From a financial perspective, can stablecoins become mainstream?

Original title: Rethinking ownership, stablecoins, and tokenization (with Addison)

Original author: @bridge__harris, @foundersfund member

Original translation: Luffy, Foresight News

Addison and I have been discussing trends and core use cases of traditional finance and cryptocurrency integration recently. In this article, we will conduct a series of dialogues around the US financial system and explore how cryptocurrencies can be integrated into it based on basic principles.

There is a view that tokenization will solve many problems in the financial field, which may be correct, or this may not be the case.

Stable coins, like banks, have new currency issuances. The current development trajectory of stablecoins has raised many major issues, such as how they are combined with the traditional partial reserve banking system. In this system, banks reserve only a small portion of their deposits as reserves and the rest is used for lending, which actually creates new currency.

1. Tokenization boom

The mainstream voice is to "tokenize everything", from open market stocks to private market shares, to U.S. Treasury bonds. This is generally beneficial for the crypto field and the world as a whole. Thinking about the tokenized market trends based on basic principles, the following points are quite critical:

• How the current asset ownership system works;

• How will tokenization change this system;

• Why is the initial scenario of tokenization necessary?

• What is the "real dollar" and how new currencies are created.

Currently, large asset issuers (such as publicly listed stocks) will grant the custody rights of securities to the U.S. Securities Deposit Trust Company (DTCC). DTCC then tracks ownership of approximately 6,000 accounts interacting with, which each manages its own books to track ownership of end users. For private companies, the model is slightly different: companies like Carta just manage the ledger for the business.

Both models are highly centralized accounting methods. The DTCC model is like a "mastiff doll-style" accounting system. Before individual investors get in touch with the actual ledger records of DTCC, they may need to go through 1 to 4 different entities. These entities may include brokerage firms or banks where investors open accounts, custodians or clearing companies of brokers, and DTCC itself. Although ordinary retail investors are not usually affected by this hierarchy, it brings a lot of due diligence and legal risks to financial institutions. If DTCC itself tokenize assets, then its dependence on these intermediate entities will be reduced, as investors can more easily connect directly to the clearing house; but this is not the proposed model discussed at the moment.

The current tokenization model is that an entity holds the underlying assets as a detailed item in the general ledger (for example, as a subset of entries in a DTCC or Carta account) and then creates a new, tokenized form of asset holding for on-chain use. This model itself is inefficient because it introduces another entity that can capture value, generate counterparty risk and lead to delays in settlement/closing. The introduction of additional entities breaks composability because it requires additional steps to "encapsulate and unblock" securities in order to interact with other parts of traditional finance or decentralized finance, resulting in delays.

Perhaps the more ideal approach is to directly link the DTCC or Carta's ledger to make all assets native to "tokenized" so that all asset holders can enjoy the benefits of programmability.

One of the main arguments that support the realization of securities tokenization is global market access and 24/7 trading and settlement. If tokenization is a mechanism to "delivery" stocks to emerging market investors, it will undoubtedly be a step-by-step improvement in how the current system works and opens the door to the U.S. capital market for billions of people. But it is still unclear whether blockchain tokenization is necessary because it is a regulatory issue. In the long run, it remains to be discussed whether tokenized assets will become an effective regulatory arbitrage like stablecoins. Similarly, a common bullish reason for on-chain stocks is perpetual contracts; however, the obstacles faced by perpetual contracts are all from the regulatory level, not the technical level.

Stablecoins are structurally similar to tokenized stocks, but the market structure of stocks is much more complex (and highly regulated) and involves a range of clearing houses, exchanges and brokers. Tokenized stocks are essentially different from "ordinary" crypto assets, which are not "endorsed" by any asset, but are native tokens and composable.

