Let Funds Flow at Internet Speed

Author: Prathik Desai

Compiled by: Block unicorn

Tokenization stitches together two vastly different worlds: one is the always-on, permissionless DeFi protocols, whose prices fluctuate every few seconds; the other is traditional funds, whose settlements follow a set of managed timeframes by a group of licensed holders.

Merging the two requires exceptional coordination skills, but for those who can successfully achieve this, there lies tremendous value. In today’s article, I will explore who is behind the scenes connecting these two worlds and who is capturing the value from it.

The size of the tokenized real-world asset (RWA) pool exceeds $33 billion, with tokenized U.S. Treasuries accounting for about $15 billion. However, it is noteworthy that its share has dropped from 55% to less than 45% in just one year. Meanwhile, other tokenized funds have seen growth, including institutional credit funds (e.g., Apollo's ACRED) and private credit funds (e.g., JAAA from Janus Henderson).

The maturation of tokenization provides financial officers or CFOs managing corporate cash with a range of options with varying risk appetites. Those seeking low-risk, low-return but high-liquidity investments can opt for Treasury funds, while those pursuing higher returns and greater programmability can choose riskier investment options. The safety of returns is no longer as concerning as it once was. These tools backed by Treasury funds are audited by the same auditing firms that audit traditional bonds.

This is the strongest argument for the impending surge of tokenized real-world assets among institutional investors.

If someone were to ask me what the difference between off-chain and on-chain currencies is, I would say it is composability. It is composability that allows one dollar to serve multiple purposes across various channels, achieving higher compound growth. The ability to cash out instantly and make your funds work more efficiently makes them seem like funds on steroids.

Traditional finance forces us to choose between yield, liquidity, and transferability. Tokenized funds, if managed properly, can allow us to enjoy all three simultaneously.

But "managed properly" is no easy feat. The composability of funds involves an engineering challenge.

Stitching Together Two Distinct Worlds

Blockchain brings speed, cost-effectiveness, and rapid settlement to tokenized risk-weighted assets (RWA). However, tokenized money market funds are still funds, not stablecoins. They still need to update their net asset value (NAV) once every business day according to the fund manager's schedule. They still need to maintain a KYC-verified holder population. For instance, BlackRock's BUIDL has a minimum investment threshold of $5 million, while Circle's USYC is limited to non-U.S. participants. They still need to comply with redemption cut-off times, as the settlement of the underlying Treasuries relies on off-chain infrastructure, which has a settlement cut-off time of 5 PM Eastern Time.

This is the indispensable legal substance of the product. If daily NAV settlements are eliminated, it is no longer a money market fund. If the whitelist mechanism is removed, the SEC will come knocking.

So, how can a fund maintain its established timelines, holder settings, and redemption windows while allowing the tokens representing its shares to flow at internet speed? Funds need specially built infrastructure to maintain NAV at the end of the period, support epoch-based settlements, and comply with strict legal boundaries when transferring assets across blockchains. This is a tricky coexistence dilemma.

A recent report released by LayerZero and Centrifuge describes how they are solving this problem.

Resolving Conflict Points

Three conflict points determine whether this coexistence model can succeed. If the coordination layer can handle these conflict points correctly, the fund can operate at internet speed without violating legal boundaries.

First is the price.

What is the value of the token between two NAV settlement periods? Some issuers will freeze the token price at yesterday's level and accept this stagnation. When interest rates fluctuate at noon, price freezes can easily be manipulated. Continuous price changes, while harder to manipulate, are also more difficult to align with the fund's actual accounts.

Second are compliance factors.

Where does the whitelist verification layer operate? If it runs with every transfer, the token cannot touch open DeFi and can only transfer between approved wallets. If that layer is encapsulated within a vault, the vault will hold regulated shares and issue a freely transferable receipt token to holders who have completed a KYC verification. This receipt can be composited through DeFi, embedding compliance within the vault rather than checking it with every transfer. Centrifuge's deRWA framework is a great example of this.

The third conflict occurs when transferring assets across chains.

