Original title: Rethinking ownership, stablecoins, and tokenization (with Addison)
Original article by: @bridge__harris, @foundersfund member
Original translation: Luffy, Foresight News
Addison and I have recently been discussing the trends and core use cases of the convergence of traditional finance and cryptocurrencies. In this article, we will have a series of conversations around the US financial system and explore how cryptocurrencies fit into it from a fundamental perspective.
There is a view today that tokenization will solve many problems in the financial sector, which may or may not be true.
Stablecoins, like banks, create new money. The current trajectory of stablecoins raises important questions, such as how they fit into the traditional fractional reserve banking system, in which banks keep only a fraction of deposits as reserves and lend the rest, effectively creating new money.
1. Tokenization boom
The mainstream voice is to tokenize everything, from public market stocks to private market shares to US Treasury bonds. This is generally beneficial to the crypto space and the world as a whole. Thinking about the dynamics of the tokenization market from the basic principles, the following points are quite key:
How the current asset ownership system works;
How tokenization will change the system;
Why the initial use case of tokenization is necessary;
What is a “real dollar” and how new money is created.
Currently in the United States, large asset issuers (such as publicly traded stocks) grant custody of their securities to the Depository Trust Company (DTCC). DTCC then tracks ownership of the approximately 6,000 accounts that interact with it, and each of these accounts manages its own ledger to track end-user ownership. For private companies, the model is slightly different: companies like Carta simply manage ledgers for enterprises.
Both models are highly centralized bookkeeping methods. The DTCC model is like a nesting doll bookkeeping system, and individual investors may need to go through 1-4 different entities before they can access the actual ledger records of the DTCC. These entities may include the brokerage firm or bank where the investor opens an account, the brokers custodian or clearing company, and the DTCC itself. Although ordinary retail investors are not usually affected by this hierarchical structure, it brings a lot of due diligence work and legal risks to financial institutions. If the DTCC itself tokenizes assets, the reliance on these intermediary entities will be reduced because investors can more easily connect directly with the clearing house; but this is not the model proposed in the current discussion.
The current tokenization model is that one entity holds the underlying asset as a line item in the general ledger (e.g., as a subset of entries in the DTCC or Carta ledger), and then creates a new, tokenized form of the asset holding for on-chain use. This model is inherently inefficient because it introduces another entity that can capture value, create counterparty risk, and cause settlement/closeout delays. Introducing an additional entity breaks composability because it requires additional steps to “wrap and unwrap” the security in order to interact with other parts of traditional finance or decentralized finance, creating delays.
Perhaps a more ideal approach would be to put the DTCC or Carta ledger directly on-chain, making all assets natively “tokenized” and allowing all asset holders to enjoy the benefits of programmability.
A major argument in favor of tokenizing securities is global market access and 24/7 trading and settlement. If tokenization is the mechanism by which stocks are “delivered” to investors in emerging markets, this would undoubtedly be a step-change improvement over how the current system works and open up access to U.S. capital markets to billions of people. But it remains unclear whether blockchain tokenization is necessary as it is a regulatory issue. Whether tokenized assets will become an effective means of regulatory arbitrage in the long run, like stablecoins, remains to be seen. Similarly, a common bullish argument for on-chain stocks is perpetual contracts; however, the obstacles faced by perpetual contracts are all regulatory, not technical.
Stablecoins are similar in structure to tokenized stocks, but the market structure for stocks is much more complex (and highly regulated), involving a range of clearing houses, exchanges, and brokers. Tokenized stocks are fundamentally different from normal crypto assets, which are not backed by any asset, but are native tokens and are composable.
In order to achieve efficient on-chain markets, the entire traditional financial system would need to be replicated, an extremely complex and arduous task given the concentration of liquidity and existing network effects. Simply putting tokenized stocks on-chain is not a panacea, and ensuring they are liquid and can be combined with other parts of traditional finance requires a lot of deep thinking and supporting infrastructure. However, if the US Congress passes a law allowing companies to issue digital securities directly on-chain, many traditional financial entities will no longer be necessary. Tokenized stocks will also reduce the traditional listing compliance costs.