In order to achieve an efficient on-chain market, the entire traditional financial system needs to be replicated, which is an extremely complex and arduous task given the concentration of liquidity and the existing network effects. Just putting tokenized stocks on the chain is not a panacea. To ensure that they are liquid and can be combined with other parts of traditional finance, a lot of in-depth thinking and supporting infrastructure construction is required. However, if Congress passes a law that allows companies to issue digital securities directly on-chain, many traditional financial entities will completely lose the need to exist. Tokenized stocks will also reduce the traditional listing compliance costs.

Currently, emerging market governments have no motivation to legalize access to the U.S. capital markets because they tend to keep capital in their own economies; for the United States, open access will cause anti-money laundering problems.

2. The real dollar and the Federal Reserve

The real dollar is an entry in the Federal Reserve ledger. Currently, about 4,500 entities (banks, credit unions, certain government agencies, etc.) can obtain these "real dollars" through the Fed's main account. None of these entities is native crypto-institutions, unless you count Lead Bank and Column Bank, they do serve crypto-in-community clients like Bridge. Entities with the main account can access Fedwire, an extremely inexpensive and nearly instant payment network that can send wire transfers for 23 hours of a day and can basically settle instantly. The real dollar falls into the category of M 0: that is, the sum of all balances on the main ledger of the Federal Reserve. "False" The US dollar (created by a private bank through loans) belongs to the M1 category and is approximately 6 times the size of M0.

The user experience interacting with real dollars is actually pretty good: transfers cost only about 50 cents and can be settled instantly. Whenever you wire money from a bank account, your bank interacts with Fedwire, which has nearly perfect uptime, instant settlement capabilities, and low latency costs for transfers. However, the tail risks in regulatory aspects, anti-money laundering requirements and fraud detection measures have led banks to put many restrictions on large-scale payments.

Based on this structure, one of the disadvantages facing stablecoins is to expand access to these "real dollars" through an instant system that does not require intermediate institutions, which: 1) intercepts basic income (this is the case with the two largest stablecoins); 2) restrict redemption rights. Currently, stablecoin issuers work with banks, which in turn have master accounts at the Fed

Then, if the stablecoin issuer obtains the main Fed account, it is like having a cheat password, and can obtain a 100% risk-free Treasury bond yield, and: 1) There is no liquidity problem; 2) The settlement time is faster, why don’t they fight for it themselves?

A stablecoin issuer's request to apply for a main account will likely be denied like Narrow Bank's application (and, crypto banks like Custodia have also failed to obtain a main account). However, Circle's relationship with the partner banks may be close enough that the main account's improvement in its capital flow is not significant.

The Fed is reluctant to approve the main account application of stablecoin issuers because the dollar model is only compatible with part of the reserve banking system: the entire economic system is based on the fact that banks only need to hold a few percentage points of reserve.

Essentially, it is creating new currency through debt and loans. But if anyone can obtain 100% or 90% interest rate returns without risk (no need to lend funds to mortgages, commercial loans, etc.), then who would still use an ordinary bank? And if no one uses ordinary banks, there will be no deposits to issue loans and create more money, and the economy will stagnate.

The two core principles cited by the Federal Reserve when considering the qualifications of the main account include: 1) The granting of a main account to an institution shall not introduce improper cyber risks; 2) shall not interfere with the implementation of the Federal Reserve's monetary policy. For these reasons, at least in the case of the current stablecoin issuers, they are unlikely to obtain a main account.

Stablecoin issuers are actually able to obtain access to the main account only if they "become" a bank. The GENIUS Act would set up bank-like regulatory regulations for issuers with a market value of more than $10 billion. Essentially, the argument here is that since they will be regulated by similar banks anyway, they can operate more like banks in the long run. However, according to GENIUS Act, stablecoin issuers are still unable to engage in business similar to partial reserve banks due to the 1:1 reserve requirement.

So far, stablecoins have not disappeared due to regulation, as most stablecoins are issued overseas by Tether. The Fed is happy to see the dollar dominate the world in this way because it strengthens the dollar's position as a reserve currency. But if entities like Circle (or even Narrow Bank) scale up significantly and are used on deposit accounts on a large scale in the U.S., the Fed and the Treasury Department may be concerned. Because this will cause funds to flow out from banks that run part of the reserve model, and the Fed implements monetary policy through this model.

