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The writer is a finance professor at Stanford University’s graduate school of business
The accelerating digitisation of financial markets creates a clear and immediate need for a new US sovereign debt instrument.
As blockchain-based activity grows rapidly, there has been a commensurate rise in demand for tokenised versions of cash and its equivalents, such as stablecoins, money market funds and deposits. These will be increasingly used not only for retail payments but also for settling financial trades.
These new dollar instruments seek to ensure a stable value, enabling holders to sell at par. For instance, investors who redeem a notional $1 unit of a money-market fund should be able to receive an actual $1 in exchange. However, the assets held by issuers of tokenised dollar instruments to back their redemption can fluctuate in value. Even the prices of common backing assets such as US Treasury bills adjust on a daily basis to changes in interest rates.
Core financial markets may become dependent on a growing quantity of tokenised dollar instruments offering daily redemption at par value but backed by assets that need not trade close to par.
A loss of confidence in the par redeemability of assets of a dollar instrument like stablecoins could trigger large redemptions, causing the instruments to “break the buck”. In the Great Financial Crisis, a well known money market fund — the Reserve Primary Fund — did this through its losses on Lehman debt, triggering widespread systemic risk concerns and forcing the Fed to step into the breach with liquidity for the entire money fund industry.
If new dollar proxies are widely used as collateral or to pay for securities trades, there could be self-fulfilling expectations of cascading failures of settlements in core financial markets.
All of this suggests the need for a type of dollar-denominated security that combines the safety of Treasury credit, the liquidity of overnight funding from the Fed and the transparency of blockchain settlement. This need could be met with a new form of Treasury note — Perpetual Overnight Rate Treasury Securities (Ports), an idea developed with Don Wilson, chief executive of DRW, that we believe would not only reduce systemic risk but also lower borrowing costs for the US government.
Ports would be issued daily at auctions where buyers compete to buy the notes on the same day at par value. The bidders would offer the interest rate they would be willing to receive on the next business day. The notes would be allotted to those bidders offering to receive the lowest rates.
At a recent Fed conference, Wilson predicted significant competition between all forms of tokenised dollars around their transparency, convertibility and risk. Issuers of tokenised dollar instruments who are the first to hold their assets on-chain, with no credit risk and with the most convincing convertibility at par would win the adoption race. If the US Treasury decides to issue Ports, they will instantly be the safest and most transparent form of same-day liquidity for tokenised dollar issuers.
This is how an auction for Ports could work. Suppose the Treasury announces an issuance of $40bn. Bids are submitted totalling $30bn at an interest rate of 3.01 per cent, $20bn at 3.02 per cent, and $25bn at 3.03 per cent. All bids at 3.01 per cent are awarded their full bid amounts of Ports, leaving $10bn more to be awarded. To clear the auction, the $20bn of bids at 3.02 per cent are thus awarded half of the amounts bid. This 3.02 per cent rate would be the auction’s co-called clearing rate. rate. Those bidding 3.03 per cent would not be awarded any Ports.
Winning bidders pay one dollar each for the Ports issued to them. On the next business day, all new and previously outstanding Ports are paid the auction clearing interest rate of the previous day, 3.02 per cent in this example. With this design, Ports will trade every day for one dollar each in the primary (auction) market and, because of that, extremely close to one dollar each in the secondary market. Ports could be held on or off chain at a safe custodian.
For short-term funding markets and large-value financial plumbing applications such as securities lending, tokenised Ports could also serve as the cash settlement medium. Wilson and I anticipate significant demand for Ports, even if they pay interest at rates somewhat below other wholesale risk-free overnight rates. If that is correct, the need to issue longer-maturity Treasuries would decline, saving US taxpayer borrowing costs. At the same time, Ports would strengthen the resilience of both traditional and digital-dollar markets, benefiting not only US taxpayers but also the stability of the global financial system.