Overview of the U.S. Department of the Treasury's Report on Crypto Assets and the Treasury Market

Despite a small base, crypto assets have still experienced rapid growth

Translated by: Pzai, Foresight News

Trends in Crypto Asset Growth and Usage

Despite a small base, crypto assets have still experienced rapid growth. The growth comes from both native cryptocurrencies like Bitcoin and Ethereum, as well as stablecoins.

Total Market Capitalization of Cryptocurrencies Chart

So far, the adoption of cryptocurrencies by households and industries has been limited to holding crypto assets for investment purposes. Compared to other financial and physical assets, the market capitalization of crypto assets remains low, and the growth so far does not seem to have encroached on the demand for government bonds. The use cases for crypto assets are continuously evolving, but public interest primarily develops along two tracks: the main use of Bitcoin appears to be as a store of value in the DeFi world, also known as "digital gold." So far, speculative interest seems to have played a prominent role in the growth of cryptocurrencies. The crypto asset market is striving to leverage blockchain and distributed ledger technology (DLT) to develop new applications and improve the clearing and settlement infrastructure of traditional financial markets.

Scale of 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 rapidly increased, including a growing demand for crypto assets with stable cash-like characteristics, which have been attractive collateral for lending on DeFi networks. While there are different types of stablecoins, the growth of fiat-backed stablecoins has been the most significant. Currently, over 80% of cryptocurrency trading in the crypto asset market involves stablecoins.

The most popular stablecoins in today's market are fiat-backed stablecoins, a significant portion of which is collateralized by government bonds and Treasury-supported repurchase agreements. We estimate that a total of $120 billion in stablecoin collateral is directly invested in government bonds. In the short term, we expect the stablecoin market and the overall scale of the digital asset market to continue to grow, while mid-term regulatory and policy choices will determine the fate of this "private currency." History shows that "private currencies" that do not meet national quality assurance requirements can lead to financial instability, making them highly undesirable.

Demand Analysis

In recent years, the price of native crypto assets like Bitcoin has surged significantly, but volatility remains high. Since 2017, Bitcoin has experienced four major price corrections. So far, access to traditional safe-haven or risk-hedging tools like government bonds has been limited in the digital asset market. In recent years, institutional support for Bitcoin (such as BlackRock ETF, MicroStrategy) has been growing, while the performance of crypto assets resembles that of "high-volatility" assets. As the market capitalization of digital assets grows, structural demand for government bonds may increase, serving simultaneously as 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 digitizing rights in the form of tokens on programmable platforms like distributed ledgers/blockchains, and it has the potential to unleash the advantages of programmable, interoperable ledgers into a broader range of traditional financial assets. The main features and advantages of tokenization include:

Core Service Layer: Tokenized assets integrate a "core layer" containing asset and ownership information with a "service layer" managing transfer and settlement rules.
Smart Contracts: Tokenization enables automation, allowing transactions to be executed automatically through smart contracts when predefined conditions are met, facilitating the transfer of assets and claims.
Atomic Settlement: Tokenization simplifies settlement by ensuring that all parts of a transaction involving government bonds settle simultaneously among all parties, thereby reducing the risk of settlement failure.
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 independently of native crypto assets like Bitcoin and the public, permissionless blockchain technologies that have popularized these assets.

Some markets (such as international payments or repos) will gain direct and significant potential benefits from tokenization, while others will see incremental gains. However, to realize this potential, a unified ledger is needed, or at least a set of highly interoperable, seamlessly collaborating integrated ledgers. These ledgers also need to be developed under the support of central banks and the trust foundation they provide.

Tokenization of Government Bonds

The tokenization of U.S. government bonds is a relatively new trend, with most projects yet to scale; some notable ongoing public and private initiatives include:

Tokenized Government Bond Funds: Allowing investors to obtain government bonds in "tokenized" form on the blockchain. Their behavior is similar in many ways to government bond ETFs or government MMFs.
Tokenized Government Bond Repo Projects: Tokenized government bonds allow for instant, 24/7 settlement and trading, potentially paving the way for more timely intraday repo transactions.
Pilot Projects by DTCC and Other Institutions: Some private and public market participants are conducting pilots using tokenization to simplify payments and securities settlement.

The main potential advantages of tokenizing government bonds include:

Improvements in Clearing and Settlement: Tokenized government bonds allow for more streamlined "atomic settlement," where all parts of transactions involving government bonds settle simultaneously among all parties, thereby reducing the risk of settlement failure.
Improved Collateral Management: Smart contracts directly programmed into tokenized treasuries can enable more efficient collateral management, including pre-programmed collateral transfers when preset conditions are met.
Increased Transparency and Accountability: Immutable ledgers can enhance the transparency of government bond market operations, reducing opacity and providing regulators, issuers, and investors with more real-time insights into trading activities.
Composability and Innovation: The ability to bundle different tokenized assets may lead to the creation of new, highly customizable financial products and services based on U.S. government bonds, such as derivatives and structured products.
Increased Inclusivity and Demand: Tokenization can make government bonds more accessible to a broader range of investors, including small retail investors and investors from emerging markets.
Increased Liquidity: Tokenization may create new investment and trading strategies through seamless integration and programmable logic, and tokenized government bonds can be traded 24/7 on blockchain networks.

