The Market Potential for Tokenized Money Funds

Author: Paul Kremsky, pkremsky@cumberland.io

Introduction

Between January 2020 and January 2022, the market cap of stablecoins surged from around $5 billion to around $160 billion. This impressive growth was propelled in part by the growth of the crypto industry as a whole and an expanding number of use-cases for on-chain cash equivalents developed. Stablecoins already play a vital role in digital asset trading and have the potential to disrupt traditional finance; in fact, stablecoins seem likely to be the first innovation that graduates from crypto usage to a material impact on mainstream finance. That product-market fit of stablecoins remains strong, but since the start of 2022, the trend has reversed; stablecoin market cap now sits around $120 billion, a decline in two years of around 25%. There are a few reasons for this decline, most notably the collapse of Terra and the closures of Signature and Silvergate which disrupted crypto’s fiat infrastructure, but the primary cause of the decline is most likely the rise of interest rates. The market top in stablecoin market cap coincides very closely with the beginning of the Federal Reserve’s tightening cycle, effectively raising the opportunity cost of holding stablecoins. In a high-rate environment, holding stablecoins means forgoing a healthy treasury yield, and in an environment where treasury yields (backed by the weight of the US government) are higher than most DeFi yields, capital has come out of crypto markets and gone back to Bonds.

This shift in dynamics has triggered a new round of growth in the space of Tokenized Money Funds. A Tokenized Money Funds (TMF) is an on-chain representation of a share of a Money Market Fund, a traditional investment vehicle which holds cash and cash-equivalents, primarily short-term government bonds or reverse repos. Even within TradFi, they’re considered TradFi—vanilla and boring, also safe and reliable. Various projects have emerged in the last few years to represent these assets on-chain; interestingly enough, there is a wide range of approaches in how issuers achieve this tokenization, and there is no guarantee yet that there is a “right” approach. For reasons to be explored in this paper, this is a space that will be heavily regulated, so structuring these projects correctly will make all the difference. The players setting up in this space are not just crypto-native startups. More so than any other sector of digital assets, this is a niche upon which the largest names from TradFi have set their sights, including asset managers with AUMs in the trillions and some of the largest bulge bracket banks.

In this paper, we will look at the implications of this emerging sector within digital assets; how large we could expect the space to get, how much revenue we think it could drive, and impacts it could have on crypto’s existing market structure. We will look at the benefits of tokenization, both for the issuer and the investor. We will look at some of the design choices issuers are faced with, and will attempt to understand the different characteristics of an TMF. Finally, we will review the current market infrastructure, and try to understand how TMFs will be traded in the future.

A Note on the Term “RWA”

The term “RWA”, or “Real -World Asset”, is a prime example of the crypto industry adopting the worst possible branding. First, it implies that assets like BTC, ETH, or stablecoins are somehow not “real”. More crucially, however, the term is extremely broad. It can apply to a TMF, and in fact is frequently used as shorthand for these tokens. However, the category also includes tokenized equities, tokenized debt, and tokenized commodities. It can also be used to describe non-fungible tokenized assets, such as real estate, or insurance policies, or art. The RWA label is broad enough to be useless.

Why Do We Care?

According to Fitch, Money Market Fund AUM at the beginning of 2023 was around $8.4 Trillion, which makes it about six times larger than crypto’s entire market cap. If 1.5% of that issuance were to move on-chain, it would be larger than the current market cap of stablecoins. If 7.5% of it moved on-chain, it would be larger than Bitcoin. If Money Market issuance meaningfully moves on-chain, it will be big enough to matter. The revenue driven from TMFs MMTs would be significant. Typically, traditional Money Markets take between 10 and 25 basis points. That means that if this space does grow to a meaningful size of the already established market, it will be sizeable revenue for the issuers.\ The question, then, becomes “Will Money Markets move on-chain?” For that to happen, two things need to be true.

Two Criteria

Criterion One: It has to benefit the customer. If the mainstream investor prefers their money market holdings off-chain, this will be a mostly moot exercise. The real target in tokenizing money market funds is not to attract the percentage of investors that are already crypto-native; rather, it’s to appeal to the larger investor class with a product that is somehow better than their current experience.