Currently, governments of emerging market countries have no incentive to legalize access to U.S. capital markets because they prefer to keep capital within their own economies; and for the United States, opening access would raise anti-money laundering issues.
2. Real Dollar and the Federal Reserve
A real dollar is an entry in the Fed’s ledger. Currently, there are about 4,500 entities (banks, credit unions, certain government agencies, etc.) that have access to these “real dollars” through the Fed’s master account. None of these entities are native crypto institutions, unless you count Lead Bank and Column Bank, which do serve crypto clients like Bridge. Entities with master accounts have access to Fedwire, an extremely cheap and near-instant payment network that can send wires 23 hours a day and settle almost instantly. Real dollars belong to the M0 category: the sum of all balances on the Fed’s main ledger. “Fake” dollars (“created” by private banks through lending) belong to the M1 category, which is about 6 times the size of M0.
The user experience of interacting with real dollars is actually pretty good: transfers cost only about 50 cents and settle instantly. Whenever you wire funds from your bank account, your bank interacts with Fedwire, which has near-perfect uptime, instant settlement, and low latency costs for transfers. But regulatory tail risks, anti-money laundering requirements, and fraud detection measures have led banks to place many restrictions on large payments.
Based on this structure, one disadvantage facing stablecoins is expanding access to these “real dollars” through an instant system without an intermediary that: 1) intercepts the underlying yield (as is the case with the two largest stablecoins); 2) restricts redemption privileges. Currently, stablecoin issuers work with banks, which in turn have master accounts at the Fed.
So, if stablecoin issuers obtain the Federal Reserve’s main account, it is like mastering the cheat code, which allows them to obtain 100% risk-free Treasury bond yields with: 1) no liquidity issues; 2) faster settlement times, why don’t they fight for it themselves?
Stablecoin issuers’ requests for master accounts will likely be rejected like Narrow Bank’s application (and crypto banks like Custodia have also been unable to obtain master accounts). However, Circle’s relationships with its partner banks may be close enough that a master account would not significantly improve its fund flow.
The Fed is reluctant to approve master account applications from stablecoin issuers because the U.S. dollar model is only compatible with a fractional reserve banking system: the entire economic system is based on banks only having to hold a few percentage points of reserves.
Essentially, it is the creation of new money through debt and loans. But if anyone can earn 100% or 90% interest rate without risk (without having to lend money for mortgage, business loan, etc.), then who would use regular banks? And if no one uses regular banks, there will be no deposits to make loans and create more money, and the economy will stagnate.
The two core principles cited by the Federal Reserve when considering the qualifications of master accounts include: 1) granting a master account to an institution must not introduce undue cyber risks; 2) it must not interfere with the implementation of the Federal Reserve’s monetary policy. For these reasons, at least in the current situation of stablecoin issuers, they are unlikely to obtain master accounts.
Stablecoin issuers can only gain master account access if they actually become a bank. The GENIUS Act would create bank-like regulations for issuers with a market cap of more than $10 billion. Essentially, the argument here is that since they will be subject to bank-like regulation anyway, they can operate more like a bank in the long run. However, under the GENIUS Act, stablecoin issuers are still unable to engage in fractional reserve banking-like operations due to the 1:1 reserve requirement.
So far, stablecoins have not disappeared due to regulation, because most stablecoins are issued overseas by Tether. The Fed is happy to see the dollar dominate the world in this way because it strengthens its position as a reserve currency. But if an entity like Circle (or even Narrow Bank) were to grow significantly in size and be used for deposit-type accounts on a large scale in the United States, the Fed and the Treasury might be concerned. This would cause funds to flow out of banks that run the fractional reserve model, which is how the Fed implements monetary policy.
