From a financial perspective, can stablecoins become mainstream?

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

Original Authors: @bridge__harris, @foundersfund members

Original Compilation: Luffy, Foresight News

Addison and I have recently been discussing the trends and core use cases of the integration of traditional finance and cryptocurrency. In this article, we will engage in a series of dialogues around the U.S. financial system and explore how cryptocurrency can fit into it from fundamental principles.

There is currently a viewpoint that tokenization will solve many problems in the financial sector, which may be correct or may not be.

Stablecoins, like banks, involve the issuance of new currency. The current trajectory of stablecoin development has raised many significant questions, such as how they integrate with the traditional fractional reserve banking system. In this system, banks only keep a small portion of deposits as reserves, while the rest is used for lending, effectively creating new currency.

I. The Tokenization Craze

The mainstream voice is to "tokenize everything," from publicly traded stocks to private market shares to U.S. Treasury bonds. This is generally beneficial for the crypto space and the world as a whole. Thinking about the dynamics of the tokenization market from fundamental principles, the following points are crucial:

• How the current asset ownership system operates;

• How tokenization will change this system;

• Why initial scenarios for tokenization are necessary;

• What "real dollars" are and how new currency is created.

Currently in the U.S., large asset issuers (such as publicly traded stocks) grant custodial rights of securities to the Depository Trust Company (DTCC). Subsequently, the DTCC tracks the ownership of about 6,000 accounts interacting with it, each of which manages its own ledger to track the ownership of end users. For private companies, the model is slightly different: companies like Carta simply manage ledgers for businesses.

Both models are highly centralized bookkeeping methods. The DTCC model resembles a "nested" bookkeeping system, where individual investors may need to go through 1 to 4 different entities before accessing the actual ledger records of the DTCC. These entities may include the brokerage or bank where the investor opened an account, the custodian or clearinghouse of the broker, and the DTCC itself. Although ordinary retail investors are usually not affected by this hierarchical structure, it imposes a significant amount of due diligence work and legal risks on financial institutions. If the DTCC itself were to tokenize assets, reliance on these intermediary entities would decrease, as investors could more conveniently connect directly with the clearinghouse; however, this is not the model proposed in the current discussion.

The current tokenization model involves an entity holding the underlying asset as a line item in a general ledger (for example, as a subset of entries in the DTCC or Carta accounts), and then creating a new, tokenized form of asset holding for on-chain use. This model is inefficient in itself because it introduces another entity that can extract value, create counterparty risk, and lead to settlement/clearing delays. Introducing additional entities breaks composability, as it requires extra steps to "wrap and unwrap" securities for interaction with other parts of traditional finance or decentralized finance, causing delays.

Perhaps a more ideal approach would be to directly put the DTCC or Carta's ledger on-chain, making all assets natively "tokenized," allowing all asset holders to enjoy the benefits of programmability.

A major argument supporting the realization of securities tokenization is global market access and 24/7 trading and settlement. If tokenization is a mechanism to "deliver" stocks to emerging market investors, it would undoubtedly represent a leap forward in how the current system operates and open the doors to the U.S. capital markets for billions of people. However, it remains unclear whether blockchain tokenization is necessary, as this is a regulatory issue. Whether tokenized assets will become an effective regulatory arbitrage tool like stablecoins in the long run is still debatable. Similarly, a common bullish argument for on-chain stocks is perpetual contracts; however, the obstacles faced by perpetual contracts are entirely regulatory rather than technical.

Stablecoins are structurally similar to tokenized stocks, but the market structure of stocks is much more complex (and highly regulated), involving a series of clearinghouses, exchanges, and brokers. Tokenized stocks are fundamentally different from "ordinary" crypto assets, which are not backed by any asset but are native tokens with composability.

