Addison (@0xaddi) and I have recently been discussing the significant interest in TradFi x crypto and its actual core use cases. Below, we formalize the conversations we’ve been having around the US financial system and how crypto can fit in from a first principles approach:

• The current narrative claims that tokenization will solve many financial problems, which may or may not be true.
• Stablecoins cause net new money issuance, just like banks. The current stablecoin trajectory poses significant questions about how they interface with the traditional fractional reserve banking system — where banks keep only a fraction of deposits as reserves while lending out the rest, effectively creating net new money.

Tokenization has become the current thing

The narrative right now is that “tokenizing everything” — from public markets stocks to private market shares to T-bills — will be net good for both crypto and the world. To think about what’s happening in the market from a first principles approach, it’s helpful to go through:

1) how the current asset ownership system operates;

2) how tokenization would change that system;

3) why it’s even necessary in the first place; and

4) what “true dollars” are and how net new money is created.

Currently in the United States, large asset issuers (such as publicly traded equities) give custodial rights to their certificates to the DTCC. The DTCC then tracks ownership of the roughly 6,000 accounts that interact with it, who in turn manage their own ledger tracking ownership for their end users. For private companies, the model is slightly different: companies like Carta just manage the ledger for businesses.

Both models involve highly centralized ledgering. The DTCC model has a “babushka doll” of ledgering where an individual may go through 1-4 different entities before reaching the actual ledger entry with the DTCC. These entities can include the brokerage firm or bank where the investor has an account, the broker’s custodian or clearing firm, and the DTCC itself. Though the average end user (retail) isn’t affected by this hierarchy, it creates significant due diligence work and legal risk for institutions. If the DTCC themselves were to natively tokenize their assets, reliance on these entities would diminish as it becomes easier to interface directly with the clearinghouse — but this is not the model being proposed by popular discourse today.

Current models of tokenization involve an entity holding an underlying asset as a line-item within a master ledger (e.g. as a subset of the entries in the DTCC or Carta) and then creating a new, tokenized representation of its holdings for onchain use. This model is inherently inefficient as it creates yet another entity which can extract value, create counterparty risk, and cause settlement/unwind delays. Introducing another entity breaks composability because it causes an extra step to “wrap and unwrap” the security to interact with the rest of tradfi or defi, which may cause delays.

It might be more optimal for all assets to be natively “tokenized” by putting the DTCC or Carta ledger onchain, giving all asset holders the benefits of programmability.

One of the main arguments for enabling tokenized equities is global market access and 24/7 trading and settlement. If tokenization is the mechanism by which equities are “delivered” to people in emerging markets, then that would of course be a step-function improvement in the way the current system operates, and open up access to American capital markets to billions of people. But it’s still unclear that tokenization via blockchain is necessary, because the task is mostly regulatory. It’s open to question whether tokenizing assets would be an effective regulatory arbitrage in the same way stablecoins are on a long enough time horizon. Similarly, a common bull-case for onchain equities is perpetuals; however, the blocker for perpetuals (including equities) is entirely regulatory and non-technical.

Stablecoins (tokenized dollars) are similar in structure to tokenized equities, but the market structure of equities is much more complicated (and highly regulated) to include a set of clearing-houses, exchanges, and brokers. Tokenized equities are inherently different from “normal” cryptoassets, which aren’t “backed” by anything but are instead natively tokenized and composable (e.g. BTC).

For efficient onchain markets, this entire TradFi system would need to be replicated which is an insanely complicated, Herculean task due to concentration of liquidity and existing network effects. Simply putting tokenized equities onchain will not be a panacea, for ensuring they are liquid and composable with the rest of TradFi will require a significant amount of thought and infrastructure. However, if Congress passes a law that allows companies to directly issue digital securities onchain (instead of doing an IPO), this would eliminate the need for many tradfi entities entirely (and there’s a chance this could be outlined in the new market structure bill). Tokenized shares would also reduce compliance costs to going public in the traditional sense.

Right now, emerging market governments are not incentivized to legalize access to US capital markets since they prefer to keep capital endogenous to their own economies; for America, opening up access from the US side would introduce AML problems.

