Article Author: Bridget, Addison

Addison (@0xaddi) and I have been discussing the huge interest in combining traditional finance (TradFi) with cryptocurrencies and their actual core use cases. Here is a summary of our discussion around the U.S. financial system and how cryptocurrencies fit into it from a first principle perspective:

The current mainstream view believes that tokenization will solve many financial problems, which may or may not be true.

Stablecoins, like banks, will lead to net new currency issuance. The current trajectory of stablecoins raises an important question of how they interact with the traditional partial reserve banking system in which banks only

tokenization has become a current hot topic

The current narrative is that "tokenization everything"—from stocks in the open market to shares in the private market to short-term Treasury bonds—will generate net positive returns on cryptocurrencies and the world as a whole. To think about what is happening in the market from a first principle perspective, the following points will be helpful:

Currently in the United States, large asset issuers (such as publicly traded stocks) hand over the custody of their certificates to DTCC (US Securities Deposit Trust). DTCC then tracks ownership of approximately 6,000 accounts interacting with it, which in turn manage their own ledgers, tracking ownership of their end users. For private companies, the model is slightly different: companies like Carta manage the ledger only for businesses.

Both models involve highly centralized ledger management. The DTCC model adopts a "Russian doll"-style ledger structure, and individuals may need to pass 1-4 different entities to reach the actual ledger entry of DTCC. These entities may include brokerage firms or banks in which investors open accounts, custodians or clearing firms of brokerage firms, and DTCC itself. Although ordinary end users (retail investors) are not affected by this hierarchy, it brings a lot of due diligence and legal risks to institutions. If DTCC itself can natively tokenize its assets, for thisThe dependence of these entities will be reduced, as it becomes easier to interact directly with the clearing house—but this is not the pattern proposed by popular discussions today.

The current tokenization model involves an entity holding an underlying 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 use on the supply chain. This model is inherently inefficient because it introduces an entity that can extract value, generate counterparty risk, and lead to settlement/desistance delays. Introducing another entity would undermine composability because it adds an additional step to “pack and unpack” securities to interact with traditional finance or decentralized finance (DeFi), which could lead to delays. Putting DTCC or Carta's ledger directly on the chain makes all assets native to "tokenization" may be better, so that all asset holders can enjoy the benefits of programmability.

One ​​of the main arguments that support tokenized stocks is global market access and 24/7 trading and settlement. If tokenization is the mechanism by which stocks are “delivered” to emerging market populations, then this is of course a major improvement in the current system’s operation and opens the U.S. capital market to billions of people. But it is not clear whether tokenization through blockchain is necessary, as this task mainly involves regulatory issues. Whether tokenized assets can become effective regulatory arbitrage like stablecoins over a long enough time frame remains to be discussed. Similarly, a common bullish reason for on-chain stocks is perpetual contracts; however, the barriers to perpetual contracts (including stocks) are entirely regulatory rather than technical.

Stablecoins (tokenized dollars) are structurally similar to tokenized stocks, but the market structure of stocks is much more complex (and highly regulated) and includes a range of clearing houses, exchanges and brokers. Tokenized stocks are essentially different from “ordinary” crypto assets, which are not “endorsed” by anything but are native tokenized and composable (e.g., BTC).

In order to achieve an efficient on-chain market, the entire traditional finance (TradFi) system needs to be replicated on-chain, which is an extremely complex and arduous task, because the concentration of liquidity and the existing network effects make this process extremely difficult. Simply putting tokenized stocks on the chain won’t be a panacea, and ensuring they are liquid and composable with the rest of the traditional financial system requires a lot of thinking and infrastructure construction. However, if Congress passes a law that allows companies to issue digital securities directly on-chain (rather thanconduct an IPO), which will completely eliminate the need for many traditional financial entities (and it may be outlined in the new market structure bill). Tokenized shares will also reduce the compliance costs of public listing in the traditional sense.

At present, emerging markets have no motivation to legalize access to the U.S. capital markets because they prefer to keep capital within their own economies; for the United States, opening access from the U.S. side will introduce anti-money laundering (AML).