This is essentially the problem that stablecoin banks will face: to make loans, you need a banking license. But if the stablecoin is not backed by real dollars, it is no longer a real stablecoin, which defeats the purpose. This is where the fractional reserve model breaks down. However, in theory, a stablecoin could be created and issued by a chartered bank that owns a master account and operates a fractional reserve model.
3. Banks, Private Credit and Stablecoins
The only benefit of being a bank is access to a master account at the Federal Reserve and insurance from the Federal Deposit Insurance Corporation (FDIC). These two features allow banks to assure depositors that their deposits are safe real dollars (backed by the US government), even if these deposits have actually been loaned out.
You don’t have to be a bank to make loans; private credit firms do that all the time. However, what distinguishes banks from private credit is that banks issue a “receipt” that is considered actual dollars, which is fungible with all receipts issued by other banks. The assets backing a bank’s receipt are completely illiquid; however, the receipt itself is completely liquid. This realization of transforming deposits into illiquid assets (loans) while maintaining the value of the deposits is at the heart of money creation.
In the private credit world, the value of your receipt is tied to the underlying loan. Therefore, no new money is created; you can’t actually spend your private credit receipt.
Lets use Aave as an example to explain the concepts similar to banks and private credit in the crypto space. Private credit: In the real world, you deposit USDC into Aave and receive aUSDC. aUSDC is not fully backed by USDC at all times, because part of the deposit has been loaned to users as collateral. Just like merchants will not accept private credit receipts, you cannot spend aUSDC.
However, if economic actors are willing to accept aUSDC in exactly the same way they accept USDC, then Aave is functionally equivalent to a bank, where aUSDC is what it tells depositors about the USD it owns, while at the same time all the backing assets (USDC) have been loaned out.
4. Do stablecoins create new currency?
If the above argument is applied to stablecoins, then stablecoins do functionally create “new money”. To further illustrate this point:
Lets say you buy a Treasury bond from the US government for $100. Now you have a Treasury bond that cant really be used as money, but you can sell it at a fluctuating market price. On the back end, the US government is using the money, and the Treasury bond is essentially a loan.
Now let’s say you send Circle $100, and Circle uses that money to buy Treasury bonds. The government is using that $100 — and so are you. You receive 100 USDC, which it can use anywhere.
In the first case, you have a Treasury bond that you can’t use directly. In the second case, Circle creates a representation of the Treasury bond that can be used in the same way as the U.S. dollar.
On a per-dollar basis, stablecoins have a relatively small “money supply” because most stablecoins are backed by short-term Treasury bills, which have interest rates that don’t fluctuate much. Banks have a much higher money supply per dollar because their liabilities are longer-term and their loans are riskier. When you redeem a Treasury bond, the money you get from the government is the money the government gets from selling another Treasury bond, and so on.
Ironically, in the cypherpunk values of cryptocurrency, every issuance of a stablecoin simply makes it cheaper for governments to borrow money and inflate: the demand for government bonds increases, which is actually government spending.
If stablecoins became large enough (for example, if Circle reached ~30% of M2. Currently, stablecoins account for 1% of M2), they could pose a threat to the U.S. economy. This is because for every dollar transferred from the banking system to stablecoins, the net money supply decreases (because banks “create” more money than stablecoin issuance creates), and the money supply has previously been the exclusive domain of the Federal Reserve. Stablecoins would also weaken the Fed’s power to implement monetary policy through the fractional reserve banking system. That said, the benefits of stablecoins on a global scale are unquestionable: they expand the dollar’s dominance, reinforce the dollar’s narrative as a reserve currency, make cross-border payments more efficient, and greatly help people outside the United States who need stable currencies.
When the supply of stablecoins reaches trillions of dollars, stablecoin issuers like Circle may be integrated into the U.S. economic system, and regulators will try to coordinate monetary policy needs with programmable currency needs. This involves the field of central bank digital currency (CBDC), which we will discuss later.
