(Kitco News) – For years, governments and financial analysts have warned that digital assets could eventually pose a threat to the established financial order, but in an interesting turn of events, a recent report from the U.S. Treasury suggests that stablecoins are actually helping to increase demand for short-term government securities.
On Wednesday, the U.S. Department of Treasury discussed the implications of stablecoins and the potential for tokenization of US Treasury bonds, and a report was produced outlining their observations and recommendations.
“Digital assets have witnessed rapid growth albeit from a small base. Growth has come both from native crypto coins like Bitcoin and Ethereum, as well as stablecoins,” the report said. “To date, household and industry adoption of cryptocurrency has been limited to holding digital assets for investment purposes.”
The “Digital asset market cap remains low relative to other financial and real assets, and growth thus far does not seem to have cannibalized demand for Treasuries,” it added. “The use case of digital assets continues to evolve, but interest has proceeded along two main tracks. [The] primary use case for Bitcoin seems to be a store of value aka ‘digital gold’ in a decentralized finance (DeFi) world; speculative interest seems to have played a prominent role in the growth of digital tokens thus far.”
The second track includes “Efforts to leverage blockchain and distributed ledger technology (DLT) to develop new applications and improve the legacy financial market clearing and settlement infrastructure.”
From there, the report discussed stablecoins and how they impact financial markets.
“Stablecoins are a type of cryptocurrency that are designed to maintain a stable value, typically by linking the value of the currency to an underlying pool of collateral,” it explained. “Use has grown rapidly in recent years as the digital asset market matures, including increased demand for crypto assets with stable cash-like characteristics.”
“Stablecoins have also gained popularity as they have been attractive collateral to lend on DeFi networks,” the report added. “While there are different types of stablecoins, fiat-backed ones have shown the most significant growth. Stablecoins play an integral role in intermediating transactions in digital asset markets – over 80% of all crypto transactions now use a stablecoin as one leg of the transaction.”
As for their effect on markets outside of cryptocurrency, the report highlighted that the “Growth in stablecoins has resulted in a modest increase in demand for short-dated Treasuries.”
“The most prevalent stablecoins in the market today are fiat-backed stablecoins,” the authors wrote. “A very significant portion of that collateral is taking the form of T-bills and Treasury-backed repo transactions. We estimate that $120bn in total stablecoin collateral is directly invested in Treasuries.”
“Over the near term, we expect continued growth in stablecoin markets along with the overall size of the digital asset market,” they said. “Medium-term regulatory and policy choices will determine the fate of this ‘private currency.’ History shows that ‘private currency’ that does not meet NQA requirements leads to financial instability and, as such, is highly undesirable.”
The Treasury said, "Rapid growth and massive volatility might lead to future hedging needs and flight-to-quality demand for Treasuries.”
“Native crypto assets like Bitcoin have seen significant price increases in recent years, but volatility remains very high. Bitcoin has experienced four large price corrections since 2017,” the report said. “To date, digital asset markets have limited access to traditional safe-haven or risk-hedging instruments like Treasuries. In recent years, institutional sponsorship of Bitcoin (BlackRock ETF, MicroStrategy) has been growing and crypto assets have behaved like ‘high beta’ assets.”
Because of the high volatility, the report suggested that “Structural demand for Treasuries may increase as the digital asset market cap grows, both as a hedge against downside price volatility and as an ‘on-chain’ safe-haven asset.”
This led to a discussion about the growing tokenization movement that is bringing real-world assets (RWA) on-chain.
“The benefits of tokenization extend far beyond and are independent of native crypto assets like Bitcoin as well as the public, permissionless blockchain technology those assets have popularized. Tokenization of a variety of financial and real-world assets across interoperable ledger systems promises to unleash new economic arrangements and enhance efficiencies,” the report said. “Some markets – like international payments or repo – stand to gain immediate and large potential benefits from tokenization, while the gains for other markets will be more incremental.”
The report noted that “The Treasury market is already highly efficient, so gains from tokenization are likely to be incremental” before saying that “even small incremental improvements in a very large market like the Treasuries market can be impactful at scale.”
