A look at the U.S. Treasury Department’s crypto asset and Treasury bond market report

Compiled by: Pzai, Foresight News

Cryptoasset growth and usage trends

Cryptoassets have experienced rapid growth despite a small base. Growth comes both from native cryptocurrencies such as Bitcoin and Ethereum and from stablecoins.

Total cryptocurrency market capitalization chart

To date, the adoption of cryptocurrencies by households and industries has been limited to holding crypto assets for investment purposes. Relative to other financial and physical assets, the market capitalization of crypto assets remains low, and growth to date does not seem to have cannibalized demand for treasuries. The use cases for crypto assets are evolving, but interest is mainly developing along two tracks: Bitcoin's main use seems to be to store value in the DeFi world, also known as "digital gold." Speculative interest appears to have played a prominent role in the growth of cryptocurrencies so far. The cryptoasset market is working to leverage blockchain and distributed ledger technology (DLT) to develop new applications and improve traditional financial market clearing and settlement infrastructure.

The size of crypto assets relative to other asset classes

Stablecoins

A stablecoin is a cryptocurrency that is designed to maintain a stable value, typically by tying the value of the currency to an underlying pool of collateral. In recent years, as the cryptoasset market has matured, its use has grown rapidly, including increased demand for cryptoassets with stable cash-like characteristics, and they have been attractive collateral for lending on DeFi networks. While there are different types of stablecoins, fiat-backed stablecoins have grown the most. The cryptoasset market now has more than 80% of cryptocurrency transactions involving stablecoins.

The most popular stablecoins in the market today are fiat-backed stablecoins, with a large portion of this collateral taking the form of Treasury bonds and Treasury-backed repo transactions. We estimate that a total of $120 billion of stablecoin collateral is invested directly in Treasury bonds. In the short term, we expect the size of the stablecoin market, as well as the overall size of the digital asset market, to continue to grow, and medium-term regulatory and policy choices will determine the fate of this "private currency". History has shown that "private currencies" that do not meet national quality assurance requirements can lead to financial instability and are therefore highly undesirable.

Demand Analysis

In recent years, the prices of native crypto assets such as Bitcoin have risen sharply, but volatility remains high. Since 2017, Bitcoin has experienced four major price adjustments. To date, the digital asset market has limited access to traditional safe-haven or risk hedging tools such as Treasury bonds. In recent years, institutional support for Bitcoin (such as BlackRock ETF, MicroStrategy) has continued to grow, and crypto assets have behaved like "high volatility" assets. As the market value of digital assets grows, the structural demand for Treasury bonds may increase and exist as both 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 digitally representing rights in the form of tokens on programmable platforms such as distributed ledgers/blockchains. Tokenization has the potential to release the advantages of programmable, interoperable ledgers to a wider range of traditional financial assets. The main features and advantages of tokenization are:

• Core Service Layer: Tokenized assets integrate a “core layer” containing asset and ownership information with a “service layer” that manages transfer and settlement rules.

• Smart Contracts: Tokenization makes automation possible, through smart contracts that automatically execute transactions and allow the transfer of assets and claims when predefined conditions are met.

• Atomic Settlement: Tokenization simplifies settlement by ensuring that all parts of a transaction are carried out simultaneously between all relevant parties, thereby simplifying settlement, reducing the risk of settlement failure, and improving the reliability of settlement.

• Composability: Different tokenized assets can be bundled together to create more complex and novel financial products, providing highly customizable solutions for asset management and transfer.

• Fractional Ownership: Tokenized assets can be divided into smaller, more accessible parts.

The benefits of tokenization extend far beyond and are independent of native crypto assets such as Bitcoin and the public, permissionless blockchain technology that these assets popularize

Some markets, such as international payments or repo, will see immediate and large potential benefits from tokenization, while the gains in other markets will be incremental. However, to realize this potential, a unified ledger is needed, or at least a set of highly interoperable, integrated ledgers that work together seamlessly. These ledgers also need to be developed with the support of central banks and the trust they provide.

Treasury Tokenization

The tokenization of U.S. Treasuries is a relatively new trend, and most projects have yet to scale; some notable public and private initiatives underway are as follows:

• Tokenized Treasury Funds: Give investors access to Treasury bonds in a "tokenized" form on the blockchain. Its behavior is similar to a Treasury ETF or government MMF in many ways.

• Tokenized Treasury Repo Programs: Tokenized Treasury bonds allow for instant, 24/7 settlement and trading, potentially paving the way for more timely intraday repo transactions.

• Ongoing Pilots by DTCC and Others: Several private and public market participants are conducting pilots to use tokenization to streamline payments and securities settlement.

