Author: Bridget, Addison
Compiled by: Block unicorn
Addison (@0 xaddi) and I have recently been discussing the great interest in the combination of traditional finance (TradFi) and cryptocurrency, as well as its actual core use cases. Here is a summary of our discussion regarding the U.S. financial system and how cryptocurrency integrates into it from a first principles perspective:
The current mainstream view is that tokenization will solve many financial problems, which may be true or may not be.
Stablecoins function similarly to banks, leading to net new money issuance. The current trajectory of stablecoin development raises an important question: how do they interact with the traditional fractional reserve banking system—where banks only hold a small portion of deposits as reserves and lend out the rest, effectively creating net new money.
Tokenization has become a current hot topic.
The current narrative is “tokenizing everything”—from publicly traded stocks to private market shares to short-term government bonds—will yield net positive gains for cryptocurrencies and the world at large. To think about what is happening in the market from a first principles perspective, the following points may be helpful:
How does the current asset ownership system operate?
How tokenization will change this system;
Why tokenization is needed in the first place;
What is “real dollars,” and how is net new currency created.
Currently in the United States, large asset issuers (such as publicly traded stocks) entrust the custody of their certificates to DTCC (Depository Trust & Clearing Corporation). DTCC then tracks the ownership of approximately 6,000 accounts interacting with it, and these accounts manage their own ledgers to track the ownership of their end users. For private companies, the model is slightly different: companies like Carta only manage ledgers for enterprises.
Both of these models involve highly centralized ledger management. The DTCC model employs a “Russian doll” style ledger structure, where individuals may need to go through 1-4 different entities to access the actual ledger entries of the DTCC. These entities may include the brokerage firms or banks where investors open accounts, the custodians or clearing companies of the brokerage firms, and the DTCC itself. Although the ordinary end users (retail investors) are not affected by this hierarchical structure, it imposes a significant amount of due diligence and legal risk on institutions. If the DTCC itself could natively tokenize its assets, the reliance on these entities would decrease, as direct interaction with the clearinghouse would become easier—but this is not the model currently popular in discussions.
The current tokenization model involves an entity holding a base asset as an entry in the main ledger (for example, as a subset of DTCC or Carta entries) and then creating a new, tokenized representation of the assets it holds for on-chain use. This model is inherently inefficient because it introduces another entity that can extract value, create counterparty risk, and lead to settlement/termination delays. Introducing another entity disrupts composability because it adds an extra step to “wrap and unwrap” securities to interact with traditional finance or decentralized finance (DeFi), which can cause delays. Placing the ledgers of DTCC or Carta directly on the chain, making all assets natively “tokenized,” might be superior, allowing all asset holders to enjoy the benefits of programmability.
One of the main arguments for tokenized stocks is global market access and 24/7 trading and settlement. If tokenization is the mechanism for “delivering” stocks to emerging market populations, then this is certainly a significant improvement over the current system and will open up the U.S. capital markets to billions of people. However, it remains unclear whether tokenization through blockchain is necessary, as this task primarily involves regulatory issues. Whether tokenized assets can become effective regulatory arbitrage like stablecoins over a sufficiently long time frame is still up for debate. Similarly, a common bullish argument for on-chain stocks is perpetual contracts; however, the barriers to perpetual contracts (including stocks) are entirely regulatory, not technical.
Stablecoins (tokenized U.S. dollars) are structurally similar to tokenized stocks, but the market structure for stocks is much more complex (and highly regulated), including a series of clearing houses, exchanges, and brokers. Tokenized stocks are fundamentally different from “ordinary” crypto assets, which are not “endorsed” by anything, but are natively tokenized and composable (e.g. BTC).
To achieve an efficient on-chain market, the entire traditional financial (TradFi) system needs to be replicated on-chain, which is an extremely complex and arduous task, as the concentration of liquidity and existing network effects make this process exceptionally difficult. Simply putting tokenized stocks on-chain will not be a panacea; ensuring they have liquidity and composability with the rest of the traditional financial system requires a great deal of thought and infrastructure development. However, if Congress passes a law allowing companies to issue digital securities directly on-chain (instead of going public through an IPO), this would completely eliminate the need for many traditional financial entities (and there may be an outline for this in the new market structure bill). Tokenized shares would also reduce the compliance costs associated with traditional public listings.