Offtopic: In a sense, the variable interest entity (VIE) structure used by Alibaba ($BABA) on U.S. exchanges have represented a form of "tokenization", and American investors do not directly own the real dollar and the Federal Reserve. The real dollar is an entry in the Federal Reserve's ledger. Currently, about 4500 entities (banks, credit unions, certain entities, etc.) have obtained these “real dollar interactions through the Fed’s main account with a pretty good user experience: only about 50 cents per transfer, which is where the friction of end-user experience is coming).

With this structure, stablecoins and the system does not require intermediary stablecoin issuers to cooperate with banks with Fed’s main account (Circle cooperates with JPMorgan/Bank New York Mellon), or with financial institutions with important positions in the U.S. banking system (Tether cooperates with Cantor Fitzgerald).

So why don't stablecoin issuers apply for a Fed main account themselves? But if this is essentially a cheat code, they can get 100% risk-free Treasury yields, while 1) no liquidity issues, 2) faster settlement times?

Stocks of stablecoin issuers applying for Fed main account will likely be rejected like the application of The Narrow Bank (and, crypto banks like Custodia have been rejected for master accounts). However, Circle's relationship with its partner banks may be close enough that the improvement of capital flows in the main account is not significant.

The Federal Reserve is unwilling to criticizeThe reason for applying for the main account of the quasi-stable currency issuer is that the US dollar model is only compatible with the partial reserve banking system: the entire economy is built on the bank holding a few percentage points of reserves.

This is basically the way to create new currency through debt and loans—but if anyone can get a 100% or 90% interest rate without risk (no funds are loaned for mortgages, businesses, etc.), then why would anyone use a regular bank? If people don’t use ordinary banks, there will be no deposits to create loans and more currencies, and the economy will stagnate.

The two core principles of the Federal Reserve's qualification certification include: 1) The granting of a main account to a certain institution shall not introduce excessive cyber risks; 2) shall not interfere with the implementation of the Federal Reserve's currency. For these reasons, at least in the current form, it is unlikely to grant the main account of the stablecoin issuer.

The only situation where stablecoin issuers may gain access to the main account is that they "turn" into banks (which may be what they do not want). The GENIUS Act would establish bank-like regulation for issuers with a market capitalization of more than $10 billion—the argument here is that, since they will be regulated as banks anyway, they can operate more like banks for a long enough time frame. However, under the GENIUS Act, stablecoin issuers are still unable to engage in banks similar to partial reserve models due to 1:1 reserve requirements, through which the Fed implements currency).

This is essentially the same problem that stablecoins will face: to issue loans, a bank license is required—but if stablecoins are not made by private credit, the difference is that in the bank, what you receive is a "receipt" deemed to be the actual dollar. Therefore, it is interchangeable with receipts from other banks. The endorsement of bank receipts is completely liquid; however, the receipts themselves are completely liquid. The core of money production is the conversion from deposits to illiquid assets (loans) while maintaining the awareness of the unchanged value of deposits.

In Private Credit: In the existing world, you deposit USDC into Aave and receive aUSDC. aUSDC is not always entirely backed by USDC, as some of the deposits are loaned to users as mortgages. Just like merchants won't accept $1,000 tokens). In this case, 1 loaned,000 is just debt, and it works like a bond:

In the backstage, the United States is spending this money (because it is essentially a loan).

When you sell another piece of money that the bank "creates" more than the stablecoin issuance), which was previously a unique operation by the Federal Reserve. Stablecoins will also undermine the Fed's ability to implement currencies through partial reserve banking systems. Still, the benefits of stablecoins globally are undisputed: They expand the dominance of the dollar, strengthen the narrative of the dollar reserve currency, make cross-border payments more efficient, and greatly help those outside the United States who need stablecoins. When the supply of stablecoins reaches trillions, stablecoin issuers like Circle may be included in the U.S. economy, and regulators will have to find out how to balance the demand for currencies and programmable currencies (and this has entered the field of central bank digital currencies, which we have plans to discuss).

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