The first benefit for the investor of TMFs is, of course, native yield. One of the promises of decentralized finance is enabling investors to make all assets both available and productive all of the time. Dollars sitting in a checking account are non-productive; the same applies to stablecoins sitting in custody. For most of 2023, off-chain yields (short-term treasury yields) were above almost all vanilla DeFi stablecoin yields, creating an arbitrage that has caused funds to flow off-chain and back into TradFi brokerage accounts. This is existential for the state of DeFi. Bringing this yield on-chain not only stops that capital exodus, but gives a baseline yield which can only be built upon using the money Legos of interoperable DeFi. Of course, this requires that TMFs actually are interoperable with wider DeFi systems, a question we will explore later. “Tokenized Money Funds, like USYC, are the natural evolution combining on-chain stable assets with traditional money funds,” said Leo Mizuhara, the founder of Hashnote. “It brings reliable yield generation on-chain, and brings the efficiency of improved capital mobility to traditional money markets.”

The next benefit flows from that same interoperability. Shares of a money market sitting in a Schwab account are only useful within that Schwab account, where they can be used as collateral. If they are brought on-chain, those same shares can be used as collateral anywhere on the network. Their composability and fungibility will make them more useful than traditional money-market products.

As an example, Copper is developing the capability to utilize USYC, the TMF issued by Hashnote, as collateral at centralized crypto exchanges. This development will not only allow crypto traders to limit their exchange risk, by keeping it off-platform with Copper, it will also allow them to collect yield on that collateral.

And the more interoperability is achieved, the faster investors can move between yield-bearing assets and whatever they want to invest in or buy. Right now, if an investor is planning to buy ETH but is not yet ready to do so, they are likely sitting in stablecoins, essentially holding non-productive assets. Or they might be holding their capital in a money market fund off-chain; this means that the lag between when they decide they want to buy ETH and the moment they’re able to do so is likely in days. Soon, though, we expect a trader to be able to hold capital in TMFs, accrue yield while doing so, and then be able to quickly swap those tokens for stablecoins, and use the stables to purchase ETH directly. (And, in the spirit of holding productive assets, they might immediately swap the ETH for stETH or another liquid staking derivative.) The faster this cycle can occur, the better the user experience; we can imagine the entire process happening in a single block. The goal here is for investors (i.e. capital providers) to hold only productive assets. The analogy here is that stablecoins are the checking account, and TMFs are the savings account. The analogy can even be extended further, with market structures potentially evolving to allow users to borrow stablecoins against TMF collateral and retaining the yield even after they spend the stablecoins, dragging credit cards into the analogy. Robert Leshner, the founder of Superstate, said “Collateral—whether for loans, trade settlement, or derivatives—has seen little evolution over the past few decades. At Superstate, we see an opportunity to create programmable, hyper-portable, capital-efficient collateral, beginning in the crypto financial markets.”

Criterion Two: it has to benefit the issuers. Make no mistake: even if TMFs are better for the user than traditional money-market funds, if the established traditional fund issuers do not want to bring their products on-chain, it will be difficult to grow TMFs meaningfully. It’s possible that crypto-native issuers alone can grow to the point where, ten years from now, the size of TMFs is 1-3% of all money-markets. However, that percentage could become considerably higher if the TradFi issuers themselves issue on-chain, and start moving their existing funds on-chain.

The good news is that tokenization should dramatically benefit traditional asset managers. According to McKinsey, asset managers spend 12bn per year on administrative costs in the US alone. Moving these funds on-chain could lead to considerable cost savings; issuing TMFs could mean as much as a 90% reduction in administrative cost compared to traditional funds. This kind of cost savings means that, finally, “The institutions are coming.”

• Franklin Templeton has launched a TMF on Stellar, called Benji.
• Wisdom Tree and T Rowe Price have been developing on Avalanche’s subnet, Spruce
• Blackrock used JP Morgan’s Onyx platform to tokenize one of its Money Funds in October

Comparison to Stablecoins: The Security Question

In many ways, TMFs are close analogues of fully-backed and segregated fiat stablecoins, to such an extent that TMFs are often referred to as “Yield-Bearing Stablecoins”. Both of them can be created or redeemed for one dollar, and so should trade for a dollar by arbitrage conditions; they are both stores of stable value. However, there are key differences between the two products: TMFs represent shares in a mutual fund, and are therefore likely to be deemed securities in many jurisdictions. Investors choose to hold TMFs specifically because they will receive yield; the yield is the primary reason to hold an TMF instead of a stablecoin. Stablecoins, on the other hand, are not considered to be securities in most jurisdictions, particularly where they do not provide yield to the holder.

