Imagine a world where your money is no longer just a number in a bank account, but a digital token that can be programmed, transferred instantly, and used across various financial platforms. This is the emerging reality of money tokens, a concept that is fundamentally transforming the finance industry and whose prototypes exist in the $170 billion stablecoin market.
In recent years, the advent of blockchain and distributed ledger technology has catalyzed a wave of innovation in the tokenization of money-like instruments. From stablecoins to tokenized deposits, these digital representations of stable, fiat-linked value are rapidly gaining traction. But with this innovation comes complexity. Terms like “tokenized money market funds,” “yield coins,” and “synthetic dollars” are proliferating, leaving even industry insiders scratching their heads. There have also been many teachable lessons from outright fraud to so-called algorithmic stablecoins like Terra-Luna, which proved under stress conditions to be anything but stable and little more than financial vaporware.
While stablecoins have dominated headlines, other forms of tokenized money have quietly experienced a surging wave of growth led by major financial institutions such as BlackRock and Franklin Templeton. These various token types, each with their unique features, are redefining how we perceive and use money in the digital age. However, understanding these tokens is not as simple as applying a single definition. Instead, they exist on a spectrum, characterized by a set of distinguishing features that determine their utility and associated risks. In effect, one way to think about all tokenized money is that they are digital demand deposits entitling the holder to redemption at par for one unit of the underlying reference currency. As in the real world, so too in digital finance, the US dollar reigns supreme.
This article delves into the world of money tokens and sheds light on the key characteristics that make each type unique. By doing so, we underscore the potential these tokens hold for transforming finance—and the challenges they present for regulators, businesses, and consumers alike.
The Foundation: Balance Sheet Constructs
At the heart of every money token lies its balance sheet structure, which defines two critical aspects: the assets backing the token and the entity responsible for the liabilities. These foundational elements shape the token’s risk profile and potential utility.
When it comes to asset backing, industry experts and policymakers generally agree that short-term, high-quality, liquid assets—such as cash and Treasury bills—provide the safest backing for money tokens. This conservative approach aims to ensure stability and minimize risk. However, different token issuers have also proposed alternative asset-backing structures, including crypto collateral and derivative exposures, self-referential crypto tokens, and assets held on general bank balance sheets such as loans.
The entities issuing these tokens and managing the liabilities can vary widely, each bringing its own set of strengths and potential concerns. Digital Asset Issuers are often associated with “stablecoins”, while Traditional asset managers typically offer “tokenized money market funds”. Banks are introducing “deposit tokens” or “tokenized deposits”, and Central Banks are extolling the virtues of “CBDCs”, or Central Bank Digital Currencies, albeit in an experimental manner. This diversity in issuers leads to an emerging ecosystem of money tokens, each with its own characteristics and regulatory considerations – and each of which with their own financial rails or networks, making for a veritable internet, extranet and intranet of value.
While the balance sheet construct forms the foundation, several other features significantly influence a token’s usefulness and associated risks. These include permissioning (the level of access control for token transactions), yield-bearing capability, which can implicate securities laws straying away from payments and banking (whether the token can pass on native yield for holders), and programmability (the extent to which the token can execute complex, automated functions).
These features, when combined with the underlying balance sheet structure, create a multifaceted profile for each money token type. Understanding this interplay is crucial for market participants and regulators who are trying to establish appropriate guard rails for a rapidly converging world of digital finance.
Permissioning: The Public vs. Private Ledger Debate
Money tokens operate on either public or private ledgers, representing a fundamental trade-off between interoperability and control. This distinction is crucial in understanding the current landscape of digital finance, as each approach offers unique benefits and challenges.
