in its initial stage.

This article will first discuss the mechanisms of asset securitization and structured finance, as well as the global financial crisis of 2008 that ensued, which can provide valuable insights for emerging asset tokenization; the third section analyzes the types and basic processes of asset tokenization within the context of Web 3.0, as well as the prospects for decentralized finance based on it; just like asset securitization in the past, asset tokenization is still far from mature, and the main content of the fourth section is how to improve financial regulation and prevent the risks of tokenization; the final part of the article presents our fundamental judgment: if humanity is destined to enter an era where the real physical world and the virtual digital world are closely integrated, then in this era, finance, as the "core of the modern economy," will naturally need to achieve a close integration of reality and virtuality.

###0****2 Towards a Complete Market: Asset Securitization

In today's financial system, asset securitization and the structured finance that has evolved from it are widely used common financial technologies. By overcoming the transaction costs of the real world, these technologies create state-dependent securities that did not originally exist, allowing previously non-tradeable financial instruments to gain liquidity. However, these technologies also bring new transaction costs—especially the costs of due diligence to identify the quality of underlying assets and the costs of monitoring the behavior of financial intermediaries. In years when regulation lagged significantly behind innovation, these new costs laid the groundwork for financial crises.

(1) Asset Securitization

The history of asset securitization is very long. As early as 1852 and 1899, France and Germany successively issued laws related to the transfer of housing loans. In Germany, the mortgage-backed bonds (Mortgage-Backed Bonds, MBB) issued under the Mortgage Bank Act—called "Pfandbriefe" in German—can be considered the earliest securitization products. In 1938, the U.S. government injected $10 million to establish the first government-sponsored enterprise (GSE)—the Federal National Mortgage Association (Fannie Mae)—and began actively exploring and nurturing the secondary market for residential mortgages. In 1970, the second GSE—Freddie Mac—was established. In the same year, the first residential mortgage-backed securities (Mortgage Backed Security, MBS) were issued.

The real takeoff of asset securitization began in the 1980s, triggered by a series of financial liberalization reforms that expanded the future state space. Just like the previous examples of street vendors and umbrella sellers, the demand from two types of economic entities drove the rapid development of asset securitization at that time. The first type was banking institutions facing interest rate risk and liquidity risk. Before interest rate liberalization, due to the protection of the Q Regulation of the 1933 Banking Act, banks issued long-term fixed-rate loans and created short-term fixed-rate deposits, allowing them to earn a stable interest margin. After interest rate liberalization, the interest rates on demand deposits began to fluctuate, increasing interest rate risk. More importantly, demand deposits started to flow to emerging non-bank financial institutions, especially money market funds, putting enormous disintermediation pressure on banks and necessitating solutions to liquidity issues on the asset side. The second type was the newly emerging institutional investors, particularly the pension funds that exploded after pension system reform. These institutions needed to allocate long-term, relatively safe fixed-income securities, but the non-standard characteristics of residential mortgage loans made them difficult to access.

In this context, the MBS market began to expand. The initial MBS was created to address the liquidity issues of housing mortgages, with the two GSEs being the main entities purchasing loans and securitizing them. The underlying assets are compliant loans (confirming loans) or prime mortgages, where credit risk is strictly controlled. These loans have three characteristics: first, borrowers must have complete income proof, and credit scores must meet high standards (credit scores above 620); second, there are strict requirements on the ratio of repayment amount to income (PTI) and the ratio of total loan amount to property value (LTV), with PTI and LTV not exceeding 55% and 85%, respectively; third, the loan interest rate is fixed and remains unchanged during the limited term of the contract. Additionally, these loans must have extra credit enhancement measures, such as guarantees provided by insurance companies.

The sole purpose of asset securitization is to obtain liquidity; therefore, the design of MBS is very simple: Fannie Mae and Freddie Mac purchase loans from banking institutions to form the original asset pool, then establish a securitization pipeline - a special purpose vehicle (SPV), transferring all rights and interests of the original assets to the SPV for real sale and bankruptcy isolation, and finally issue homogeneous securities in the name of the SPV with the same amount, risk, and return. In this issuance method, the cash flows from the original asset pool are simply distributed evenly to each investor without any changes, and the SPV is merely a vehicle for transferring asset rights, having no other function. Therefore, these securities are referred to as pass-through securities.

(2) Structured Finance

Since the 1990s, with the development of the financial derivatives market, a completely new financial model based on securitization technology—"structured finance"—has begun to emerge. Structured finance is a financial activity centered around financial intermediaries such as investment banks (Yin Jianfeng, 2006), and the process includes three steps: first, pooling, where financial intermediaries bundle original assets into an asset pool; second, de-linking, usually achieved through SPV to enable true sale and bankruptcy isolation, ensuring that the returns and value of the underlying assets are not affected by the actions of the original equity holders and intermediary institutions; third, structuring—reconstructing the risk and return characteristics of the asset pool according to the preferences of investors, thereby forming new securities, namely structured finance products.

Figure 1 Structured Finance and Products

Structured finance is a continuation of asset securitization, but there are significant differences from traditional asset securitization: First, the financial instruments being securitized are no longer limited to compliant residential mortgages with low credit risk that only need to solve liquidity issues; they can also include any other assets—one could even say that everything can be tokenized; Second, the role of financial intermediaries is no longer to passively package assets into simple standardized securities, but to become active designers of securities and asset managers; Third, based on the attributes of the packaged assets and the design of the structure by financial intermediaries, the final structured financial products can be various complex and sophisticated securities related to interest rates, equity, credit, and so on.

