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

Compiled by: Pzai, Foresight News

Trends in Crypto Asset Growth and Adoption

Although from a small base, crypto assets have experienced rapid growth. The growth has come from both native cryptocurrencies like Bitcoin and Ethereum, as well as stablecoins.

Chart of Total Crypto Market Capitalization

So far, household and industry adoption of cryptocurrencies has been limited to holding crypto assets for investment purposes, and the market capitalization of crypto assets remains low relative to other financial and real assets, and the growth so far does not appear to have eroded demand for government bonds. The use cases of crypto assets are evolving, but interest seems to be developing along two main tracks: the primary use case for Bitcoin appears to be as a store of value in the DeFi world, often referred to as "digital gold". Speculative interest appears to have played a prominent role in the growth of cryptocurrencies so far. The crypto asset market is working to leverage blockchain and distributed ledger technology (DLT) to develop new applications and improve traditional financial market clearing and settlement infrastructure.

Crypto Assets Relative to Other Asset Classes

Stablecoins

Stablecoins are a type of cryptocurrency designed to maintain a stable value, typically by linking the value of the currency to an underlying collateral pool. In recent years, as the crypto asset market has matured, their usage has grown rapidly, including increased demand for crypto assets with cash-like stable characteristics, and they have been an attractive collateral for lending on DeFi networks. While there are different types of stablecoins, fiat-backed stablecoins have seen the most significant growth. The crypto asset market now accounts for over 80% of cryptocurrency trading involving stablecoins.

The most popular stablecoins in today's market are fiat-backed stablecoins, a significant portion of whose collateral is in the form of government bonds and treasury-supported repurchase agreements. We estimate a total of $120 billion in stablecoin collateral directly invested in government bonds. In the near term, we expect the stablecoin market, as well as the overall digital asset market, to continue growing, while in the medium term, regulation and policy choices will determine the fate of these "private monies". History has shown that "private monies" 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 like Bitcoin have seen significant appreciation, but volatility remains high. Since 2017, Bitcoin has experienced four major price corrections. So far, the digital asset market has had limited access to traditional safe-haven or risk-hedging instruments like government bonds. In recent years, institutional support for Bitcoin (e.g. BlackRock ETF, MicroStrategy) has been growing, and the performance of crypto assets has been like "high-volatility" assets. As the market capitalization of digital assets grows, structural demand for government bonds may increase, serving both as a hedging instrument and as 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, and tokenization has the potential to unlock the advantages of programmable, interoperable ledgers to a wider range of traditional financial assets. The key features and benefits of tokenization include:

• Integrated Core and Service Layers: Tokenized assets will integrate the "core layer" containing the asset and ownership information with the "service layer" managing the transfer and settlement rules.
• Smart Contracts: Tokenization enables automation, with smart contracts automatically executing transactions upon predefined conditions being met, allowing for the transfer of assets and claims.
• Atomic Settlement: Tokenization can simplify settlement, ensuring all parts of a transaction occur simultaneously across all relevant parties, reducing settlement failures and improving settlement reliability.
• Composability: Different tokenized assets can be bundled together, creating 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 fractions.

The benefits of tokenization go far beyond and are independent of native crypto assets like Bitcoin and the public, permissionless blockchain technology that has proliferated these assets.

Some markets (e.g. international payments or repo) will see direct and significant potential benefits from tokenization, while others will see incremental gains. However, to realize this potential, a unified ledger, or at least a highly interoperable, seamlessly integrated set of ledgers, is required. These ledgers also need to be developed under the support and trust provided by central banks.

Tokenization of US Treasuries

The tokenization of US Treasuries is a relatively new trend, with most projects not yet at scale; some notable public and private initiatives underway include:

• Tokenized Treasury Funds: Allowing investors to gain "tokenized" exposure to US Treasuries on the blockchain. Their behavior is similar in many ways to Treasury ETFs or government MMFs.
• Tokenized Treasury Repo Projects: Tokenized Treasuries can enable instant, 24/7 settlement and trading, potentially paving the way for more timely intraday repo transactions.
• Pilots by DTCC and Other Institutions: Some private and public market participants are conducting pilots using tokenization to simplify payments and securities settlement.