Private ledgers offer a double-edged sword in the world of money tokens. While they provide enhanced control and possible regulatory compliance through exclusively controlled networks, they also limit interoperability and innovation and blunt much needed competition in how money moves. These closed ecosystems, reminiscent of existing systems like Zelle or the RTP network both owned by banking consortiums, offer issuers greater oversight over transactions and user access. However, this exclusivity comes at a cost: high barriers to entry can lead to isolated, uncompetitive recreations of current payment networks, potentially stifling widespread adoption and innovation. Moreover, the assumption that closed systems can fully eliminate risks is flawed, as evidenced by instances of money laundering in existing closed payment networks. The challenge lies in balancing the benefits of control with the need for an open, innovative financial ecosystem.
On the other end of the spectrum, public ledgers offer a more open environment, veritable financial services shareware. Tokens on public ledgers are more likely to be interoperable and convertible with one another. Even with token-level permissioning, the ability to transfer on the same ledger as other tokenized assets facilitates Payment versus Delivery settlements, a key aspiration for many money token projects. This open interoperability on blockchain rails can drive adoption and utility, creating a more vibrant ecosystem through powerful network effects. However, this openness is not without risks. In times of financial stress, the ease of conversion between tokens could lead to rapid flights to or from safety, with users quickly exchanging tokens perceived as less stable for those deemed more secure. The highly runnable, sentiment driven nature in digital asset markets, has even rattled the safests assets in circulation showing the interconnectedness between risks in the banking system and these novel markets.
The choice between public and private ledgers is not merely a technical decision but a strategic one that shapes the future of digital finance. As the industry evolves, finding the right balance between openness and control will be crucial. Hybrid models that combine elements of both approaches, such as through (dis)allow list, may emerge as a middle ground that maximizes benefits while mitigating risks. For businesses and policymakers alike, understanding these trade-offs is essential. The permissioning structure of money tokens will play a significant role in determining their utility, adoption, and potential impact on the broader financial system.
To Yield or not to Yield
Money-like tokens that pass on yields generated from asset backing present both opportunities and risks. On the one hand, yield-bearing tokens can enhance the utility of money tokens by providing additional returns to holders, thereby increasing their appeal as a store of value. Competitive yield offerings are a key for some institutional financial use cases such as a collateralization, in which asset owners face stiff pressure to generate returns.
On the other hand, the inclusion of yield in money tokens also introduces new challenges, particularly for prudential regulators and banks that are weary of disintermediation risks and deposit flight. Recent studies based on structural models (Chiu et al., 2023 and Whited, et al., 2022) have revealed a nuanced relationship between digital currencies and traditional bank deposits. When banks hold market power, the introduction of low-yield digital currencies for payments can stimulate competition, leading to higher deposit rates that actually draw in more deposits. But there is a tipping point: if the yield from these new digital currencies becomes too high, it could crowd out bank deposits, potentially reducing credit availability in the broader economy.
Moreover, yield-bearing tokens may attract a different breed of investors—those primarily seeking to maximize returns. This shift in holder demographics could increase the risk of sudden liquidity runs, mirroring the vulnerabilities seen in money market funds. Given these complexities, both issuers and regulators must navigate this terrain with caution. Their challenge lies in striking a delicate balance: maintaining the innovative potential of yield-bearing tokens while ensuring a clear separation between savings and payment functions to safeguard the stability of the financial system. Notwithstanding their attractiveness, yield-bearing tokens generally stray into risky regulatory territory, either implicating securities laws, or cross-over into banking territory. Under Europe’s new Markets in Crypto Assets regulation (MiCA), yield-bearing e-money tokens are impermissible.
The Programmability Paradox
Programmability stands as a cornerstone of tokenization, offering a revolutionary approach to financial transactions. Smart contracts, the digital equivalents of traditional legal agreements, enable complex financial operations to be executed automatically and transparently. This “code is law” paradigm empowers tokens with unprecedented capabilities, from decentralized market-making to sophisticated auto-executable lending and trading mechanisms. At its heart, programmability addresses a fundamental challenge in finance: the misalignment between principals and agents. By enforcing contracts on a shared, verifiable ledger, it introduces a new level of trust and efficiency to financial intermediation.