The main potential benefits of Treasury tokenization are:

• Improvements in Clearing and Settlement: Tokenized Treasury bonds allow for more streamlined “atomic settlements,” where all parts of a transaction involving Treasury bonds are settled simultaneously among all parties, reducing the risk of settlement failures

• Improved Collateral Management: Smart contracts programmed directly into tokenized treasuries enable more efficient collateral management, including pre-programmed collateral transfers when preset conditions are met.

• Increased transparency and accountability: An immutable ledger could increase transparency into the workings of the Treasury market, 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 could 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 inclusion and demand: Tokenization could make Treasuries more accessible to a wider range of investors, including small retail investors and those in emerging markets.

• Increased liquidity: Tokenization could potentially create new investment and trading strategies through seamless integration and programmable logic, and tokenized Treasuries could be traded 24/7 on blockchain networks.

While tokenization of U.S. Treasuries has potential benefits, design choices may present certain risks and challenges that require careful consideration

• Technical Risks: Tokenized infrastructure will be difficult to develop in parallel in a cost-effective manner and is unlikely to be as efficient as traditional markets (“incumbent advantage”) until it reaches sufficient scale (“incumbent advantage”). It is unclear whether DLT platforms have convincing technical advantages over traditional systems, and transition costs may also be high given the smaller size of traditional markets.

• Cybersecurity Threats: Certain types of DLT solutions (public, permissionless blockchains) are vulnerable to hacking and other cybersecurity attacks, which may pose a risk to the security of tokenized Treasuries

• Operational Risk:

• Counterparty Risk: Investors may be exposed to counterparty risk, which is the risk that the issuer or custodian of the tokenized security may default.

• Custody Risk: Ensuring the safekeeping of tokenized Treasuries requires strong custodial solutions, which may include challenges associated with digital asset custody.

• Privacy issues: Some participants will view the increased transparency of public blockchains as a disadvantage

• Regulatory and legal uncertainty:

• Evolving regulations: Legal requirements/compliance obligations regarding tokenized assets remain unclear

• Jurisdictional challenges: Regulatory frameworks vary across jurisdictions, which can complicate cross-border transactions and create complex legal issues.

Financial stability and market risks if the tokenized market grows significantly:

• Contagion risks

• Complexity and interconnectedness

• Banking/payment disintermediation

• Basic risks

• 24/7 trading: May make it more vulnerable to market manipulation and higher volatility

Financial stability risks arising from significant future expansion of the tokenized market

• Contagion and linkage risks:

• Tokenization provides a bridge, and as tokenized assets grow in size, volatility in “on-chain” assets may spread to broader financial markets

• Seamless ledgers can become a negative factor in times of stress, as deleveraging and hot sales can quickly spread to all assets

• Liquidity and maturity mismatch risks:

• There may be liquidity and maturity mismatches between non-native tokens and underlying assets, which can trigger price volatility caused by potential deleveraging; similar to ETFs, MMFs and Treasury futures

• Smart contract-driven automatic margin liquidations may cause liquidity pressures while also needing to meet fast settlement objectives

• Increased leverage:

• Tokenization can directly increase the leverage of the financial system. For example, the underlying assets of a token can be rehypothecated, or the tokens themselves can be designed as derivatives

• Tokenization has the potential to create securities from illiquid or physical assets that can be used as collateral

• Increased Complexity and Opacity

• Tokenization leads to greater 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 can quickly trigger unnecessary financial transactions, causing unintended consequences

• Disintermediation of the Banking Industry

• Tokenized short-term Treasury bills may prove to be an attractive alternative to bank deposits and have the potential to disrupt the banking system, negatively affecting core businesses.

• Stablecoin Operational Risks:

• Even with better collateral support, stablecoins are unlikely to meet the NQA principles required to support tokenization

• Stablecoin runs have been common in recent years, and the collapse of major stablecoins like Tether could lead to a sell-off in short-term Treasuries

Designing DLT/Blockchain for Tokenized Treasuries: Framework Elements

Establishing a framework that encourages trust and industry-wide recognition is necessary for the expansion of digital assets and distributed ledger technology, as fraud, scams, and theft have grown in tandem with the growth of digital asset markets, undermining trust in the underlying technology.

To date, most major crypto projects have been developed on public and permissionless blockchains. This is considered one of the main attractions of blockchain.

We believe that this architecture is not suitable for wider adoption of tokenized treasuries:

• Technology Choice: Public, permissionless blockchains use complex consensus mechanisms (such as proof of work, proof of stake), making it difficult to process large numbers of transactions efficiently.

