Compiled by: Pzai, Foresight News
Trends in the growth and usage of crypto assets
Despite a small base, crypto assets have still experienced rapid growth. The growth comes from both native cryptocurrencies like Bitcoin and Ethereum, as well as stablecoins.
Cryptocurrency Total Market Capitalization Chart
So far, household and industry adoption of cryptocurrencies has been limited to holding crypto assets for investment purposes, with the market capitalization of crypto assets still relatively low compared to other financial and physical assets. The growth so far does not seem to have eroded demand for Treasuries. The use cases for crypto assets are evolving, but interest appears to be developing mainly along two tracks: the primary use of Bitcoin seems to be storing value in the DeFi world, also known as 'digital gold.' So far, speculative interest has played a prominent role in the growth of cryptocurrencies. The crypto asset market is striving to leverage blockchain and distributed ledger technology (DLT) to develop new applications and improve traditional financial market clearing and settlement infrastructure.
The scale of crypto assets relative to other asset classes
Stablecoins
Stablecoins are a type of cryptocurrency designed to maintain stable value, typically by linking the value of the currency to a pool of underlying collateral. In recent years, with the maturation of the crypto asset market, their usage has grown rapidly, including increased demand for crypto assets with stable cash-like characteristics, and they have been attractive collateral for lending in DeFi networks. While there are different types of stablecoins, those backed by fiat currencies have seen the most significant growth. Currently, over 80% of crypto trading in the crypto asset market involves stablecoins.
The most popular stablecoins in today's market are fiat-backed stablecoins, a significant portion of which use Treasuries and Treasury-supported repo transactions as collateral. We estimate that a total of $120 billion in stablecoin collateral is directly invested in Treasuries. In the short term, we expect the stablecoin market and the overall size of the digital asset market to continue to grow, while in the medium term, regulatory and policy choices will determine the fate of this 'private currency.' History shows that 'private currencies' that do not meet national quality assurance standards lead to financial instability and are therefore highly undesirable.
Demand analysis
In recent years, the prices of native crypto assets like Bitcoin have surged significantly, but volatility remains high. Since 2017, Bitcoin has experienced four major price adjustments. So far, access to traditional safe-haven or hedging instruments like Treasuries has been limited in the digital asset market. In recent years, institutional support for Bitcoin (such as BlackRock ETF, MicroStrategy) has been growing, while the performance of crypto assets behaves like 'high volatility' assets. As the market capitalization of digital assets grows, structural demand for Treasuries may increase, existing simultaneously as a hedging tool and an on-chain safe-haven asset.
Tokenization
Similarities between the digital asset ecosystem and traditional financial markets
Tokenization is the process of digitizing rights in the form of tokens on programmable platforms like distributed ledgers/blockchains, with the potential to unleash the advantages of programmable, interoperable ledgers on a broader array of traditional financial assets. The main features and advantages of tokenization include:
Core service layer: Tokenized assets will integrate a 'core layer' containing asset and ownership information with a 'service layer' managing transfer and settlement rules.
Smart contracts: Tokenization enables automation by automatically executing transactions through smart contracts when predefined conditions are met, allowing for the transfer of assets and claims.
Atomic settlement: Tokenization can simplify settlement to ensure all parts of a transaction involving Treasuries occur simultaneously among all relevant parties, thereby streamlining settlement, reducing the risk of settlement failure, and increasing reliability.
Composability: Different tokenized assets can be bundled together to create more complex, innovative financial products, providing highly customizable solutions for asset management and transfer.
Fractional ownership: Tokenized assets can be divided into smaller, more accessible portions.
The benefits of tokenization extend far beyond and are independent of native crypto assets like Bitcoin and the public, permissionless blockchain technology these assets have popularized.
Some markets (such as international payments or repos) will gain direct and significant potential benefits from tokenization, while other markets' gains will be incremental. However, realizing this potential requires a unified ledger, or at least a set of highly interoperable, seamlessly cooperating integrated ledgers. These ledgers also need to be developed with the support and trust foundation provided by central banks.
Treasury tokenization
The tokenization of U.S. Treasuries is a relatively new trend, and most projects have yet to scale. Some notable ongoing public and private initiatives include:
Tokenized Treasury Funds: Allow investors to obtain 'tokenized' forms of Treasuries on the blockchain. Their behavior is similar in many ways to Treasury ETFs or government MMFs.
Tokenized Treasury Repo Projects: Tokenized Treasuries allow for instant, 24/7 settlement and trading, potentially paving the way for more timely intraday repo transactions.
Ongoing pilot projects by DTCC and other institutions: Some private and public market participants are conducting pilots using tokenization to simplify payments and securities settlement.