However, this same feature that makes tokens so powerful also introduces new vulnerabilities. The ability to combine smart contracts like lego blocks allows users to create intricate financial structures in a single transaction. This “composability” can transform seemingly stable tokens into volatile assets in secondary markets, potentially triggering cascading price dislocations, in addition to the everpresent irrevocability of blockchain-based transactions. For instance, users can stack borrowing, leveraging, and short-selling operations in one seamless action, amplifying both potential gains and risks. Marrying programmability and composability along with always-on nature of digital finance, has created a boom and bust cycle in decentralized finance (DeFI) over the years.
Moreover, programmability can supercharge traditional financial behaviors in ways that may threaten market stability. “Programmable reaching-for-yield” could emerge, where automated strategies aggressively seek higher returns, potentially pushing investors into higher yielding tokens. Similarly, the concept of “programmable runs” becomes a concern, where smart contracts could automate and accelerate the withdrawal of funds during market stress, exacerbating liquidity crises. These dynamics are further intensified by trading bots that can instantly react to publicly visible blockchain transactions, potentially turning minor market movements into major swings.
Recognizing these risks, many issuers of yield-bearing tokens, particularly those subject to securities regulations, have opted for a cautious approach. They have largely avoided integrating with extensive programmable contract ecosystems. As the industry evolves, the degree of programmability allowed for different types of money tokens will likely be shaped by a combination of issuer strategies, regulatory guidance and standardized market-facing risk disclosures.
Hard Lessons from Stablecoins: False risk equivalence breeds instability
The quest for unification in digital currency settlements has driven many innovators in the money tokenization space to pursue the concept of “singleness of money” – the idea that all tokens of the same currency should be interchangeable at par value. While this goal is admirable, it has often been pursued through decree or forced fungibility between different tokens, the spirit from which the word fiat comes. However, financial markets have repeatedly shown us that when prices are artificially fixed, risks adjust through quantity, often manifesting as sudden and unexpected outflows.
The stablecoin sector, despite its relatively short history, has already experienced significant price dislocations and runs. These events offer valuable lessons for other types of money tokens still in their early stages, as well as for their regulators:
- Avoid false risk equivalence: In the pursuit of a singleness of money concept, it is crucial not to equate tokens with different underlying risks. Enforcing price discovery for yield-bearing securities and deposits with varying asset backings can help mitigate this issue.
- Embrace speed bumps: Breaking at-par fungibility between tokens and introducing speed bumps for converting between payment and saving instruments, even if it slows adoption, can lead to a safer, more systematically stable growth trajectory.
- Take cues from traditional markets: The pricing of brokered deposits and unsecured short-term funding in conventional finance can provide insights into potential pricing for different tokenized claims, even within the same category of money tokens.
Today’s landscape of money tokens is characterized by a diverse range of backing assets, capital structures, and liquidity standards. True risk equivalency of liabilities can only be achieved when the underlying backing assets have sufficient standardization in terms of quality and liquidity, and when the issuers of liability claims follow similar risk management practices, including technology, cyber, and operational risk management. All too often, trust in money tokens falters by their failure of the simple “Jerry McGuire” show me the money test. Harmonizing disclosure across all money token categories, can improve market confidence, stability and adoption.
Instead of creating new terminology that obscures similarities, money token issuers and regulators should work towards common standards for common features, thus supporting market driven fungibility, as opposed to decree driven interoperability. A recent proposal on a capital framework for stable value tokens aims to establish just that — a unified approach that different types of money token issuers and their regulators can adopt.
As the industry evolves, the challenge lies in balancing innovation with risk mitigation. By learning from past experiences and implementing appropriate safeguards, we can harness the full potential of tokenized finance while maintaining market stability and protecting investors.
Dante Disparte is Chief Strategy Officer and Head of Global Policy at Circle. Gordon Liao is Chief Economist at Circle.
To continue reading at Circle, click here.
All views expressed by members are their own and not reflective of the views of the Bretton Woods Committee.