Currently, emerging-market governments have no incentive to legalize access to U.S. capital markets, as they prefer to keep capital within their economies; For the U.S., opening access from the U.S. side introduces anti-money laundering (AML) issues.
By the way: In a sense, the Variable Interest Entity (VIE) structure used by Alibaba ($BABA) on U.S. exchanges represents a form of “tokenization”; American investors do not directly own the native shares of Alibaba but instead own a Cayman Islands company that enjoys the economic rights of Alibaba through contracts. This has indeed opened up the market, but it has also created a net new entity and new shares, significantly increasing the complexity of these assets.
Real dollars and the Federal Reserve
The real dollar is an entry in the Fed’s ledger. Currently, about 4,500 entities (banks, credit unions, certain government entities, etc.) have access to these “real dollars” through the Fed master account. None of these entities are native cryptocurrency-related, unless you count Lead Bank and Column Bank, which serve specific crypto clients like Bridge. Entities with master accounts have access to Fedwire, an ultra-low-cost and near-instantaneous payments network that can send wire transfers 23 hours a day with essentially instant settlement. The real dollar exists in M 0: that is, the sum of all balances on the Fed’s main ledger. And the “fake” dollar (“created” by private banks through loans) belongs to M1, which is about 6 times the size of M0.
Interacting with actual US dollars provides quite a good user experience: each transfer only costs about 50 cents and allows for instant settlement. Whenever you transfer money from your bank account, your bank interacts with Fedwire, which has near-perfect uptime, instant settlement, and low transfer delays—but regulatory tail risks, anti-money laundering requirements, and fraud detection have led banks to impose many restrictions on large payments (which is where the friction in the end-user experience comes from).
With this structure, the bearish argument for stablecoins will be to expand access to these “real dollars” through an instant system that does not require intermediaries to: 1) obtain underlying yields (which is the case for the two largest stablecoins), 2) restrict redemption rights. Currently, stablecoin issuers collaborate with banks that have Federal Reserve master accounts (Circle partners with JPMorgan/BNY Mellon) or with financial institutions that hold significant positions in the U.S. banking system (Tether partners with Cantor Fitzgerald).
So, why don’t stablecoin issuers apply for a Fed master account themselves? But if this is essentially a cheat code that allows them to earn 100% risk-free treasury yields, while 1) has no liquidity issues, and 2) has faster settlement times?
The case of stablecoin issuers applying for a master account with the Federal Reserve is likely to be rejected, similar to The Narrow Bank’s application (in addition, crypto banks like Custodia have also been consistently denied a master account). However, Circle’s relationship with its partner banks may be close enough that the improvement in fund flow from the master account is not significant.
The reason the Federal Reserve is reluctant to approve the main account applications of stablecoin issuers is that the dollar model is only compatible with a fractional reserve banking system: the entire economy is built on banks holding a few percentage points of reserves.
This is basically a way to create new money through debt and loans—but if anyone can obtain a 100% or 90% interest rate without risk (with no funds being lent out for mortgages, businesses, etc.), then why would anyone use a regular bank? If people do not use regular banks, there will be no deposits to create loans and more money, and the economy will stagnate.
The two core principles of the Federal Reserve in determining eligibility for master accounts include: 1) granting a master account to an institution must not introduce excessive network risks; 2) must not interfere with the implementation of the Federal Reserve’s monetary policy. For these reasons, at least in its current form, the likelihood of granting master accounts to stablecoin issuers is low.
The only situation in which stablecoin issuers may gain access to a master account is if they “become” a bank (which they may not wish to do). The “GENIUS Act” will establish bank-like regulation for issuers with a market capitalization exceeding $10 billion—the argument here is basically that since they will be regulated like banks anyway, they can operate more like banks over a sufficiently long time frame. However, under the “GENIUS Act,” due to the 1:1 reserve requirement, stablecoin issuers still cannot engage in banking practices similar to fractional reserves.
So far, stablecoins have not been eliminated by regulation, primarily because most stablecoins exist overseas through Tether. The Federal Reserve is satisfied with the dominance of the dollar in this way globally— even if not through a fractional reserve banking model— as it enhances the dollar’s status as a reserve currency. However, if entities like Circle (or even a narrow bank) were to scale up by several orders of magnitude and be widely used for deposit-style accounts in the U.S., the Federal Reserve and the Treasury might become concerned (as this would siphon funds away from banks operating on a fractional reserve model, which is how the Federal Reserve implements monetary policy).
