Tokenizing Alternatives With LayerZero

Introduction

A recent research report from Bain & Company and Onyx by J.P. Morgan estimates that tokenizing the alternatives industry is a $400 billion opportunity for wealth managers. Their report analyzes the current state of alternatives as an asset class and theorizes how tokenizing assets on top of blockchains may lead to an increase in the market share of alternatives compared to the $290 trillion global wealth pool.

The report, though insightful, stops short of delving into the specifics of implementing such a blockchain-based approach. It identifies the challenge and hints at a possible solution but leaves the detailed execution open for discussion. This article aims to explore how the LayerZero protocol could play a pivotal role in the tokenization process. LayerZero doesn’t offer a direct tokenization solution; instead, it acts as a foundational layer that facilitates various aspects crucial for the tokenization process. Key features of LayerZero that align with this include:

• Universal contract standards: ensuring consistency in how tokens operate across different blockchains.

• Support for multiple token standards: allowing for a diverse range of tokens corresponding to different types of assets.

• Universal messaging capabilities: enabling seamless transmission of data, tokens, and messages across both private and public networks.

In general, the focus of this article is not on tokenizing assets per se, but on highlighting LayerZero’s underlying infrastructure that could be instrumental in any blockchain-based approach to managing alternative assets.

Alternatives and Tokenization

The State of Alternatives

As explained by Bain and J.P. Morgan, alternatives typically include assets like private equity, hedge funds, real estate, and private credit. These assets are known to be high-upside, long-term investment vehicles accessible to sophisticated investors. According to data from Bain and J.P. Morgan, the majority of alternatives are currently held by institutional investors due to their capacity for large, long-term capital commitments and sophistication in handling complex investment structures. Individual investors have yet to infuse the alternatives market with much capital, as limited educational avenues, high capital requirements for entry, regulatory constraints, and abstruse operational complexity have made it difficult to do so.

In general, the current state of alternative investments is marked by a lack of shared infrastructure and standards, making them cumbersome to manage (operational hurdles) and hard to acquire (ownership hurdles). Let’s dive into those a bit more:

• Operational Hurdles: Operational processes are often siloed, involving multiple handoffs among participants, which raises administrative burdens and operating costs. Data is a massive overhead, as alternatives often suffer from a lack of standardization. Each participant in the investment chain — from asset managers to administrators — operates on different platforms, leading to data inconsistencies and operational risks in aggregating, reporting, and analyzing investment data. Servicing is also tricky, as servicing investors in alternative investments involves complex processes like handling subscription documents, which are lengthy and require meticulous attention. This increases the likelihood of errors and delays in onboarding investors. This general fragmentation leads to inefficiencies and high operational costs due to the need for multiple reconciliations and manual interventions.

• Ownership Hurdles: Alternatives are typically restricted to accredited or qualified investors and may require a net worth of over $5 million, in some cases. This necessitates a thorough and often complex vetting process to ensure investors meet the specific financial criteria, adding another layer of operational complexity. In addition, the regulatory landscape for alternative investments is complex and varies significantly across jurisdictions, making it difficult to understand if an asset is even legal for someone to hold. The long-term nature of these assets means they are typically illiquid, with long lock-up periods, often spanning several years. This makes it challenging for investors to exit their positions or realize cash quickly.

These technical challenges contribute to the high operational costs and resource intensity of managing alternative investments, thus forming a barrier to entry for smaller investors and creating inefficiencies for asset managers. In other words, alternatives are hard to manage and hard to own.

The State of Tokenization

Bain and J.P. Morgan make the case that the tokenization of alternatives will streamline the process of both operating and owning alternatives, bringing forth the possibility of higher allocations to the asset class from institutions and high-net-worth individuals (HNWIs).

Tokenization is a process in which an asset is wrapped into a contract on a blockchain. In theory, tokenization can significantly streamline these operational processes by representing the ownership and properties of an asset on a blockchain. By operating on a blockchain, tokens inherit a shared state and workflow that enables more seamless, automated order processing, settlement, ownership tracking, and data management. Tokenization is a major talking point for institutions, as exemplified by BlackRock CEO Larry Fink’s conversation on the Squawk Box this week, where he noted the Bitcoin ETF as the first step towards everything being a token.

With alternatives specifically, Bain and J.P. Morgan make the case that tokenization specifically could improve the following verticals:

• Operational Streamlining and Automation: Bain emphasizes that tokenization can simplify alternative investments’ traditionally complex and manual operational processes. This includes automating administrative tasks and standardizing workflows, reducing the operational burden for fund managers and improving efficiency in fund distribution.

• Improving Liquidity and Access: Tokenization is poised to revolutionize liquidity in the alternatives sector, bridging the gap between traditional illiquidity and modern investment flexibility. Converting assets into divisible, blockchain-based tokens, enables the creation of smaller, more affordable investment units. This accessibility paves the way for a broader range of individual investors to engage with these assets, fostering a more dynamic market. Importantly, this increased granularity in ownership doesn’t just lower the entry barrier; it also enhances market liquidity. Assets that were once cumbersome and slow to trade can now be bought and sold with greater ease and speed, reflecting a significant shift in the liquidity profile of alternative investments.