To achieve an efficient on-chain market, the entire traditional financial system needs to be replicated, which is an extremely complex and daunting task given the degree of liquidity concentration and existing network effects. Simply putting tokenized stocks on-chain is not a panacea; ensuring they are liquid and can interoperate with other parts of traditional finance requires a lot of deep thinking and supporting infrastructure development. However, if the U.S. Congress were to pass a law allowing companies to issue digital securities directly on-chain, many traditional financial entities would lose their necessity entirely. Tokenized stocks would also reduce the compliance costs associated with traditional listings.

Currently, emerging market governments have no incentive to legitimize access to U.S. capital markets, as they prefer to keep capital within their domestic economies; for the U.S., opening access would raise anti-money laundering issues.

II. Real Dollars and the Federal Reserve

Real dollars are an entry in the Federal Reserve's ledger. Currently, about 4,500 entities (banks, credit unions, certain government agencies, etc.) can access these "real dollars" through a Federal Reserve master account. None of these entities are native crypto institutions, unless you count Lead Bank and Column Bank, which do serve crypto clients like Bridge. Entities with master accounts can access Fedwire, which is an extremely cheap and nearly instantaneous payment network that can send wire transfers for 23 hours a day and settle almost instantly. Real dollars fall under the M0 category: the total of all balances on the Federal Reserve's master ledger. "Fake" dollars (created by private banks through loans) fall under the M1 category, which is about six times the size of M0.

The user experience of interacting with real dollars is actually quite good: transfers cost about 50 cents and can settle instantly. Whenever you wire funds from your bank account, your bank interacts with Fedwire, which has near-perfect uptime, instant settlement capabilities, and very low transfer delay costs. However, regulatory tail risks, anti-money laundering requirements, and fraud detection measures lead banks to impose many restrictions on large payments.

Based on this structure, a disadvantage faced by stablecoins is the expansion of access to these "real dollars" through an instant system that does not require intermediaries, which would: 1) capture underlying earnings (the two largest stablecoins do this); 2) restrict redemption rights. Currently, stablecoin issuers collaborate with banks, which in turn hold master accounts at the Federal Reserve.

So, if stablecoin issuers were to obtain a Federal Reserve master account, it would be like having a cheat code, allowing them to earn a 100% risk-free Treasury yield, with: 1) no liquidity issues; 2) faster settlement times. Why wouldn't they pursue this themselves?

Requests from stablecoin issuers for master accounts are likely to be rejected, similar to the application of Narrow Bank (additionally, crypto banks like Custodia have also failed to obtain master accounts). However, Circle's relationship with its partner banks may be close enough that the improvement in fund flow from a master account is not significant.

The Federal Reserve is reluctant to approve master account applications from stablecoin issuers because the dollar model is only compatible with the fractional reserve banking system: the entire economic system is built on the premise that banks only need to hold a few percentage points in reserves.

Essentially, new currency is created through debt and loans. But if anyone could access a 100% or 90% interest rate risk-free (without lending funds for mortgages, business loans, etc.), who would still use ordinary banks? And if no one uses ordinary banks, there would be no deposits to lend out, create more currency, and the economy would stagnate.

The two core principles the Federal Reserve cites when considering master account eligibility include: 1) granting a master account to an institution must not introduce undue network risks; 2) it must not interfere with the implementation of the Federal Reserve's monetary policy. For these reasons, at least in the case of current stablecoin issuers, they are unlikely to obtain a master account.

Stablecoin issuers can only potentially gain access to master accounts if they "become" banks. The GENIUS Act would establish bank-like regulatory requirements for issuers with a market capitalization exceeding $10 billion. Essentially, the argument here is that since they will be regulated like banks anyway, they can operate more like banks in the long run. However, under the GENIUS Act, due to the 1:1 reserve requirement, stablecoin issuers still cannot engage in fractional reserve banking.

So far, stablecoins have not disappeared due to regulation because most stablecoins are issued by Tether overseas. The Federal Reserve is pleased to see the dollar dominate globally in this way, as it reinforces the dollar's status as a reserve currency. However, if entities like Circle (or even Narrow Bank) significantly expand and are widely used for deposit accounts in the U.S., the Federal Reserve and the Treasury may become concerned. This is because it would divert funds from banks operating under a fractional reserve model, which is how the Federal Reserve implements monetary policy.