The key potential benefits of tokenizing US Treasuries include:

• Improvements in Clearing and Settlement: Tokenized Treasuries can enable more simplified "atomic settlement", where all parts of a Treasury-involved transaction settle simultaneously across all parties, reducing settlement failure risk.
• Enhanced Collateral Management: Smart contracts embedded directly in the tokenized Treasuries can enable more efficient collateral management, including pre-programmed collateral transfers upon predefined conditions being met.
• Increased Transparency and Accountability: The immutable ledger can enhance transparency in the functioning of the Treasury market, reducing opacity, and provide more real-time insights into transaction activity for regulators, issuers, and investors.
• 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 US Treasuries, such as derivatives and structured products.
• Increased Inclusiveness and Demand: Tokenization can make Treasuries more accessible to a wider range of investors, including smaller retail investors and those 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.

While the tokenization of US Treasuries has potential benefits, design choices may also introduce certain risks and challenges that need to be carefully considered.

• Technical Risks: Tokenized infrastructure is difficult to develop in a cost-effective parallel manner, and is unlikely to be as efficient as traditional markets (the "existing advantage") before reaching sufficient scale (the "incumbent advantage"). It is still unclear whether DLT platforms have compelling technical advantages over traditional systems, and given the smaller scale of traditional markets, the transition costs may also be higher.
• Cybersecurity Threats: Certain types of DLT solutions (public, permissionless blockchains) are vulnerable to hacking and other cybersecurity attacks, which could pose risks to the security of tokenized government bonds.
• Operational Risks:
• Counterparty Risks: Investors may face counterparty risks, i.e., the risk of default by the issuer or custodian of the tokenized securities.
• Custody Risks: Ensuring the secure custody of tokenized government bonds requires robust custody solutions, which may involve challenges associated with digital asset custody.
• Privacy Concerns: Some participants may view the increased transparency of public blockchains as a disadvantage.
• Regulatory and Legal Uncertainties:
• Evolving Regulations: The legal requirements/compliance obligations for tokenized assets remain unclear.
• Jurisdictional Challenges: Varying regulatory frameworks across different jurisdictions may complicate cross-border transactions and create complex legal issues.

If the tokenized market grows significantly, it could bring financial stability and market risks:

• Contagion Risks
• Complexity and Interconnectedness
• Bank/Payment Disintermediation
• Basis Risks
• 24/7 Trading: May make it more susceptible to market manipulation and higher volatility

Financial Stability Risks from a Significant Expansion of the Tokenized Market

• Contagion and Spillover Risks:
• Tokenization provides a bridge, and as the scale of tokenized assets grows, the volatility of "on-chain" assets may spill over into broader financial markets.
• In times of stress, the seamless ledger may become a liability, as deleveraging and fire sales could rapidly propagate across all assets.
• Liquidity and Maturity Mismatch Risks:
• There may be liquidity and maturity mismatches between non-native tokens and underlying assets, which could trigger potential deleveraging-induced price volatility, similar to ETFs, MMFs, and government bond futures.
• Smart contract-driven automatic margin calls could lead to liquidity pressures, while also needing to meet rapid settlement targets.
• Increased Leverage:
• Tokenization can directly increase the leverage in the financial system. For example, the underlying assets of tokens can be re-hypothecated, or the tokens themselves can be designed as derivatives.
• Tokenization may create tradable securities from illiquid assets or physical assets that can be used as collateral.
• Increased Complexity and Opacity:
• Tokenization leads to more composability, and the addition of new non-traditional assets to the digital finance ecosystem could significantly increase the complexity and opacity of the financial system.
• Poorly coded smart contracts can rapidly trigger unnecessary financial transactions, leading to unintended consequences.
• Bank Disintermediation:
• Tokenized short-term government bonds may prove to be an attractive alternative to bank deposits, and could potentially disrupt the banking system, with negative impacts on core business.
• Stablecoin Run Risks:
• Even with better collateral backing, stablecoins are unlikely to meet the NQA principles required to support tokenization.
• Stablecoin runs have been a recurring issue in recent years, and the collapse of major stablecoins like Tether could lead to a sell-off of short-term government bonds.