This is essentially the same problem that stablecoin banks will face: to issue loans, a banking license is required—however, if the stablecoin is not backed by real dollars, then it is no longer a true stablecoin, which goes against its original intention. This is where the partial reserve model “collapses”. However, theoretically, a chartered bank with a master account can create and issue stablecoins based on the partial reserve model.
Bank vs. Private Lending vs. Stablecoin
The only benefit of becoming a bank is obtaining a Federal Reserve master account and FDIC insurance. These two features allow banks to tell depositors that their deposits are safe “real dollars” (backed by the U.S. government), even though those deposits have all been lent out.
To issue a loan, you don’t need to be a bank (private credit companies do this all the time). However, the difference between a bank and a private credit is that in a bank, you receive a “receipt” that is treated as an actual dollar. As a result, it is interchangeable with receipts from other banks. The endorsement of the bank receipt is completely illiquid; However, the receipts themselves are completely fluid. The perception that deposits are converted into illiquid assets (loans) while keeping the value of deposits unchanged is at the heart of money production.
In the private lending sector, your receipts are priced based on the value of the underlying loan. Therefore, no new money is created; you cannot actually spend your private credit receipts.
Let’s use Aave to explain the analogy between cryptocurrency and banks and private credit. Private credit: In the existing world, you deposit USDC into Aave and receive aUSDC. aUSDC is not always fully backed by USDC, as part of the deposits are lent to users as collateralized loans. Just like merchants do not accept private credit ownership, you cannot spend aUSDC.
However, if economic participants are willing to accept aUSDC in the same way they accept USDC, then Aave would functionally be equivalent to a bank, with aUSDC representing the dollars it tells depositors they own, while all the backing (USDC) is lent out.
A simple example: Addison provided $1,000 of tokenized private credit to the Bridget Credit Fund, which can be used like dollars. Then, Bridget lent this $1,000 to others, and now the value in the system is $2,000 (the lent $1,000 + $1,000 tokens from the Bridget Fund). In this case, the lent $1,000 is just a debt, operating similarly to a bond: a claim on the $1,000 that Bridget lent to others.
Stablecoins: Are they net new money?
If the above argument is applied to stablecoins, then stablecoins do indeed create “net new money” functionally. To elaborate further:
Suppose you bought a short-term bond from the U.S. government for $100. The short-term bond you now own cannot actually be used as money, but you can sell it at a fluctuating market price. In the background, the U.S. government is spending this money (since it is essentially a loan).
Suppose you send 100 dollars to Circle, and they use that money to buy treasury bonds. The government is spending that 100 dollars, but you are also spending. You will receive 100 USDC, which can be used anywhere.
In the first case, you have a government bond that cannot be used. In the second case, Circle has created a representative form of the government bond that can be used like a dollar.
The “currency issuance” of stablecoins is negligible when calculated at one dollar per deposit, as most stablecoins are backed by short-term government bonds, which are less affected by interest rate fluctuations. The currency issuance per dollar by banks is much higher because their debts come from long-term and riskier loans. When you redeem a short-term government bond, you are obtaining funds from another short-term government bond sold by the government — this cycle continues.
Ironically, in the cyberpunk values of cryptocurrency, every time a stablecoin is issued, it makes government borrowing and inflation cheaper (increased demand for government bonds essentially means increased government spending).
If the scale of stablecoins is large enough (for example, if Circle occupies about 30% of M2 – currently stablecoins account for 1% of M2), they could pose a threat to the U.S. economy. This is because every dollar that moves from banks to stablecoins reduces the money supply (since the money “created” by banks exceeds the money created by stablecoin issuance), which was previously the exclusive operation of the Federal Reserve. Stablecoins also undermine the Federal Reserve’s ability to implement monetary policy through the fractional reserve banking system. Nevertheless, the benefits of stablecoins on a global scale are undeniable: they expand the dominance of the dollar, reinforce the narrative of the dollar as a reserve currency, make cross-border payments more efficient, and greatly assist those outside the U.S. who need stable currency.
When the supply of stablecoins reaches trillions, stablecoin issuers like Circle may be incorporated into the U.S. economy, and regulators will have to figure out how to balance the demands of monetary policy and programmable money (which leads into the realm of central bank digital currencies, a topic we plan to discuss further).