This is essentially the problem that stablecoin banks will face: to issue loans, they need a banking license. But if stablecoins are not backed by real dollars, then they are no longer true stablecoins, which contradicts their original purpose. This is where the fractional reserve model "fails." However, theoretically, stablecoins could be created and issued by a chartered bank that has a master account and operates under a fractional reserve model.

III. Banks, Private Credit, and Stablecoins

The only benefit of becoming a bank is the ability to obtain a Federal Reserve master account and insurance from the Federal Deposit Insurance Corporation (FDIC). These two features allow banks to assure depositors that their deposits are safe "real dollars" (backed by the U.S. government), even if those deposits have actually been lent out.

Issuing loans does not necessarily require becoming a bank; private credit companies have been doing this. However, the difference between banks and private credit is that banks issue a "receipt" that is considered actual dollars, which is interchangeable with receipts issued by other banks. The backing assets of bank receipts are completely illiquid; however, the receipts themselves are fully liquid. This cognitive dissonance of converting deposits into illiquid assets (loans) while maintaining the value of deposits is at the core of money creation.

In the private credit space, the value of your receipt is tied to the underlying loan. Therefore, no new currency is created; you cannot actually use your private credit receipt for consumption.

Let’s take Aave as an example to explain concepts in the crypto space that are similar to banks and private credit. Private credit: in the real world, if you deposit USDC into Aave, you receive aUSDC. aUSDC is not fully backed by USDC at any given time, as part of the deposits have been lent out as collateral to users. Just as merchants do not accept private credit receipts, you cannot use aUSDC for consumption.

However, if economic participants are willing to accept aUSDC in exactly the same way they accept USDC, then Aave functionally becomes a bank, where aUSDC is what it tells depositors it has in dollars, while all the backing assets (USDC) have been lent out.

IV. Do Stablecoins Create New Currency?

If we apply the above arguments to stablecoins, then stablecoins do functionally create "new currency." To illustrate this further:

Suppose you buy a Treasury bond from the U.S. government for $100. Now you have a bond that cannot truly be used as currency, but you can sell it at a fluctuating market price. On the backend, the U.S. government is using that money; the bond is essentially a loan.

Now suppose you send $100 to Circle, and Circle uses that money to buy a Treasury bond. The government is using that $100 ------ and so are you. You receive 100 USDC, which can be used anywhere.

In the first case, you have a bond that cannot be used directly. In the second case, Circle has created a representative form of the bond that can be used in the same way as dollars.

Based on each dollar of deposits, the "currency issuance" of stablecoins is relatively small, as most stablecoins are backed by short-term Treasury bonds, which have little interest rate volatility. The currency issuance per dollar for banks is much higher because they have longer liability durations and higher lending risks. When you redeem a Treasury bond, the money you receive from the government is what the government earns from selling another Treasury bond, and this cycle continues.

Ironically, in the crypto space's cypherpunk values, each issuance of stablecoins merely makes the cost of government borrowing and inflation lower: increasing demand for Treasury bonds, which are essentially government spending.

If the scale of stablecoins becomes large enough (for example, if Circle's scale reaches about 30% of M2, while stablecoins currently account for 1% of M2), they could pose a threat to the U.S. economy. This is because every dollar transferred from the banking system to stablecoins reduces the net money supply (since the money created by banks is greater than that created by stablecoin issuance), and the money supply has previously been the exclusive domain of the Federal Reserve's regulation. Stablecoins would also undermine the Federal Reserve's power to implement monetary policy through the fractional reserve banking system. That said, 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 of dollars, stablecoin issuers like Circle may integrate into the U.S. economic system, and regulators will seek to coordinate the demands of monetary policy with the demand for programmable currency. This brings us to the realm of central bank digital currencies (CBDCs), which we will discuss further later.