Stablecoins vs Tokenized Deposits (EN)
On November 2, 2022, as part of the ongoing “Project Guardian” by the Monetary Authority of Singapore, a cross-border FX deal was executed between J.P. Morgan and SBI Digital Asset Holdings using decentralized finance (DeFi) technology. This marks the first-ever cross-border transaction as well as the first-ever transaction using tokenized deposits issued by deposit-taking institutions on a public blockchain.
There are several aspects of this transaction that are noteworthy, such as why J.P. Morgan and SBI chose to use the Polygon network, the AAVE Arc protocol, and how they utilized Verifiable Credentials (VC), but the most interesting aspect is why they chose to use tokenized deposits instead of stablecoins. To understand this decision, it is important to understand what tokenized deposits are, how they differ from stablecoins, and the advantages of tokenized deposits.
Fiat to Crypto: Stablecoins, CBDCs, Tokenized Deposits
As the crypto market continues to expand, there is an increasing interest in methods for converting fiat money into crypto assets, known as “Fiat to Crypto” (F2C). As the name suggests, F2C refers to a medium that enables the exchange of fiat money for crypto assets. Unlike other crypto assets, F2C assets are designed to be exchanged for fiat currency without experiencing significant price volatility. Currently, F2C assets are being widely adopted in various financial applications, such as payments, transfers, exchanges, and loan products. Notable examples include stablecoins, tokenized deposits, and Central Bank Digital Currencies (CBDCs).
- Stablecoins: Unlike other crypto assets, which can be affected by price volatility depending on market conditions, stablecoins are designed to have relatively low-price volatility. There are several approaches to guarantee the value of stablecoins, such as using fiat currency collateral (e.g. USDT, USDC), crypto assets collateral (e.g. DAI), or an algorithm-based method (e.g. UST, USDN). Currently, most stablecoins use fiat currency collateral based on the U.S dollar. As of December 2022, the market capitalization of the top 4 biggest stablecoins (USDT, USDC, BUSD, DAI) is around $134 billion, representing a large portion of the crypto market.
- CBDCs: Central Bank Digital Currency, as its name suggests, is a digital liability issued and managed by a central bank. CBDCs are gaining attention alongside with the growth of stablecoins and around 86% of central banks in major countries are exploring ideas for issuing their own CBDCs. However, the implementation and detailed design of CBDCs are still at the experimental phase and are not yet ready for commercial use.
- Tokenized Deposits: Tokenized deposits are bank deposits that are tokenized to be used on the blockchain. They have the same attributes as conventional deposits, except for their tokenized form. Like conventional deposits, they are recognized as bank liabilities and are subject to the same regulations and protections. Therefore, unlike stablecoins which are considered as “new currencies” created for the digital crypto era, tokenized deposits can be considered as financial products that focus on “new exchange methods” utilizing blockchain technology.
“It is useful to make a distinction between “money,” the asset that is being exchanged, and the “exchange mechanism,” that is, the method or process through which the asset is transferred.”
Stablecoins vs Tokenized Deposits
Insufficient regulatory frameworks for stablecoins and differences in creditworthiness.
Stablecoins do not have legally mandated regulations or disclosure requirements for their collaterals, unlike regulated conventional banks. As a result, there are controversies surrounding the reserve funds of stablecoins. For example, during the collapse of the Hengda Group, there were allegations that Tether owned Hengda issued bonds. Additionally, crypto-collateralized stablecoins raise questions about their value stability as the volatility of crypto prices can affect the value of their financial reserves. To dispel these controversies, stablecoin issuers such as Tether and Circle are voluntarily disclosing information about their proof of reserves. However, similar to the accounting audits on crypto exchanges, which are also a main topic of dispute, this initiative does not seem to help them gain much market trust as the fundamental lack of regulated accounting standards and compliance controls remains unresolved. Therefore, even with their proof of reserve disclosures, there are still question marks surrounding Tether’s capital reserve whenever the market conditions are bad, and there are even rumors that some hedge funds are making short bets on Tether for its depegging possibility.
On the other hand, tokenized deposits are under traditional regulatory control and protection, just like conventional deposits. Banks are the most regulated institutions in the market, and this also allows for a higher degree of protection for its investors. In the U.S, any deposit is guaranteed to be protected by the Federal Deposit Insurance Corporation (FDIC) up to $250,000 in case of any issues, and there also exist central banks that act as the lender of last resort in case of any solvency issues with the bank.