Aside: In some sense, the Variable Interest Entity (VIE) structure used by Alibaba ($BABA) on US exchanges already represents a form of “tokenization” where American investors don’t directly own native BABA shares but instead own a Cayman company with contractual rights to Alibaba’s economics. This does open up the market but also creates a net new entity and new shares that dramatically increase complexity around these assets.

True dollars & the Fed

A true dollar is an entry in the Federal Reserve ledger. Currently, there are roughly ~4,500 entities (banks, credit unions, certain government entities, etc) that have access to these “true dollars” via a Fed Master Account. Zero of these entities are cryptonative, unless you count Lead Bank and Column Bank, which do service select crypto customers like Bridge. With a Master Account, these entities get access to Fedwire, a super cheap and near-instantaneous payment network where a wire can be sent 23 hours of the day and settle basically instantly. True dollars sit in M0: the sum of all the balances on the Fed’s master ledger. The “fake” dollars (“created” via loans by private banks) are M1, which is approximately 6x the size of M0.

Interacting with true dollars is actually pretty good UX: it only costs ~50 cents for a transfer and you get instant settlement. Anytime you wire money out of your bank account, your bank will interact with Fedwire, which has nearly perfect uptime, instant settlement, and cheap transfer delays — but regulatory tailrisk, AML requirements, and fraud detection have caused banks to put lots of guardrails around large payments (this is the origin of end-user friction).

With this structure, a bear case for stablecoins would be the broadening of access to these “true dollars” via an instant system that doesn’t require an intermediary that 1) takes the underlying yield (true for the largest two stablecoins), and 2) limits redemption access. Right now, stablecoin issuers partner with banks who in turn have Master Accounts at the Fed (Circle with JP Morgan / BNY Mellon) or with financial institutions with significant access to the US banking system (Tether with Cantor Fitzgerald).

So why wouldn’t stablecoin issuers want a Fed Master Account themselves, if it’s essentially a cheat code where they get 100% risk-free treasury yield with 1) no liquidity issues, and 2) faster settlement times?

The case for a stablecoin issuer getting a Fed Master Account would likely be rejected in a similar way The Narrow Bank’s application was rejected (and in addition, crypto banks like Custodia have also been consistently denied Master Accounts). However, it is possible that Circle has a sufficiently close relationship with their partner banks for a master account to not be a significant improvement in money movement.

The reason it wouldn’t be in the Fed’s interest to approve a Master Account application from stablecoin issuers is because the dollar model is only compatible with the fractional reserve banking system: the whole economy is built on banks having a few percentage points worth of reserves.

This is essentially how new money gets created via debt and loans — but if anyone can access 100% or 90% of the interest rate risk-free (no money lent out for mortgages, businesses, etc), why would anyone even use a normal bank? And if they don’t use normal banks, there aren’t deposits to create loans and more money, and the economy would grind to a halt.

Two of the core principles the Fed cites regarding Master Account eligibility include 1) granting a master account to an institution must not introduce undue cyber risk and 2) it must not interfere with the Fed’s implementation of monetary policy. For these reasons, granting stablecoin issuers a Master Account — at least as they exist today — is unlikely.

The only situation where stablecoin issuers may in fact get Master Account Access is in the case that they “become” a bank (which they probably don’t want to be). The GENIUS Act would establish bank-like regulation for issuers with more than $10 billion in market cap — essentially, the argument here is that since they’ll be regulated like a bank regardless, they could operate more like a bank over a long enough time horizon. However, stablecoin issuers still would not be able to engage in fractional-reserve-like banking practices under the GENIUS Act because of the 1:1 reserve requirement.

To date, stablecoins haven’t been regulated out of existence because most of them exist offshore via Tether. The Fed is fine with dollar dominance extending globally in this way — even if it’s not via the fractional reserve banking model — because it strengthens the dollar as a reserve currency. But if an entity like Circle (or even a narrow bank) were orders of magnitude larger and being used in depository style accounts at scale in the US, the Fed and treasury would likely be concerned (because it takes money out of banks running the fractional reserve model where the Fed can implement their monetary policy).