Designing DLT/Blockchain for Tokenized Government Bonds: Framework Elements

Establishing a framework that encourages trust and industry-wide acceptance is necessary for the expansion of digital assets and distributed ledger technology, as fraud, scams, and theft have grown alongside 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 wider adoption of tokenized government bonds:

• Technology Choice: Public, permissionless blockchains use complex consensus mechanisms (e.g., proof-of-work, proof-of-stake), making it difficult to process large volumes of transactions efficiently.
• Operational Fragility: These blockchains rely on decentralized nodes, without a centralized authority, leading to fragility.
• Governance Gaps: Public blockchains lack a clear governance structure, increasing the risk of system failures or attackers exploiting vulnerabilities in the blockchain.
• Security Risks: The decentralized nature and lack of vetting of public blockchains increase the risk of vulnerabilities and attacks. The history of exploits on Bitcoin and Ethereum is a testament to this.
• AML and Compliance Issues: Open, permissionless blockchains allow for anonymity, which could facilitate money laundering and sanctions evasion, and circumvent compliance.

The tokenization of the government bond 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 an increase in the regulation of digital assets and cryptocurrencies globally, but it remains highly fragmented and with many loopholes.

United States: Regulation in the US remains fragmented, with regulatory authority split across multiple agencies such as the SEC, CFTC, and FinCEN.

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

European Union: The Crypto-Asset Markets (MiCA) regulation will come into effect in 2024. MiCA is the EU's first comprehensive regulatory framework for cryptocurrencies and digital assets, setting rules for the issuance of crypto-assets, stablecoins, and utility tokens, and regulating service providers such as exchanges and custodians. It focuses on consumer protection, stablecoin oversight, anti-money laundering measures, and environmental impact transparency. Entities licensed under MiCA can operate under a "passporting" model across the EU, allowing them to provide services in all member states under a unified framework.

Impact on the Government Bond Market

Assuming the current trend of stablecoin collateral selection continues (or is mandated by regulators), the continued growth of stablecoins will create structural demand for short-term US Treasuries, although stablecoins currently represent a marginal part of the government bond market. Over time, however, the government bond market may face greater sell-off risks due to stablecoin runs. The different redemption and settlement characteristics may lead to liquidity and maturity mismatches between tokens and underlying assets, potentially exacerbating financial instability in the government bond market.

• The tokenization of "derivative" government debt products can create an underlying market (such as futures or total return swaps) between digital and physical - this will create additional demand and also lead to increased volatility during deleveraging periods.
• During periods of heightened downside volatility, the growth and institutionalization of the cryptocurrency market (Bitcoin) may generate additional hedging and quality demand for tokenized government debt. Demand for quality may be difficult to predict. Hedging demand may be structural, but depends on how US Treasuries continue to hedge against cryptocurrency downside volatility.
• Tokenization may create more opportunities for domestic and global savings pools (especially households and small financial institutions) to access government debt, which could lead to increased demand for US Treasuries.
• Tokenization can improve the liquidity of government debt trading by reducing operational and settlement frictions.

Conclusion

• While the overall market for digital assets remains small compared to traditional financial assets like stocks or bonds, interest in digital assets has grown significantly over the past decade.
• So far, the growth of digital assets has created negligible incremental demand for short-term government debt, primarily through the use and adoption of .
• Institutional adoption of "high volatility" and cryptocurrencies may lead to increased hedging demand for short-term government debt in the future.
• The development of DLT and blockchain offers hope for new financial market infrastructure, with a "unified ledger" improving operational and economic efficiency.
• Both the private and public sectors have some ongoing projects and pilots to leverage blockchain technology in traditional financial markets, particularly and the Bank for International Settlements (BIS).
• Central banks and tokenized dollars (CBDC) may need to play a critical role in future tokenized payment and settlement infrastructure.
• The legal and regulatory environment needs to evolve with the progress of traditional asset tokenization. Careful consideration of operational, legal, and technological risks is needed in design choices around the technological infrastructure and tokenization.
• Research efforts should include the design, nature, and focus points of Treasury tokenization, the introduction of sovereign CBDCs, and the technology and technological risks.
• Currently, financial stability risks remain relatively low due to the relatively small scale of the tokenized asset market; however, as the tokenized asset market grows strongly, financial stability risks will increase.
• The way forward should include a prudent approach led by a trusted central authority with broad support from private sector participants.