Yield surges, reviewing the "tokenization" of US Treasury fixed income products, operational models, and concerns

Written by: Frank, Foresight News

"Benchmark interest rate for the crypto market"? After achieving a fixed annualized return of 20% in 2022 with UST/Anchor in a "laddering" manner, it personally destroyed this grand vision and opened the painful phase of continuously declining interest rates in the DeFi market.

As time changes, the 10-year U.S. Treasury yield, known as the "anchor of global asset pricing," has been climbing steadily over the past two quarters, even breaking the 5% mark last night, reaching a 16-year high since July 2007. However, with prominent short-sellers of U.S. Treasuries like "pandemic warrior" Bill Ackman and "bond king" Bill Gross suddenly switching sides, U.S. Treasury yields quickly fell back below 5% at the close.

In this context, the continuously rising U.S. Treasury yields have also prompted many institutions to launch a large number of "tokenized" projects backed by U.S. Treasuries through the RWA channel, marking the beginning of a new golden era for fixed-income projects in the crypto market.

This article by Foresight News aims to provide an overview of the current DeFi fixed-income projects in the crypto market that are leveraging U.S. Treasuries, exploring the sources of yields of 4%, 5%, or even higher, as well as the potential future concerns of these projects against the backdrop of rising U.S. Treasury yields.

Overview of Tokenized Fixed Income Products

The fixed-income projects involving tokenized U.S. Treasuries mainly refer to those that link cryptocurrencies with U.S. Treasury assets, meaning that holding on-chain tokens is equivalent to owning the underlying financial asset in the traditional market—U.S. Treasuries.

Moreover, these underlying financial assets are often custodied by institutions to ensure redemption, while on-chain tokenization can provide better liquidity for the underlying financial assets and opportunities for further financialization (leverage, lending, etc.) through other DeFi components.

Currently in the crypto market, besides established projects like MakerDAO and Frax Finance expanding their tracks, new projects like Mountain Protocol and Ondo Finance have also entered the fray.

MakerDAO's EDSR

MakerDAO, as the leading project in the RWA space, needs no further introduction. However, the proportion of assets that can be used to purchase Treasuries within MakerDAO is limited. Previously, MakerDAO used USDC within the PSM module to withdraw and purchase Treasuries, but if too many users deposit DAI to earn interest, the interest could even fall below the Treasury yield.

Currently, the Enhanced DAI Savings Rate (EDSR) is 5%, with a total of 1.73 billion DAI in DSR, resulting in an overall utilization rate of the DSR contract (the amount of DAI in the DSR contract / total DAI supply) far exceeding the 20% threshold, reaching as high as 31%.

If the DSR utilization rate subsequently breaks the 35% threshold, the EDSR yield will continue to decline:

When in the 35% - 50% range, the EDSR multiplier will be 1.35 times the base DAI savings rate, meaning the EDSR value will be approximately 4.15%;

Once it exceeds 50%, the EDSR will no longer be effective, and the contract will only adopt the base DSR value of 3.19%;

Mountain Protocol's USDM

As a yield-stablecoin protocol backed by Coinbase Ventures, Mountain Protocol's yield-stablecoin USDM is primarily supported by short-term U.S. Treasuries. After completing KYB certification, global investors can access the opportunity to share in U.S. Treasury yields.

Additionally, USDM provides daily rewards in a Rebase format, similar to the mechanism of stETH, with a current annual interest rate of 5%. It has also launched the crvUSD-USDM liquidity pool on Curve, meaning non-U.S. users can indirectly purchase and hold USDM to earn yields.

According to OKLink data, the total circulating supply of USDM is approximately 4.81 million, with a total of 116 holding addresses.

The official documentation states that at least 99.5% of its total assets are invested in cash, U.S. Treasury bills, notes, and other debts issued or guaranteed by the U.S. Treasury for principal and interest, as well as repurchase agreements secured by such debts or cash, thus can be seen as fully backed by U.S. Treasuries, with specific asset details updated monthly.

Angle Protocol's stEUR

As a decentralized stablecoin protocol, Angle Protocol's euro savings solution, stEUR, allows users to stake the euro stablecoin agEUR to earn stEUR while earning a 4% annual yield paid in agEUR. However, this 4% yield is just an initial setting and will be updated periodically based on the contract's usage.