• Automation of Capital Calls: Capital calls are a key advantage of tokenization. By implementing smart contracts, capital calls could be streamlined and precisely timed, reducing the manual effort and uncertainty currently involved in managing investor commitments and fund deployments.

• Increased Transparency in Investment Holdings: The article alludes to the increased transparency in holdings as a benefit of tokenization. This refers to the improved clarity and tracking of asset ownership and investor stakes through blockchain technology, enhancing the overall visibility and trust in the investment process.

• Potential for Significant Revenue Growth: The article suggests a significant revenue opportunity, approximately $400 billion annually, resulting from adopting tokenization. This revenue growth is attributed to the increased distribution and management of assets under management, facilitated by the operational efficiencies and broader investor access that tokenization brings to the alternative investment market.

That being said, tokenization is not without its challenges. It will not address all aspects of the alternative investment lifecycle. Investor onboarding, AML/KYC checks, and reporting requirements remain areas that could be improved by complementary technological solutions. Furthermore, introducing tokenization will require careful consideration of regulatory frameworks and jurisdictional nuances. While moving alternative assets onto the blockchain is an efficiency boost (primarily from a backend financial plumbing perspective), from a regulatory standpoint, the same laws and rules that the alternatives industry faces now will likely continue to apply to them once on chain.

Overall, however, tokenization presents a significant opportunity to enhance the operation and ownership of alternative investments, making them more accessible and desirable for HNWIs and institutions. This is where LayerZero comes in.

LayerZero and Tokenization

The Basics of LayerZero

LayerZero is a protocol that allows for the development of applications that work the same across all blockchains. It is designed to solve the challenge of interoperability — a term that refers to different blockchain networks communicating and working together seamlessly.

At its core, the LayerZero protocol enables any application to communicate with any other application across any blockchain environment — public, private permissioned, EVM, or non-EVM — while enabling each application to retain full ownership of its messaging security. LayerZero’s design can be separated into three categories: immutable protocol, universal standards, and permissionless infrastructure. Each plays a crucial role in how it operates:

• Immutable Protocol — The Fundamental Layer: At its heart, LayerZero operates in perpetuity on a set of rules and agreements encoded in smart contracts, which are immutable (unchangeable) programs stored on the blockchain. These smart contracts, known as Endpoints, exist on each blockchain that LayerZero supports and act as the anchors of the protocol. They provide a consistent interface for applications to manage security settings and handle cross-chain messages.

• Universal Standards — Consistency Across Chains: LayerZero introduces a set of standards to ensure applications and tokens behave consistently across different blockchains. These standards are called OApp (omnichain application), OFT (omnichain fungible token), ONFT (omnichain non-fungible token) and extend the concept of an application or token from being a thing that exists on one chain to a thing that exists universally across any blockchain a developer or business desires. This is crucial for developers who want to build applications or digital assets that work seamlessly, regardless of the underlying blockchain technology.

• Permissionless Infrastructure — The Support System: LayerZero’s infrastructure includes off-chain (not stored on the blockchain) components essential for verifying and executing transactions. This part of LayerZero is highly customizable, allowing applications to choose their preferred methods and entities for carrying out these functions. Notably, anybody can verify messages (teams like Google, Animoca, and Blockdaemon do so now) and/or execute transactions. Due to this permissionless nature, enterprise applications may run their own infrastructure within their own environments for verifying and conducting transactions, while dApps may select a wide set of verifiers and executors in the ethos of decentralizing their projects.

To summarize, LayerZero’s unique proposition lies in its ability to enable seamless communication across different blockchains. This setup allows for transferring data, assets, and commands across chains, effectively eliminating the barriers that have traditionally segmented the traditional alternatives industry, along with the blockchain economy. For alternative investments, LayerZero enables businesses to issue, trade, manage, and settle assets across multiple blockchains (public <> public, private <> private, private <> public), significantly broadening market accessibility and appeal for alternative investments.

Tokenizing With LayerZero

LayerZero offers an omnichain toolkit for wealth managers to build alternative asset products on blockchains. Here are a few examples of how LayerZero can be used in the world of alternatives:

• Token Standardization: LayerZero’s OFT Standard could represent any fungible asset (like shares in a private equity fund) across different private and public blockchains. This standardization simplifies the complexities of managing these assets on multiple platforms, offering a uniform experience for issuance, trading, and tracking. In the case of unique assets like artwork or specific real estate properties, LayerZero’s ONFT Standard allows these assets to maintain their distinct characteristics, fungibility, and ownership records across various networks. This capability is essential for preserving the individuality and provenance of such assets while enabling their trade and management on a global scale. OFTs also give token issuers complete control over the security configuration and the end user the ability to self-custody assets if they so desire.