• Operational vulnerabilities: These blockchains rely on decentralized nodes and have no centralized authority, which leads to vulnerabilities

• Governance vulnerabilities: Public blockchains lack a clear governance structure, which increases the risk of system failure or attackers exploiting vulnerabilities in the blockchain.

• Security risks: The decentralized nature and lack of review of public blockchains increase the risk of vulnerability exploits and attacks. This can be seen in the historical cases of Bitcoin and Ethereum vulnerabilities being exploited.

• Money laundering and compliance issues: Public, permissionless blockchains allow for anonymity, which may facilitate illegal activities such as money laundering and sanctions evasion, and circumvent sanctions.

Tokenization of the treasury market may require the development of a blockchain governed by a single or multiple trusted private or public institutions.

Regulatory elements

Regulatory efforts for digital assets and cryptocurrencies have increased globally in recent years, but remain highly fragmented and porous

United States: Regulation in the United States remains fragmented, with oversight authority spread across multiple agencies such as the SEC, CFTC, and FinCEN

Ensuring the Responsible Development of Digital Assets (2022): An executive order signed in 2022 outlines a government-wide strategy to address the opportunities and risks of digital assets. The order calls for the development of a regulatory framework for digital assets - the 21st Century Financial Innovation and Technology Act (FIT21) passed by the House of Representatives in 2024, which will be the most significant and comprehensive effort to regulate digital assets, stablecoins, and cryptocurrencies.

EU: The Crypto-Assets Market Regulation Act (MiCA) will come into effect in 2024. MiCA is the EU's first comprehensive regulatory framework for cryptocurrencies and digital assets. It sets rules for issuing crypto assets, stablecoins and utility tokens, and regulates service providers such as exchanges and custodians. Focus on consumer forecasting, stablecoin supervision, anti-money laundering measures and environmental impact transparency. Licensed entities under MiCA can operate a "passport" model across the EU, enabling them to provide services to all member states under a unified framework.

Impact on Treasury Markets

Assuming the current trend in stablecoin collateral selection continues (or is forced by regulators), the continued growth of stablecoins will create structural demand for short-term U.S. Treasuries. Although stablecoins currently represent a marginal part of the Treasury market, over time, the Treasury market may face greater risk of selling due to runs in the stablecoin market. Different redemption and settlement characteristics could lead to liquidity and maturity mismatches between tokens and underlying assets, which in turn could exacerbate financial instability in Treasury markets.

• Tokenized “derivative” Treasury products could create an underlying market between digital and local (such as futures or total return trading) - which would both create additional demand and lead to increased volatility during deleveraging.

• During periods of increased downside volatility, the growth and institutionalization of cryptocurrency markets (Bitcoin) could create additional hedging and quality demand for tokenized Treasuries. Demand for quality may be difficult to predict. Hedging demand may be structural but depends on how well Treasuries continue to hedge against downside cryptocurrency volatility.

• Tokenization could create greater access to Treasuries for domestic and global savings pools (particularly households and small financial institutions), which could lead to increased demand for Treasuries.

• Tokenization can improve liquidity in Treasury trading by reducing operational and settlement frictions.

Conclusion

• Although the overall market for digital assets is still small compared to traditional financial assets such as stocks or bonds, interest in digital assets has grown substantially over the past decade.

• To date, the growth of digital assets has created negligible incremental demand for short-term Treasury bonds, which has been generated primarily through the use and popularity of stablecoins.

• Institutional adoption of "high-volatility" Bitcoin and cryptocurrencies may lead to increased hedging demand for short-term Treasury bonds in the future.

• The development of DLT and blockchain holds promise for new financial market infrastructures, with a “unified ledger” that will improve operational and economic efficiency

• There are a number of ongoing projects and pilots in both the private and public sectors to leverage blockchain technology in traditional financial markets, notably DTCC and the Bank for International Settlements (BIS).

• Central banks and tokenized dollars (CBDCs) may be required to play a key role in future tokenized payment and settlement infrastructures.

• The legal and regulatory environment needs to evolve with advances in tokenization of traditional assets. Operational, legal, and technical risks need to be carefully considered when making design choices around technical infrastructure and tokenization.

• Research projects should include the design, nature, and concerns of treasury tokenization, the introduction of sovereign CBDCs, and the technology and technical risks.

• Currently, financial stability risks remain low due to the relatively small size of the tokenized asset market; however, financial stability risks will increase due to strong growth in the tokenized asset market.

• The way forward should include a cautious approach led by a trusted central authority with broad support from private sector participants.