Structured finance is widely applied in the area of subprime mortgages in the United States. Subprime loans emerged as early as the 1960s, but they were not called by this name at that time; they were referred to as non-conforming loans. The term "non-conforming" refers to loans that do not meet the purchase requirements of Fannie Mae and Freddie Mac, and they mainly have three characteristics: first, the borrower's credit quality is poor, primarily consisting of low-income minority groups, who generally lack credit history and income proof, with credit scores below 620; second, the PTI and LTV exceed 55% and 85%, respectively, meaning that the borrower's income is far below the amount needed to cover the loan principal and interest, and many loans have down payments below 20%, or even zero down payment; third, more than 85% of subprime loans implement variable interest rates, and the overall debt burden is significantly higher than that of prime loans. To alleviate the initial repayment pressure, the loan repayment adopts a low-to-high approach, meaning that typically only a small monthly payment is required during the first two years of the loan, after which there is an "interest rate reset"—the loan interest rate increases significantly according to market rates. For example, some subprime mortgages allow borrowers to repay at a fixed rate below the market interest rate level during the first two years, after which it converts to a variable rate loan at a level higher than the market interest rate; some subprime mortgages allow borrowers to pay only interest in the initial stages, and even allow for negative amortization (i.e., the payment amount is less than the interest due for the current period).

Figure 2 General Structure of Collateralized Debt Obligations (CDOs)

Clearly, unlike the securitization of compliant loans which only needs to address liquidity issues, securitizing subprime mortgages requires tackling the high credit risk inherent in them. Otherwise, institutional investors with lower risk appetites, such as pension funds, life insurance companies, and sovereign wealth funds, will not participate in this market. A structured financial product has accomplished this task: CDOs (Collateralized Debt Obligations). There are numerous types of CDOs, but their structures are generally similar.

First, the subprime loans are packaged and injected into an asset pool, and then through SIV (structured investment vehicle) – a securitization conduit similar to SPV but more aggressive – bankruptcy isolation and true sale are achieved. The securities designed in the end are classified according to the credit risk they bear, from low to high, and the investment returns also from low to high, which are priority securities, mezzanine securities, subordinated securities, and equity securities. If the underlying assets default, the losses are first borne by the investors of equity securities, then by subordinated security investors, and so on. Thus, the tiered structured design segments high-risk, homogeneous subprime loans into securities that cater to investors with different risk appetites. Furthermore, CDOs can hedge credit risk through credit derivatives trading or utilize external credit enhancement agencies to provide credit enhancement. Through a series of means, priority securities can usually achieve credit ratings close to government bonds, thus becoming the target of competition among domestic institutional investors and foreign sovereign funds.

(3) Financial Crisis

Subprime loans appeared in the 1960s, but their scale was very small. With the promotion of structured financial products mainly based on CDOs, subprime loans began to spread. Since the securitized products issued by GSEs are mainly MBS, while the securitized products issued by non-GSE institutions mainly include structured financial products such as CDOs, comparing the scale of the two can reveal the changes in the market (Figure 3).

Figure 3 Proportion of Various Institutional Assets in Total Assets of Financial Institutions in the U.S. (%)

Note: "GSE" refers to the proportion of securitized products issued by GSE; "non-GSE" refers to the proportion of securitized products issued by institutions outside of GSE.

Data source: US flow of funds.

In 1980, the proportion of non-GSE securitized products was still lower than that of GSE securitized products. By 1990, the former's scale had already exceeded more than twice that of the latter, and by 2007, at the outbreak of the subprime mortgage crisis, it was even more than three times that of the latter. While structured finance was thriving, the business model of banks also changed: from the original "loan-hold" model to a "loan-distribution" model, meaning that after issuing loans, they immediately packaged and sold these loans to the market through securitization. One result of this was a significant decrease in the proportion of bank assets relative to the total assets of financial institutions (Figure 3): in 1980, bank assets accounted for more than 40%, but by 2000, it had fallen to 20%.

Structured finance has continuously evolved, ultimately triggering the U.S. subprime mortgage crisis in 2007, and amplifying into the global financial crisis after the collapse of Lehman Brothers in October 2008. In hindsight, the outbreak of the crisis is not surprising at all, as the three major potential risks accompanying financial innovation have always existed.

First, the structural design of the product ignores systemic risks. By using tiered and other structured designs to disperse credit risk, the underlying assumption is that credit risk is merely sourced from the specific risks of individual subprime borrowers, rather than from systemic risks caused by a simultaneous decline in national housing prices. When national housing prices decline simultaneously, all subprime loans will face default, and thus even investors in senior securities cannot avoid losses.

Secondly, it ignores the moral hazard of financial intermediaries, including lending banks, rating agencies, and investment banks. In the "loan-distribution" model, lending banks transfer loan risks to securities investors, bearing only a minimal risk loss themselves, thus being more inclined to issue high-interest and high-risk subprime loans. At the same time, after issuing loans, they are also more lax in supervising the behavior of borrowers, resulting in increasingly poor quality of the underlying assets in securitization. The three major credit rating agencies are similar; in order to gain the benefits brought by credit ratings, they tend to give higher ratings to structured products such as CDOs. As for investment banks typified by Lehman Brothers, in pursuit of profits from high leverage, they even deliberately conceal the poor quality of underlying assets from investors, designing product structures to be increasingly complex, amplifying leverage through complicated structures, thus allowing risks to rapidly spread and amplify into a financial crisis among financial institutions.

Finally, the lack of regulation. Asset securitization and structured finance not only span traditional banking and securities businesses but also cross national financial systems. However, before 2008, the regulatory model in the United States was a multi-headed segmented supervision model, which could not effectively monitor the accumulation and contagion of cross-market risks. At the same time, regulatory agencies in various countries lacked close international regulatory cooperation, thus being unable to prevent the mutual contagion of country-specific risks or provide unified liquidity support after a crisis broke out.