It is primarily backed by short-term European bonds with a theoretical yield of around 3.6%. The protocol allocates part of the income to agEUR holders, and the current asset return rate of the protocol is about 1.6%.

Its yield distribution approach is also straightforward: the earnings of un-staked agEUR holders are subsidized to staked users. Since not all agEUR holders will stake for stEUR, the earnings for stEUR users will definitely be greater than 1.6%.

For example, if only 50% of the circulating agEUR is in the stEUR contract, then 50% of stEUR holders would receive the entire agEUR yield, resulting in a yield of 3.2%.

Frax Finance's sFRAX

Frax Finance has always been one of the most proactive DeFi projects in aligning with the Federal Reserve—applying for a Federal Reserve Master Account (FMA) (Foresight News note: the FMA allows holding dollars and trading directly with the Federal Reserve), thus escaping the limitations of using USDC as collateral and the risks of bank failures, making FRAX the closest thing to a risk-free dollar.

On the 12th of this month, Frax Finance also launched the sFRAX staking vault, which utilizes U.S. Treasury yields. It collaborates with Lead Bank in Kansas City to open a brokerage account to purchase U.S. Treasuries, tracking Federal Reserve rates to maintain relevance.

Users can deposit funds into sFRAX and earn a 10% yield, which will gradually shrink to the current IORB rate of the Federal Reserve, around 5.4%, as the scale grows.

As of the time of writing, the total amount staked in sFRAX has exceeded 43.46 million, achieving such results in less than half a month, which is quite remarkable, while the current annualized rate has already dropped to 6.18%.

Ondo Finance's USDY

In August, Ondo Finance also launched the tokenized note USD Yield (USDY), backed by short-term U.S. Treasuries and bank demand deposits. However, U.S. users and institutions cannot use USDY, and it can be transferred on-chain 40 to 50 days after purchase.

As a bearer note, USDY can pay variable yields to holders, with an annual interest rate starting from 5%. Individuals and institutions have no certification requirements and can directly collaborate with Ondo to mint or redeem USDY daily.

Ondo has currently launched four bond funds: the U.S. Money Market Fund (OMMF), Short-Term U.S. Treasury Fund (OUSG), Short-Term Investment Grade Bond Fund (OSTB), and High-Yield Corporate Bond Fund (OHYG), with OMMF achieving an annual yield of 4.7%, while OUSG can yield up to 5.5%.

Overall, most projects are configured for short-term Treasuries and Treasury reverse repos, with the rates offered generally concentrated between 4% and 5%, which aligns with the current yield space of U.S. Treasuries. Some high yields are often supplemented by other earnings (like EDSR) or involve sacrificing some non-re-staked users to compensate staked users (like stEUR).

Where do high yields come from?

Where do high yields come from? It's simple: they stem from the increasingly rising "risk-free interest" of U.S. Treasuries (with a few projects like stEUR anchoring to government bonds of their respective countries/regions).

We need to clarify that, as of now, the likelihood of a U.S. national debt default remains extremely low, so U.S. Treasury yields are typically viewed as risk-free rates by the capital markets. This means that holding U.S. Treasuries carries a risk profile similar to holding dollars, while also earning additional interest income.

In summary, the core idea of these fixed-income projects is to raise dollars from users, buy U.S. Treasuries, and share the generated (partial) interest with users.

In short, these fixed-income projects will launch yield-stablecoins backed by U.S. Treasuries, allowing holders to earn "interest income" from the underlying financial asset simply by holding the stablecoin as proof:

Users who complete KYC/KYB can mint/redeem at 1 dollar, and the project buys the corresponding Treasuries, allowing stablecoin holders to enjoy the opportunity of Treasury yields, thereby maximizing the transmission of Treasury interest to stablecoin deposit users.

Currently, the yields on U.S. short- to medium-term Treasuries are close to or exceed 5%, so the interest rates of most fixed-income projects backed by Treasuries are also generally in the 4%-5% range.