Despite the potential benefits of tokenizing U.S. government bonds, design choices may pose certain risks and challenges that require careful consideration:

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

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

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

Financial Stability Risks from the Significant Expansion of the Future Tokenization Market

Contagion and Interconnectedness 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.
During times of stress, seamless ledgers may become a negative factor, as deleveraging and fire sales could quickly spread to all assets.
Liquidity and Mismatch Risks:
There may be liquidity and maturity mismatches between non-native tokens and underlying assets, which could trigger potential price volatility due to deleveraging; similar to ETFs, MMFs, and Treasury futures.
Smart contract-driven automated margin clearing may lead to liquidity pressures while also needing to meet rapid settlement targets.
Increased Leverage:
Tokenization can directly increase the leverage of the financial system. For example, the underlying assets of tokens can be re-collateralized, or the tokens themselves can be designed as derivatives.
Tokenization has the potential to create marketable securities from illiquid 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 may significantly increase the complexity and opacity of the financial system.
Poorly coded smart contracts can quickly trigger unnecessary financial transactions, leading to unintended consequences.
Disintermediation of Banking:
Tokenized short-term government bonds may prove to be an attractive alternative to bank deposits and could potentially disrupt the banking system, negatively impacting core operations.
Operational Risks of Stablecoins:
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 of short-term government bonds.

Designing DLT/Blockchain for Tokenized Government Bonds: 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 increased alongside the growth of 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 technology.

We believe this architecture is not suitable for the broader adoption of tokenized government bonds:

Technical Choices: Public, permissionless blockchains use complex consensus mechanisms (such as proof of work, proof of stake), making it difficult to efficiently handle large volumes of transactions.
Operational Fragility: These blockchains rely on decentralized nodes without centralized authority, leading to vulnerabilities.
Governance Gaps: Public blockchains lack clear governance structures, increasing the risk of system failures or exploitation of vulnerabilities by attackers.
Security Risks: The decentralized nature of public blockchains and lack of scrutiny increase the risk of exploits and attacks. Historical cases of vulnerabilities being exploited in Bitcoin and Ethereum illustrate this.
Money Laundering and Compliance Issues: Public, permissionless blockchains allow for anonymity, which may facilitate illegal activities such as money laundering and evading sanctions.

The tokenization of the Treasury market may require the development of a blockchain managed by one or more trusted private or public institutions.

Regulatory Elements

In recent years, there has been an increased global regulatory focus on digital assets and cryptocurrencies, but it remains highly fragmented and riddled with gaps.

United States: Regulation in the U.S. remains fragmented, with 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 outlined a strategy for addressing the opportunities and risks of digital assets across the government. The order called for the establishment of a regulatory framework for digital assets—The House of Representatives is set to pass the "Financial Innovation and Technology for the 21st Century Act" (FIT21) in 2024, which will be the most significant and comprehensive effort to regulate digital assets, stablecoins, and cryptocurrencies.

European Union: The Markets in Crypto-Assets Regulation (MiCA) will come into effect in 2024. MiCA is the EU's first comprehensive regulatory framework for cryptocurrencies and digital assets, establishing 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. Licensed entities under MiCA can operate across the EU in a "passport" model, allowing them to provide services under a unified framework to all member states.

Impact on the Treasury Market

Assuming the current trends in stablecoin collateral selection continue (or are mandated by regulators), the ongoing growth of stablecoins will create structural demand for short-term U.S. government bonds. Although stablecoins currently represent a marginal portion of the Treasury market, over time, due to runs in the stablecoin market, the Treasury market may face greater sell-off risks. Different redemption and settlement characteristics may lead to liquidity and maturity mismatches between tokens and underlying assets, potentially exacerbating financial instability in the Treasury market.

Tokenized "derivative" government bond products could create a foundational market (such as futures or total return swaps) between digital and local—this would create additional demand while also leading to increased volatility during deleveraging periods.
During periods of heightened downward volatility, the growth and institutionalization of the cryptocurrency market (Bitcoin) may generate additional hedging and quality demand for tokenized government bonds. The pursuit of quality demand may be difficult to predict. Hedging demand may be structural but depends on how U.S. government bonds continue to hedge against the downward volatility of cryptocurrencies.
Tokenization may create more opportunities for domestic and global pools of savings (especially households and small financial institutions) to access government bonds, potentially leading to increased demand for U.S. government bonds.
Tokenization can enhance the liquidity of government bond trading by reducing operational and settlement friction.

Conclusion

Although the overall market for digital assets remains small compared to traditional financial assets like stocks or bonds, interest in digital assets has significantly increased over the past decade.
So far, the growth of digital assets has created negligible incremental demand for short-term government bonds, primarily driven by the use and proliferation of stablecoins.
Institutional adoption of "high-volatility" Bitcoin and cryptocurrencies may lead to increased hedging demand for short-term government bonds in the future.
The development of DLT and blockchain brings hope for new financial market infrastructure, with a "unified ledger" improving operational and economic efficiency.
Both the private and public sectors have ongoing projects and pilots to leverage blockchain technology in traditional financial markets, particularly by DTCC and the Bank for International Settlements (BIS).
Central banks and Central Bank Digital Currencies (CBDCs) may need to play a key role in the future tokenized payment and settlement infrastructure.
The legal and regulatory environment needs to evolve alongside the progress of traditional asset tokenization. Operational, legal, and technical risks need to be carefully considered when making design choices around technological infrastructure and tokenization.
Research projects should include the design, nature, and concerns of Treasury tokenization, the introduction of sovereign CBDCs, and technological and technical risks.
Currently, due to the relatively small scale of the tokenized asset market, financial stability risks remain low; however, as the tokenized asset market grows robustly, financial stability risks will increase.
The path forward should include a cautious approach led by a trusted central authority with broad support from private sector participants.

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