This is fundamentally the same issue a stablecoin bank would face: to do loans, a banking license is needed — but if a stablecoin isn’t backed by true dollars, then it’s not really a stablecoin anymore and defeats the whole purpose. This is where the fractional reserve model “breaks.” In theory, however, a stablecoin could be created and issued by a chartered bank (that has a Master Account) that operates a fractional reserve model.

Banks vs. private credit vs. stablecoins

The only benefit of becoming a bank is access to a Fed Master account and FDIC insurance. These two features allow banks to tell their depositors that their deposits are safe “true dollars” (backed by the US government) despite all being loaned out.

To make loans, you don’t need to be a bank (private credit firms do it all the time). However, the distinction between a bank and private credit is that with a bank, you receive a “receipt” that is perceived as actual USD. Thus it is fungible with all other receipts from other banks. The backing of bank receipts is fully illiquid; however, the receipt is fully liquid. This conversion from deposits, into illiquid assets (loans), while maintaining perception that the deposits maintain their value is the crux of money production.

In the private credit world, your receipt is marked to the value of the underlying loans. Thus no new money is created; you can’t really spend your private credit receipt.

Let’s explain analogues to banking and private credit in crypto using Aave. Private credit: In the existing world, you deposit USDC into Aave and receive aUSDC. aUSDC is not fully backed at all times by USDC because some of the deposits are loaned out to users in collateralized loans. Much like merchants will not accept private credit ownership, you cannot spend aUSDC.

However, if economic participants were somehow willing to accept aUSDC in the exact same way as USDC Aave would be functionally equivalent to a bank where aUSDC is the USD it tells its depositors it owns, meanwhile all of the backing (USDC) is loaned out.

A simple example as an aside: Addison gives Bridget Credit Fund $1,000 of tokenized private credit, which can be spent as if it is dollars. Bridget then gives the $1,000 to someone else via a loan, and there is now $2,000 of value in the system ($1,000 that is lent out + $1,000 of tokenized Bridget Fund). In this instance the lent out $1,000 is just debt and operates like a bond: a claim on the $1,000 Bridget lent out to someone else.

Stablecoins: net new money or not?

If the argument above is applied to stablecoins, then stablecoins functionally do create “net new money.” To illustrate this further:

1. Let’s say you buy a T-bill for $100 from the US government. You now own a T-bill that can’t really be spent as money, but you can sell it for a fluctuating market price. On the backend, the US government is spending this money (because it is inherently a loan).
2. Let’s say you send $100 to Circle, and with that money, they buy T-bills. The government is spending this $100 — but you are too. You receive 100 USDC which can be spent anywhere.

In the first case, there was a treasury bond that you couldn’t do anything with. In the second case, Circle created a representation of the treasury bond that was usable in the same way dollars are.

On a per dollar of deposit basis, the amount of “money issuance” for stablecoins is marginal because most stablecoin backings are in short-term treasuries that are not highly subject to rate movements. Bank’s money issuance per dollar is way higher because their liabilities are much longer term and in riskier loans. When you redeem your T-bill, you’re getting money from the government selling yet another T-bill — and the cycle continues.

It’s a bit ironic that within the cypherpunk values of crypto, each time a stablecoin is issued it just makes it cheaper for the government to borrow and inflate (more demand for treasuries which is effectively just government spending).

If stablecoins get big enough (e.g. if Circle had ~30% of M2 — currently stablecoins represent 1% of M2), they could potentially pose a threat to the American economy. This is because every dollar that moves from banking into stablecoins net reduces the money supply (because the money banks “create” is more than the money created by stablecoin issuance), which was previously a Fed-only operation. Stablecoins also weaken the Fed’s power in implementing monetary policy via the fractional reserve banking system. That said, the benefits of stablecoins globally are indisputable: they spread dollar dominance, strengthen the USD reserve currency narrative, make cross-border payments more efficient, and immensely help people outside of the US that need access to a stable currency.

And when stablecoin supply hits trillions, stablecoin issuers like Circle may become enshrined into the US economy, and regulators will figure out how to intertwine the needs for monetary policy and programmable money (this gets into CBDC territory which we’ll save for later).

Disclaimer:

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