An example may help clarify this concept—these yield-stablecoins essentially distribute the Treasury interest income that Tether/USDT monopolizes among a broader base of stablecoin holders:

It's important to note that the process of Tether issuing USDT is essentially the process of crypto users "purchasing" USDT with dollars—when Tether issues 10 billion dollars of USDT, it means crypto users have deposited 10 billion dollars with Tether to obtain this 10 billion dollars of USDT.

Once Tether receives this 10 billion dollars, it does not need to pay interest to the corresponding users, effectively obtaining real dollar funds from crypto users at zero cost. If it buys U.S. Treasuries, that becomes zero-cost, risk-free interest income.

According to Tether's disclosed second-quarter attestation report, it directly holds 55.8 billion dollars in U.S. government bonds. At the current Treasury yield of around 5%, this means Tether earns approximately 2.8 billion dollars annually (around 700 million dollars per quarter), and the data showing Tether's second-quarter operating profit exceeding 1 billion dollars also confirms the profitability of this model.

Additionally, these stablecoins can be freely used in DeFi, including through other DeFi protocol components to achieve leveraged, lending, and other derivative needs.

Concerns of the U.S. Treasury Turmoil

Overall, the potential risks faced by such fixed-income projects supported by government bonds and their launched stablecoins mainly stem from three aspects:

Psychological risk of continuous decline in Treasury prices. If the value of Treasury bonds (the value of Treasuries) does not cover the debt (the market value of stablecoins), once it falls to a psychological critical point, it could trigger a de-pegging avalanche;

Liquidity risk due to maturity mismatch. If the crypto market experiences significant volatility, users selling stablecoins to replenish liquidity could lead to a bank run;

Custodian institution risk. There is still considerable reliance on the trust in the custodial institutions of the underlying Treasury assets;

Risk of Treasury price decline

As is well known, the yield of bonds and their prices are two sides of the same coin, so the previously mentioned continuous rise in Treasury yields, reaching a new high, also means that Treasury prices have been continuously declining, hitting a new low during the same period.

Including the earlier mention of the 10-year Treasury yield breaking 5%, the underlying cause is naturally linked to the fact that since the debt ceiling negotiations were passed in June of this year, the issuance of Treasuries has far exceeded historical levels:

From a data perspective, as of the end of May, the U.S. government's debt stood at 31.4 trillion dollars, but after the debt ceiling was lifted in June, the total debt has now surpassed 33 trillion dollars, disrupting the supply-demand relationship of Treasuries and affecting market liquidity.

This also means that the market value of the underlying financial assets (i.e., Treasuries) supporting these yield-stablecoins is continuously depreciating alongside rising yields. However, as long as they are not actually sold, it remains merely a paper loss, presenting a latent "insolvency."

According to predictions, U.S. Treasury issuance may remain high in the fourth quarter. If this supply-demand imbalance continues, Treasury prices will undoubtedly remain under pressure.

This is also the key point of risk accumulation—if Treasury yields continue to rise, Treasury prices will continue to fall. Once users realize that the asset prices behind them have shrunk to an unacceptable level, reaching a psychological critical point, and begin to redeem, then "paper losses become real losses," and the situation of insolvency will become a reality, ultimately triggering an avalanche.

Liquidity risk

Liquidity risk is also a potential technical risk that deserves attention. If the decline in Treasury prices is passively leading to a decrease in the asset value behind yield-stablecoins, it actively exacerbates this issue through an imbalance in the asset-liability structure.

The core issue is that the project parties hold the yield from Treasuries until maturity, but users holding the tokenized RWA assets (i.e., the stablecoins they launched) do not need to wait for Treasuries to mature to redeem their earnings. Where does the money come from?

For example, with the yield of the 10-year Treasury just breaking 5%, even if the project party buys now, they need to wait 10 years until maturity to secure the average annualized yield of 5%. Meanwhile, on-chain token holders can redeem almost instantly. Why is that?

Maturity mismatch

From the analysis of the sources of high yields above, it can be seen that since the stablecoins launched by various projects are primarily not used as a medium of exchange but to provide yields to holders, the underlying financial assets are fundamentally different maturities of government bonds.

To ensure that the risk and return of the investment portfolio are matched and to provide on-chain token holders with the highest possible fixed income (not to mention the current inversion of short- and long-term Treasury yields), it is undoubtedly a combination of "long-term bonds" and "short-term bonds" to balance liquidity (to prevent user redemptions) and yield (to provide fixed income).