“To fulfill this potential, though, there is a need for a unified ledger, or at least a highly interoperable set of integrated ledgers that work together seamlessly,” the authors said. “Legacy systems are built from individually maintained ledgers that are often ‘siloed,’ with a need for complex messaging protocols between the institutions maintaining these ledgers. This creates significant inefficiencies and settlement fail risk for a variety of transactions, for which tokenization on a unified ledger could help streamline.”
In order to reach the full potential of tokenization, the report said it “requires some monetary unit of account that denominates transactions, accompanies the means of payment, and is accepted without question by market participants.”
“In a similar manner to how privately-issued ‘wildcat’ currencies were replaced by government-backed central currencies in the late-1800s, Central Bank Digital Currencies (CBDC) will likely need to replace stablecoins as the primary form of digital currency underpinning tokenized transactions,” the authors wrote.
The pivot by the Treasury highlights the mantra that the established financial order has said for years regarding the growing digital asset industry: blockchain, not Bitcoin.
“The tokenization of U.S. Treasuries is a relatively new trend, and most projects have yet to scale; some of the notable public and private initiatives underway” include “tokenized Treasury funds, tokenized Treasury repo projects, and ongoing pilot projects from DTCC and others.”
According to the report, the benefits of tokenization include “improvements in clearing and settlement, improved collateral management, composability and innovation, increased inclusion and demand, and increased liquidity.
“Tokenization of the Treasury market holds promise but needs further study; caution is warranted as the Treasury market is already highly liquid and efficient,” the report said. “Although the tokenization of U.S. Treasuries has potential benefits, design choices can present certain risks and challenges that need to be carefully considered.”
“Continued growth in stablecoins, assuming the current trend in stablecoin collateral choices continues (or is forced by a regulator), will create structural demand for short-dated U.S. Treasuries,” the report said. “Recommended issuance should on the margin lean to a higher proportion of T-bills.”
“While stablecoins currently represent a marginal segment of the T-bills market, growth over time may expose the T-bills market to increased risk of fire sales due to runs in the stablecoin market,” it warned. “Different redemption and settlement characteristics can lead to liquidity and maturity mismatches between tokens and the underlying assets, which in turn can create potential for heightened financial instability in the Treasury market.”
The Treasury noted that “Tokenized ‘derivative’ Treasury products could create a basis market between digital and native markets (like futures or total return swaps),” which can “both create additional demand and lead to heightened volatility during deleveraging episodes.”
“Growth in, and institutionalization of, crypto markets (Bitcoin) could create additional hedging and flight-to-quality demand for tokenized Treasuries in periods of heightened downside volatility,” they added, before highlighting that “Flight-to-quality demand can be hard to predict.”
“Hedging demand could be structural, but depends on how well Treasuries continue to hedge downside crypto-volatility,” the report said. “Tokenization might create additional access to Treasuries from both domestic and global pools of savings, particularly from households and smaller financial institutions, which can lead to incremental demand for U.S. Treasuries. Tokenization can potentially improve liquidity in the trading of Treasuries by reducing operational and settlement frictions.”
Putting all the analysis together, the report said that while “the overall market for digital assets remains quite small in comparison to traditional financial assets like equities or bonds, interest has grown substantially over the past decade.”
“To date, growth in digital assets has created marginal incremental demand for short-dated Treasuries,” the authors reiterated. “This has so far come primarily through increased use and prevalence of stablecoins.”
“Institutional adoption of ‘high-beta’ bitcoin and crypto might lead to increased future hedging demand for Treasuries,” they added. “Advances in DLT and blockchain offer the promise of a new financial market infrastructure with ‘unified ledgers’ leading to enhanced operational and economic efficiencies.”
To accommodate the growing demand, the Treasury said the “Legal and regulatory landscape will need to evolve alongside advances in tokenization of legacy assets. Operational, legal, and technology risks need to be considered carefully in making design choices around the technology infrastructure and tokenization.”
They recommended that “Projects of study should include the design, nature, and concerns around Treasury tokenization, [the] introduction of sovereign CBDCs, technology and financial architecture choices, and financial stability considerations.”
“Currently, financial stability risks remain low given the relatively small size of the tokenized asset market; however, strong growth in tokenized assets could lead to a myriad of financial instability risks,” the report concluded. “The way forward should involve a cautious approach spearheaded by a trusted central authority, with widespread buy-in from private sector participants.”