When a tokenized fund is deployed across nine chains, you need a unified data source to clarify ownership and value. While on-chain infrastructure can update in real-time, discrepancies still need to be updated and reconciled across the nine chains. The more failure points there are, the greater the chance of errors.

LayerZero and Centrifuge solved this problem by building a hub-and-spoke model. In this model, one authoritative chain is responsible for managing NAV, accounting, and compliance. The messaging layer (coordinated by LayerZero in this case) pushes these updates to the spoke chains where the tokens are actually used.

Centrifuge's V3 architecture is built on this model, where each funding pool selects a central chain as its data source, with branch chains serving as distribution endpoints for deposits, enabling DeFi composability. LayerZero is responsible for transmitting operational data across chains to ensure synchronization of NAV updates, compliance instructions, and cross-chain balance statuses.

What I mentioned earlier is this enviable yet crucial coordination mechanism that brings value to those who can execute it. Whoever can maintain the consistency of the fund's authoritative status across chains will be hard to replace. While fund managers still control the timing, and blockchains still possess composability, some intermediary participant must achieve both simultaneously.

The most vulnerable part of asset transfers is the accounting of the transferred assets.

When assets transfer between different chains, they may temporarily disappear from the fund's visible balance sheet. Centrifuge V3 will issue tokenized confirmation information for assets in transit, so even if the underlying tokens are still in the process of transferring, the fund's balance sheet can maintain continuity. This is akin to on-chain trade date accounting. While tedious, it is crucial.

Despite these conflicts, why should institutional investors still consider tokenized funds?

One of the best ways to optimize idle funds through tokenization is through circular trading. CFOs can deposit tokenized Treasury funds and use them as collateral to borrow stablecoins. If the borrowing rate is lower than the fund's yield, holding that fund can generate returns. Subsequently, CFOs can redeploy the stablecoin funds to other yield sources and repeat this cycle.

Only by resolving the aforementioned conflict points can the entire circular trading process operate effectively. This is the next challenge faced by those building tokenized infrastructure. These conflict points have been exploited in the past. For example, if the on-chain NAV price of smaller tokenized products remains unchanged for two to four hours and lags behind the underlying asset price, arbitrage opportunities will arise before the next NAV price surge.

When off-chain NAV triggers liquidity constraints, if an independent on-chain smart contract attempts to process token redemptions immediately, redemption gate conflicts may occur. This can lead to smart contracts holding "isolated" or unexecuted token trades that continuously attempt to execute simultaneously, countering off-chain limits.

Currently, large private credit funds and business development companies (BDCs) are facing this situation. Three weeks ago, Apollo Global's $26 billion private credit fund—the Apollo Debt Solutions Fund (ADS)—had to set a redemption limit of 5% after investors attempted to redeem about 16.8% of their shares. If a similar situation occurs with funds trading tokenized versions simultaneously, it would be hard to rule out the possibility of redemption channel conflicts. In the second quarter, investors redeemed $15.6 billion from widely held private credit funds, up from about $13.9 billion in the previous quarter.

Cross-chain messaging processes may encounter failures, leading to positions not being fully settled. Only by monitoring each failure mode and having qualified personnel responsible can institutional investors' trust be earned.

If tokenization is to realize its potential, it must address the following challenges. It is not just about putting U.S. Treasuries on the blockchain or creating a new asset class. Those building the infrastructure must break the outdated rules that force investors to choose between yield, liquidity, and transferability. If tokenization can allow the dollar to serve multiple purposes simultaneously without compromising the credibility brought by existing safeguards, then institutions holding billions of dollars in cash will surely take notice.

I have previously written that SWIFT, as the current coordination layer, has value and influence that surpasses either end of the network it serves. Visa's value also exceeds that of all the global banks it serves, except for JPMorgan.

This is the driving force behind playing the role of a coordination layer in the evolving financial world. It allows participants to secure a place in the capital markets of the next decade. Centrifuge is defining the role of funds, while LayerZero is responsible for building the bridges connecting all the links.

That’s all for today, see you in the next article.