The main potential advantages of Treasury tokenization include:
Improvements in clearing and settlement: Tokenized Treasuries allow for more streamlined 'atomic settlement,' meaning all parts of transactions involving Treasuries settle simultaneously among all parties, reducing the risk of settlement failure.
Improved collateral management: Smart contracts directly programmed into tokenized Treasuries can enable more efficient collateral management, including pre-programmed collateral transfers when preset conditions are met.
Increased transparency and accountability: Immutable ledgers can enhance the transparency of Treasury market operations, reduce opacity, and provide regulators, issuers, and investors with more real-time insights into trading activity.
Composability and innovation: The ability to bundle different tokenized assets may lead to the creation of new and highly customizable financial products and services based on U.S. Treasuries, such as derivatives and structured products.
Increased inclusivity and demand: Tokenization can make Treasuries more accessible to a broader range of investors, including small retail investors and investors in emerging markets.
Increased liquidity: Tokenization may create new investment and trading strategies through seamless integration and programmable logic, and tokenized Treasuries can be traded 24/7 on blockchain networks.
Although the tokenization of U.S. Treasuries has potential benefits, design choices may pose certain risks and challenges that need careful consideration.
Technological risks: Tokenization infrastructure is difficult to develop in a cost-effective parallel manner, and is unlikely to be as efficient as traditional markets until sufficient scale ('first mover advantage') is achieved. It is also unclear whether DLT platforms provide compelling technological advantages compared to traditional systems, and given the smaller scale of traditional markets, transition costs may also be high.
Cybersecurity threats: Certain types of DLT solutions (public, permissionless blockchains) are vulnerable to hacking and other cybersecurity attacks, posing risks to the security of tokenized Treasuries.
Operational risk:
Counterparty risk: Investors may face counterparty risk, meaning the issuer or custodian of tokenized securities may default.
Custodial risk: Ensuring the secure custody of tokenized Treasuries requires strong custodial solutions, which may include challenges associated with digital asset custody.
Privacy concerns: Some participants may view the increased transparency of public blockchains as a disadvantage.
Regulatory and legal uncertainty:
Evolving regulations: Legal requirements/compliance obligations for tokenized assets remain unclear.
Jurisdictional challenges: Different regulatory frameworks across jurisdictions may complicate cross-border transactions and create complex legal issues.
If the tokenization market grows significantly, it will bring financial stability and market risk:
Contagion risk
Complexity and interconnectedness
Banking/payment disintermediation
Basis risk
All-day trading: May make it easier to be influenced by market manipulation and higher volatility.
Financial stability risks arising from the significant expansion of the future tokenization market.
Contagion and interconnected risk:
Tokenization provides a bridge, as the scale of tokenized assets grows, the volatility of 'on-chain' assets may spill over into broader financial markets.
During periods of stress, seamless ledgers may become negative factors, as deleveraging and fire sales can rapidly spread to all assets.
Liquidity and maturity mismatch risk:
There may be liquidity and maturity mismatches between non-native tokens and underlying assets, which can trigger potential price volatility caused by deleveraging; similar to ETFs, MMFs, and Treasury futures.
Smart contract-driven automatic margin clearing may lead to liquidity pressures while also needing to meet rapid settlement objectives.
Increased leverage:
Tokenization can directly increase leverage in the financial system. For example, the underlying assets of tokens can be re-collateralized, or the tokens themselves can be designed as derivatives.
Tokenization has the potential to create marketable securities that can be used as collateral from illiquid or physical assets.
Increased complexity and opacity:
Tokenization leads to more composability, and the addition of new non-traditional assets to the digital financial ecosystem may significantly increase the complexity and opacity of the financial system.
Poorly coded smart contracts may trigger unnecessary financial transactions rapidly, leading to unintended consequences.
Banking disintermediation:
Short-term tokenized Treasuries may prove to be an attractive alternative to bank deposits, with the potential to disrupt the banking system and negatively impact core business.
Risks of stablecoin operations:
Even with better collateral support, stablecoins are unlikely to meet the NQA principles required for tokenization.
Runs on stablecoins have become increasingly common in recent years, and the collapse of major stablecoins like Tether could lead to sell-offs of short-term Treasuries.
Designing DLT/blockchain for tokenized Treasuries: Framework elements
Establishing a framework that encourages trust and broad industry recognition is necessary for the expansion of digital assets and distributed ledger technology, as fraud, scams, and theft have increased alongside the growth of the digital asset market, undermining trust in the underlying technology.
So far, most major crypto projects have been developed on public and permissionless blockchains. This is considered one of the main attractions of blockchain.