This difference in classification is likely to have a significant impact on where TMFs can trade, and as a result will shape the market structure. The US is certainly at the center of this conversation; without registering under the Investment Company Act of 1940 (“1940 Act”) or an applicable exemption, TMF issuers generally will not be able to onboard US investors to mint or redeem. Equally or perhaps more significantly, absent applicable exemptions from 1940 Act and Securities Act registration, issuers will be responsible for ensuring that their tokens are not distributed to US investors. A regulatorily conservative issuer, then, will have to active take steps to control where the token can flow. Since most TMFs are set to exist on public blockchains, the most obvious solution is to maintain a whitelist: the issuer maintains a list of addresses, each associated with a KYCed customer, and only addresses on this list would be able to hold the token.

How issuers will contend with the fact that an TMF is likely to be deemed a security product will likely fall into one of four categories:

• Category One: The head in the sand method; take no action to follow a security registration, seek exchange listings, etc.
• Category Two: Only allow Non-US persons to mint and redeem, but otherwise take no action with respect to who holds the token.
• Category Three: Maintain a whitelist and only allow KYC’ed, Non-US persons to hold the token.
• Category Four: Utilize a permissioned blockchain for the TMF, and only allow KYC’ed Non-US persons to access.

Category One is clearly a risky approach, from a regulatory perspective. It is our view that Category Two is also an insufficient approach, as it does nothing to prevent US persons from holding the token. Category Four is extremely conservative to the point that it severely reduces the token’s usefulness: we expect to see some institutional issuers take this approach with the plan to eventually transition to Category Three. Category Three, in our view, represents the correct approach for TMF issuers.

There is a high likelihood that many projects adopt the Category Two approach, as it feels like compliance and opens up a much larger customer base. Furthermore, there is a possibility that these TMFs actually end up taking the lead in terms of AUM, because of the fact that more investors will have access to them. It is our hope that with proper discussion and education on the topic, the market aligns behind Category Three tokens, in order to avoid undue market-wide regulatory repercussions further down the road.

This has a critical impact on how and where TMFs could trade. As always, we consider three different trading venue types: centralized exchanges, decentralized exchanges, and the OTC market.

Market Structure for Tokenized Money Funds

Before we dive into the venue types, it’s worth checking: does trading matter? Since TMFs are able to be created or redeemed for a dollar, do they need to trade anywhere? The answer is unequivocally yes. Issuers do not want to continuously administer creations and redemptions; instead, they want to onboard a handful of liquidity providers who will in turn ensure that the TMFs are liquid on secondary venues.

Centralized Exchanges

The mainstream crypto exchanges will likely not list TMFs, at least not anytime soon. These exchanges are not regulated as securities exchanges, and TMFs are almost certain to be deemed to be securities. However, there are some exchanges which have worked with securities regulators and have been approved to trade securities; these exchanges seem likely to be among the first to list TMFs. In Hong Kong, for example, two crypto exchanges have been approved by the SFC to list securities products. AsiaNext, in Singapore, runs a spot crypto exchange, but also runs a separate exchange authorized to list tokenized securities. In the near term, it seems likely that TMFs will trade on centralized exchanges, but likely not on the largest ones.

Decentralized Exchanges

Earlier we discussed that one of the main benefits of tokenizing money-markets is interoperability, but here comes the bad news: DeFi with security tokens is really hard. Open DEXs (non-custodial, decentralized exchanges) have no concept of KYC, and therefore no safeguards to control which investors are able to hold the tokens: bad news for the issuer. DEXs where TMFs trade may also be subject to registration and regulatory requirements for securities exchanges in certain jurisdictions and may have difficulty establishing the other compliance and operational infrastructure needed to comply with such requirements.The standard DEX structure of AMMs, whereby liquidity providers add capital to a non-custodial exchange in order to market-make automatically via a pre-defined bonding curve, is challenging as well. Given the difficulty in ensuring that TMFs would not be distributed to US persons, having TMFs trade on permissionless DEXs could open the issuer to liability, because a fund that has not registered under the 1940 Act and the Securities Act is responsible for preventing distributions of the shares of the fund to U.S. investors, absent applicable exemption.

What does seem likely, however, are permissioned DEXs with a restricted group of LPs. If only KYCed investors can access liquidity pools, issuers are likely to be more comfortable allowing their tokens to trade there, and since the issuers control the whitelist, their wishes matter.

Over-the-Counter

OTC desks might be the most important piece of the TMF market structure. The key problem with TMF market structure is that because of regulatory guardrails, stablecoins and TMFs are essentially non-interoperable. This is the type of problem OTC desks are purpose-built to solve. By analogy, at Cumberland, we’ve found that a very large percentage of our OTC flow is stablecoin vs fiat; this is because these two products are often non-interoperable, living on different rails, and a trusted OTC desk is able to bridge the two markets. Similarly, OTC desks are well-built to bridge between TMFs and stablecoins; they have full KYC knowledge of their counterparties, so can put access policies in place. They have large balance sheets, allowing them to keep inventory in TMFs. They’re also best-suited to work directly with the issuers as liquidity providers. As a result, we anticipate this being one of the key roles that OTC desks play in digital assets over the next several years, recognizing that this shift may carry potential registration and regulatory implications in certain jurisdictions.