• Universal Applications: In general, LayerZero allows for applications that used to be siloed in one bank or blockchain to live everywhere — and to interoperate everywhere. Anything built on-chain can be built via LayerZero and experience finance without borders. Imagine a platform where investors worldwide can buy and sell tokenized shares of real estate properties. LayerZero can facilitate cross-chain transactions required for such a platform, enabling investors on public chains like Ethereum and/or private permissioned chains to participate seamlessly in purchasing, selling, or interacting with those tokenized assets. LayerZero could also create a secondary market for private equity, where shares in private companies are tokenized as OFTs. These tokens could then be easily traded across different blockchains (public or private, depending on the bank’s needs), increasing liquidity and potentially providing a way for a wider range of investors to purchase equity. For unique assets like art, ONFTs on LayerZero can ensure that each piece’s authenticity and ownership history are preserved across blockchains — there is no need for manual tracking of ownership or rights when everything can be queried on every chain via LayerZero. This could open up new avenues for alternative asset investments, allowing investors to trade assets in a decentralized, secure manner.

• Scalable Liquidity, Access & Distribution: LayerZero’s OFTs can transform traditionally illiquid assets into more liquid forms if every alternative is tokenized. By tokenizing assets like private equity or real estate on multiple blockchains, they become more accessible to a broader range of investors, including those whom high entry barriers or platform-specific limitations might have previously barred. This increased liquidity not only opens up new investment opportunities but also enhances the overall market efficiency.

• Automating Compliance and Reporting Truth with Smart Contracts: The OApp smart contract interface can help businesses automate complex data querying of on-chain compliance, reporting, and historical outputs across chains. For instance, OApp smart contracts could be programmed to automatically perform verifiable credentials checks or generate conditional or deterministic functionality across all, or a subset of chains, applications, wallets in a single batch call, thus streamlining these typically labor-intensive processes into a single transaction for the user. This automation reduces the administrative burden on institutions and provides on-chain truth, ensuring compliance while allowing them to focus on strategic activities.

• Programmable Investment Vehicles: Smart contracts allow for the creation of tailored investment products. For example, a real estate investment vehicle can be configured to adapt to changing market conditions or investor preferences, offering dynamic investment strategies that are not feasible in traditional setups. Additionally, the tokenization of these assets paves the way for new collateralization models, where investors can use their tokenized assets as collateral for loans, further integrating alternative investments into the broader financial markets. As LayerZero offers a universal smart contract experience, every type of programmable investment vehicle can be immediately distributed, accessed, and used in a multi-chain environment — meaning no silos, no accounting segmentation, etc.

Currently, LayerZero supports 50 networks, spanning EVM, non-EVM, and private blockchains. Over 90 million messages and over $50 billion in assets have been moved through the protocol across roughly 30,000 deployed smart contracts. Anything that can be built on a single chain can be extended through LayerZero to also exist across others without compromising on security choices or semantics. LayerZero is the only institutional-grade interoperability protocol that a wealth manager should leverage when building out rails for the future of alternative investments.

Conclusion: Connecting Siloes

In alternatives, tokenization presents a new pathway to resolving longstanding, legacy inefficiencies, particularly in liquidity, accessibility, and operational complexity. In this context, LayerZero emerges as an end-game solution, offering a suite of functionalities uniquely tailored to address these challenges.

LayerZero’s value proposition is its unparalleled ability to unlock omnichain interoperability while enabling application owners to control 100% of their security. In the fragmented world of finance (traditional or native DeFi), where assets and data are often confined to their native databases, LayerZero acts as a unifying force. It provides a conduit for free-flowing, peer-to-peer communication across disparate networks, akin to the internet’s role in global connectivity. This is critical in creating a cohesive and fluid market for alternative assets, allowing for their issuance, trading, and management across diverse ecosystems. Such interoperability is vital in breaking down the barriers that have traditionally hampered the liquidity and distribution of these assets. With LayerZero, the alternatives industry gets a universal solution that will exist forever — which comes with standardization, liquidity depth, and interoperability. LayerZero promises a future where the boundaries between different blockchain networks are largely removed, creating a unified and efficient marketplace.

To wealth managers seeking to innovate and stay ahead in the rapidly evolving financial landscape, the adoption of LayerZero for the tokenization of alternative assets should present a very clear-cut opportunity. LayerZero directly addresses the challenges inherent in traditional alternative investment management (too many siloes) while also offering the benefits of blockchain development (tokenization, smart contract automation, etc). The ability to move assets and data freely across chains, coupled with standardized token formats and streamlined operations, positions LayerZero as a cornerstone technology in the tokenization process in general. Its ability to address the core challenges of interoperability, standardization, liquidity, and operational efficiency makes it an indispensable tool for institutions and investors across the globe to begin to tokenize not just alternative assets — but every type of asset that exists on any DLT or blockchain.