This is essentially a problem that stablecoin banks will face: to issue loans, a bank license is required. But if the stablecoin is not endorsed by the real dollar, it is no longer a real stablecoin, which goes against its original intention. This is where some reserve model "fails". However, in theory, stablecoins can be created and issued by a franchised bank that has a main account and operates a partial reserve model.

III. Banks, private credit and stablecoins

The only benefit of being a bank is the ability to obtain insurance from the Federal Reserve’s main account and Federal Deposit Insurance Corporation (FDIC). These two characteristics allow banks to assure depositors that their deposits are safe "real dollars" (endorsed by the U.S. government), even if these deposits have actually been loaned out.

Issuing loans does not necessarily require becoming a bank, private credit companies have been doing this all the time. However, the difference between banks and private credit is that banks issue a "receipt" deemed to be the actual US dollar, which is interchangeable with all receipts issued by other banks. The endorsement assets of bank receipts are completely lacking in liquidity; however, the receipts themselves are completely liquid. This perception of converting deposits into illiquid assets (loans) while maintaining the unchanged value of deposits is the core of currency creation.

In the private credit space, your receipt value is linked to the underlying loan. Therefore, no new currency is created; you can't actually spend it using your private credit receipt.

Let’s take Aave as an example to explain the concepts similar to banking and private credit in the crypto space. Private Credit: In the real world, you deposit USDC into Aave and you receive aUSDC. aUSDC is not completely endorsed by USDC at any time, as some of the deposits have been loaned to users as collateral. Just as merchants don’t accept private credit receipts, you can’t use aUSDC for consumption.

However, if economic players are willing to accept aUSDC in the exact same way as accepting USDC, Aave is functionally equivalent to a bank where aUSDC is the dollar it informs depositors of which they own, and at the same time, all endorsement assets (USDC) have been loaned out.

4. Does stablecoins create new currency?

If the above argument is applied to stablecoins, then stablecoins do indeed create "new currency" in function. To illustrate this further:

Suppose you bought a Treasury bond from the U.S. government for $100. Now you have a Treasury bond that cannot be really used as currency, but you can sell it at a volatile market price. On the backend, the U.S. government is using this money, and Treasury bonds are essentially a loan.

Suppose you send $100 to Circle, and Circle uses this money to buy government bonds. The government is using this $100 – you are using it too. You receive 100 USDC, which can be used anywhere.

In the first case, you have a national debt that cannot be used directly. In the second case, Circle created a representative form of government bonds that were used in the same way as the US dollar.

Based on deposits per dollar, the "currency issuance" of stablecoins is relatively small, because the endorsement assets of most stablecoins are short-term Treasury bonds and their interest rates are not fluctuating much. Banks are much higher in currency issuance per dollar because their liabilities have longer maturities and higher loan risks. When you redeem your government’s debt, the money you get from the government is the government’s proceeds from selling another government debt, and this cycle goes on.

Ironically, in the crypto-punk values ​​that cryptocurrencies uphold, each stablecoin issuance only makes the government's borrowing money and inflation cost less: the demand for government bonds increases, which is actually government spending.

If stablecoins become large enough (for example, if Circle reaches about 30% of M2. Currently stablecoins make up 1% of M2), they could pose a threat to the U.S. economy. This is because every time a dollar transferred from the banking system to a stablecoin, the net money supply decreases (because banks "create" more money than stablecoin issuance creates), and money supply has been an exclusive regulatory area for the Federal Reserve. Stablecoins will also weaken the Fed's power to implement monetary policy through partial reserve banking systems. That being said, the benefits of stablecoins globally are beyond doubt: They expand the dominance of the dollar, strengthen the narrative of the dollar as a reserve currency, make cross-border payments more efficient, and greatly help people outside the United States who need stablecoins.

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 demand with programmable currency demand. This involves the field of central bank digital currency (CBDC), which we will leave to discuss later.