This is not inherently problematic; one of the essences of finance lies in maturity mismatch, which is a major source of income in the financial industry. However, it should not be forgotten that this is also a significant source of liquidity risk.

We only need to envision a scenario—if the crypto market experiences significant volatility, and investors generally face liquidation or are close to liquidation, holders may sell RWA to replenish liquidity.

In such a liquidity risk shock, the project party can only sell Treasuries to recover liquidity, starting with short-term bonds that have good liquidity and small discounts. However, once user redemption demands exceed the remaining short-term bonds, they will have to choose to sell long-term bonds at a discount.

Especially since the underlying financial assets (i.e., Treasuries) are only traded during working hours, while on-chain tokenized assets trade 24/7, this mismatch in trading hours may hinder the project party from selling Treasuries in a timely manner to recover liquidity, further exacerbating the selling pressure during market fluctuations.

At this point, the project party must either lower the touted fixed yield or silently recognize losses. However, if they lower the touted fixed yield, it could likely trigger a trust crisis leading to a bank run, exacerbating the selling trend, making it easy for stablecoins to de-peg, and further increasing liquidity risk.

Does this sound familiar?

Indeed, this is almost an identical risk chain and transmission pathway that initiated the Silicon Valley Bank crisis in March of this year, which led to the bankruptcy of several banks, including Silicon Valley Bank and Signature Bank, nearly causing systemic risk.

Custodian institution risk

Of course, to some extent, the connection between the crypto market's tokenized U.S. Treasury fixed-income projects and the traditional financial market is bidirectional. Extreme volatility in the crypto market may transmit through "RWA—Treasuries" to the traditional financial market.

However, the scale of the current tokenized fixed-income projects backed by U.S. Treasuries is still quite limited, and the liquidity of the Treasury market is ample enough to handle such scale shocks, so such sell-offs are currently unlikely to impact the prices of the underlying financial assets.

This leads to another potential risk point—the reliability of custodial institutions. For example, major crypto projects like Circle, which hold a massive amount of Treasuries, are mostly custodied by U.S. financial institutions like BlackRock (Circle Reserve Fund), which are relatively safe.

Currently, many fixed-income stablecoins backed by Treasuries still rely heavily on trust in the custodial institutions of the underlying Treasury assets, and the information disclosed is quite limited, which is also a risk point that should not be overlooked.

Conclusion

Amidst the feast of interest rate hikes, will this brutal revelry ultimately end in brutality?

For ordinary investors, fixed-income projects tokenized with U.S. Treasuries through RWA, although most have corresponding entry barriers, represent a rare opportunity to participate in sharing U.S. Treasury yields.

At the same time, they can also introduce richer funds and high-quality underlying assets to the DeFi space and the crypto market, which is a positive factor for the entire crypto market.

However, the autumn wind has not yet stirred, and since June, the surge in short-term Treasury supply has allowed the U.S. government to overcome the predicament of issuing bonds to alleviate funding gaps. Therefore, the previously mentioned 5% is indeed an important psychological threshold, but it also means that actual yields cannot remain at the current high levels for long.

Thus, for users currently hoping to obtain yields through the tokenization of U.S. Treasuries, it is undoubtedly necessary to manage expectations and control risks:

On one hand, it is essential to understand that no one can guarantee that the 4%, 5%, or even higher U.S. Treasury yields will continue indefinitely, and between the interplay of "yield - price," there exists a critical point. Once Treasury prices fall below a certain level, the situation of insolvency (the value of Treasuries not covering the market value of stablecoins) could materialize, and a de-pegging avalanche may occur in an instant.

On the other hand, the higher the fixed yield provided by the project party above 5%, the more complex the "long-short bond" maturity mismatch may be—as mentioned above, this also indicates that projects with higher fixed yields carry greater potential liquidity risks, and the likelihood of bank runs may increase.

There are no eternal feasts in financial markets, and the crypto industry is no exception.

What is taken can also be given back, and having experienced UST/Anchor, we should perhaps be more aware that no matter how grand the narrative of high yields may be, if it cannot exit completely, it will only be an illusion.

Time will provide us with the answer.