We believe this architecture is not suitable for the broader adoption of tokenized Treasuries:
Technical choices: Public, permissionless blockchains use complex consensus mechanisms (like proof of work, proof of stake), making it difficult to process large volumes of transactions efficiently.
Operational vulnerabilities: These blockchains rely on decentralized nodes without centralized authority, resulting in vulnerabilities.
Governance gaps: Public blockchains lack clear governance structures, increasing the risk of system failures or exploitation of blockchain vulnerabilities by attackers.
Security risks: The decentralized nature of public blockchains and lack of scrutiny increase the risks of exploitation and attacks. Historical cases of vulnerabilities in Bitcoin and Ethereum illustrate this.
Money laundering and compliance issues: Public, permissionless blockchains allow for anonymity, which may facilitate illegal activities such as money laundering and evading sanctions.
The tokenization of the Treasury market may require the development of a blockchain managed by a single or multiple trusted private or public institutions.
Regulatory elements
In recent years, there has been increased regulatory scrutiny of digital assets and cryptocurrencies globally, but it remains highly fragmented and riddled with loopholes.
United States: Regulation in the U.S. remains fragmented, with regulatory authority dispersed among multiple agencies including the SEC, CFTC, and FinCEN.
Ensuring the responsible development of digital assets (2022): An executive order signed in 2022 outlined a strategy for addressing the opportunities and risks of digital assets across government. The order calls for the establishment of a regulatory framework for digital assets — the 21st Century Financial Innovation and Technology Act (FIT21), which will be the most significant and comprehensive effort to regulate digital assets, stablecoins, and cryptocurrencies.
European Union: The Markets in Crypto-Assets Regulation (MiCA) will come into effect in 2024. MiCA is the EU's first comprehensive regulatory framework for cryptocurrencies and digital assets, establishing rules for the issuance of crypto assets, stablecoins, and utility tokens, and regulating service providers such as exchanges and custodians. The focus is on consumer protection, stablecoin oversight, anti-money laundering measures, and environmental impact transparency. Licensed entities under MiCA can operate across the EU in a 'passport' model, enabling them to serve all member states under a unified framework.
Impact on the Treasury market
Assuming the current trend in stablecoin collateral selection continues (or is mandated by regulators), the ongoing growth of stablecoins will create structural demand for short-term U.S. Treasury securities. Although stablecoins currently represent a marginal part of the Treasury market, over time, due to the runs on stablecoins, the Treasury market may face greater sell-off risks. Different redemption and settlement characteristics may lead to mismatches in liquidity and duration between tokens and the underlying assets, which could further exacerbate financial instability in the Treasury market.
Tokenized 'derivative' Treasury products can create a foundational market (such as futures or total return swaps) between digital and local — this will both create additional demand and lead to increased volatility during deleveraging periods.
During periods of heightened downside volatility, the growth and institutionalization of the cryptocurrency market (Bitcoin) may create additional hedging and quality demand for tokenized Treasuries. The demand for quality may be difficult to predict. Hedging demand may be structural but depends on how U.S. Treasuries continue to hedge cryptocurrency downside volatility.
Tokenization could create more opportunities for domestic and global pools of savings (especially households and small financial institutions) to access Treasuries, potentially increasing demand for U.S. Treasuries.
Tokenization could enhance the liquidity of Treasury transactions by reducing operational and settlement friction.
Conclusion
Despite the overall market for digital assets remaining small compared to traditional financial assets like stocks or bonds, interest in digital assets has surged significantly over the past decade.
So far, the growth of digital assets has created negligible incremental demand for short-term Treasuries, primarily driven by the usage and popularity of stablecoins.
Institutional adoption of 'high-volatility' Bitcoin and cryptocurrencies may lead to increased hedging demand for short-term Treasuries in the future.
The development of DLT and blockchain has brought hope for new financial market infrastructure, and a 'Unified Ledger' will enhance operational and economic efficiency.
Both the private and public sectors have ongoing projects and pilots to leverage blockchain technology in traditional financial markets, particularly at DTCC and the Bank for International Settlements (BIS).
Central banks and tokenized dollars (CBDCs) may play a key role in future tokenized payment and settlement infrastructure.
The legal and regulatory environment needs to evolve alongside the progress in the tokenization of traditional assets. Careful consideration of operational, legal, and technological risks is needed when making design choices around technology infrastructure and tokenization.
Research projects should include the design, nature, and considerations of Treasury tokenization, the introduction of sovereign CBDCs, and technological and technical risks.
Currently, owing to the relatively small size of the tokenized asset market, financial stability risks remain low; however, due to the strong growth of the tokenized asset market, financial stability risks will increase.
The path forward should include a cautious approach led by a trusted central authority with broad support from private sector participants.