Design Choices

There are already a handful of TMFs on the market; as of the beginning of 2024, they all look fairly different. It echoes the stablecoin market five years ago, when there was a wide range of design and implementation approaches. Now, however, most new stablecoins have fallen into a pretty homogeneous design; the market has decided what works best, and new projects all build something that looks like that design. Five years from now, TMFs are likely to all converge on a single design, but at this point in the evolution, we don’t know what that design is, so we’re left with some choices.

Whitelist or Blacklist? This is a key decision to be made by issuers at the outset; what is the approach to control who can access the TMF? A whitelist offers the most complete control, but significantly limits growth. A whitelist would give the issuer control of what exchanges (including DEXs) could list their TMF. A blacklist allows faster growth, but can result in the wrong people touching the token, and it’s a largely reactive approach, which makes it hard to maintain control.

Where will the TMF trade? In the above section, we laid out our views as to the steps that an issuer should take to understand who holds the token, and a key part of that is understanding where the token will trade. That’s our view, the result of an intentionally regulatory-conservative approach. There may be issuers that are not registered in the US and decide it’s sufficient to simply say “US persons cannot mint or redeem this token.” We expect to see a wide spectrum of approaches to this key question.

How quickly can it be redeemed? This is not so much a decision, as a challenge. Obviously, faster is better. T+1 seems like it needs to be table-stakes here, and ideally, T+0 should be the goal for issuers; otherwise, crypto rails don’t seem that impressive.

How is the Fund structured? An TMF is a centralized structure, but the tokenization means that credit risk is not necessary. Issuers should seek to be bankruptcy-remote, so that even if the fund issuer goes bankrupt, investors can withdraw value from the fund, avoiding credit risk.

How is yield delivered? There are a few approaches to delivering yield to holders of the TMF. One approach is rebasing; airdropping yield to the holder of an TMF. Another is allowing the price of the TMF to drift higher as the fund realizes yield.

What blockchain(s) does the TMF trade on? In most cases, issuers will start on one chain and then expand where they find good product-market fit. Transaction fees likely aren’t as important here as they are with payment stablecoins, but for any TMF that operates as a rebasing token, cheap transactions will be important, due to the need for persistent interest payments. It’s noteworthy that Avalanche has made significant inroads working with TradFi issuers, and has launched a fund specifically to invest in TMFs. And back to that question of control: there are already TMFs that exist in walled gardens on private blockchains, or permissioned subnets, allowing the issuer to have complete control of everyone who holds them.

What is the Underlying Product? The simplest design here is to have the tokens represent shares of the fund; there are also examples where the tokens represent shares of an ETF with a money-market fund as the underlying.

Jurisdictional Choices? This will be a key decision for many funds; which jurisdictions’ investors will be allowed to hold TMFs? Obviously, the biggest question here is whether US investors will be allowed to participate; the US market makes up about two-thirds of all money markets globally.

Quality of Custodian and Fund Administrator? TMFs are not the space where one wants to experiment; issuers should seek high-quality TradFi custodians for their treasuries, and look to work with proven fund administrators.

It’s not our intention in this paper to examine the TMFs already in circulation, to classify them, or compare them. Cumberland and DRW have made investments in the space, and we have partners who have built projects, so it would be challenging to be completely impartial. With that said, we do think it’s an important endeavor, and we hope someone will take up the baton.

Conclusion

With a clear-cut product-market fit, as well as beneficial economics for issuers, growth in Tokenized Money Funds seems almost inevitable. They will provide market-shifting benefit for both consumers and issuers, and will have a meaningful impact on the entire digital asset environment. Whenever we discuss an impending innovation that seems this obvious, it is worth asking why it doesn’t already exist; in this case, there are not technological barriers but rather market structure decisions, as well as design choices which need to be made in order to properly comply with securities regulations.

As with many digital asset products, there is a balance to be struck between being first to market and getting the design right, both from a product and from a regulatory standpoint. There are a number of key decisions to be made both by issuers as well as infrastructure role-players which will play important roles in the eventual market structure; a thoughtful approach will be important in driving long-term growth to the sector. Tokenized Money Funds are capable of developing into an asset class that dwarfs the current size of the digital asset class by orders of magnitude, and we look forward to participating in the development of this market.

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