These differences in regulatory controls and safeguards lead to differences in creditworthiness. Banks are considered the safest and most secure institutions in the financial industry, and in the bond market, bank-issued bonds are considered of the highest grade. As of December 2022, J.P. Morgan was rated A1 by Moody’s, which is higher than credit ratings of some emerging countries such as Brazil (Ba2), India (Baa3), and Thailand (Baa1). While it is possible that CBDCs may carry a higher rating than U.S bank bonds, it will take a considerable amount of effort and time to design and materialize it before it can be ready to use.
Bank Reserve System vs Overcollateralization
This difference in creditworthiness also leads to a difference in liquidity. For bank deposits, a “fractional reserve” system is used, which relies on the bank’s credit rather than 100% of its collateral. In the case of the U.S, only a minimum of 10% of assets in deposits needs to be kept in the central bank to respond to depositor’s withdrawal/deposit requests, and the remaining 90% of assets can be used for loans, investments, and so on.
In contrast, the top 4 biggest stablecoins maintain an overcollateralized status. Although there is no legal collateralization rate for stablecoins yet, through many market turmoil over the years, overcollateralization has become an unwritten standard in the stablecoin industry. Additionally, Circle’s recent proof of reserve disclosure shows that they hold more than 100% of its reserves in cash equivalents.
In short, tokenized deposits have an advantage over stablecoins in terms of liquidity. For example, for $100 on a blockchain, stablecoins would need to lock up all $100, whereas tokenized deposits would only need to lock up $10 and can use the remaining $90 for other purposes such as loans. In a podcast with Defiant, Tyrone Lobban, the Head of Blockchain at J.P. Morgan’s Onyx business unit, described this limitation of stablecoins as the reason why J.P. Morgan and SBI used tokenized deposits rather than stablecoins. He adds that J.P. Morgan’s daily trade volume is bigger than the entire market capitalization of stablecoins, around $10T, and it would be very inefficient to lock up 100% of stable assets of this size with collateralization and could lead to liquidity issues in the financial industry.
Existing system
After discussing the previous points, it raises the question: “Why do we need a new financial product called stablecoins after all?” Until recently, stablecoins were considered the only option for F2C as there were no other alternatives. However, as seen from the previous J.P. Morgan-SBI trade, the use of methods and products from the traditional financial industry will increase with more institutional market entry. Most importantly, these methods and products have already been market-proven in the traditional financial industry. Bank deposits have been used as a means of payment for decades, and regulations have been effective in maintaining trust in banks and bank deposits over time. This established trust and proven track record could potentially be leveraged in the development of tokenized deposit systems, which utilize blockchain technology to provide a new exchange method within the crypto space. In addition, there are criticisms that decentralization, which is the common logic behind stablecoins, is in fact just a transfer of authority from existing banking institutions to stablecoin issuers and there is no difference from the existing banking system from the decentralization perspective.
With these reasons, it may be more efficient to try to adapt and evolve proven existing systems rather than trying to reinvent the wheel from scratch. As the form of currency has shifted from paper money to electronic money in line with the digital era, it may be more ideal to leverage existing well-established infrastructure by transforming it to blockchain-based tokenized systems rather than trying to invent a new currency.
Conclusion
- While the institutions strongly agree on the future of blockchain technology combined with finance, they take cautious positions regarding the stablecoins or crypto assets with regulatory uncertainty. In fact, when asked about the future in a podcast with Defiant, Lobban stated, “Future of finance is going to have very strong blockchain element (…) not super clear on crypto aspect.” Also, just like the “Blockchain not Bitcoin” statement, there needs to be a debate about whether the generalization of blockchain and the entry of institutions will unconditionally lead to crypto asset price increase.
- Through various attempts to improve the products and services used in traditional finance by leveraging blockchain technology, it will be one step closer to being incorporated into the instructional system. JPM is piloting the intraday-repo service that utilizes blockchain’s atomic-settlement, and the efforts to evolve existing technology and service by adopting blockchain technology will continue to expand further.
- The future of the Fiat to Crypto (F2C) system is uncertain and subject to ongoing analysis and discussion. Some market participants believe that stablecoins will play a significant role in the development of F2C, while others suggest that tokenized deposits or other alternatives such as crypto collateral stablecoins or Central Bank Digital Currencies (CBDCs) may be more viable options. As the crypto industry continues to evolve and new developments emerge, discussions surrounding the future of F2C will likely become more active.
Disclaimer
All content in this article is intended to communicate and provide information and is not intended as the basis for investment decisions or for recommendations or advice for investment. The contents of the text are not responsible in any shape or form including matters that pertain to investment, law, or tax matters
