Addison (@0xaddi) and I have recently been discussing the huge interest in cryptocurrencies between TradFi (traditional finance) and their actual core use cases. Below, we formally lay out our conversation around the US financial system and how cryptocurrencies fit into it from a first principles perspective:

The current narrative is that tokenization will solve many financial problems, which may or may not be true.

Stablecoins lead to new money issuance, just like banks do. The current trajectory of stablecoins raises significant questions about how they interact with the traditional “fractional reserve banking system” — in which banks hold only a fraction of deposits as reserves and lend the rest, effectively creating new money.

Tokenization has become a hot topic

The narrative now is that “tokenizing everything” — from public market stocks to private market stocks to short-term Treasury bills — is good for crypto and good for the world. To think about what’s happening in the market from a first principles perspective, it’s helpful to review the following:

Currently, in the US, large asset issuers (such as public companies) grant custody of their certificates to DTCC (Depository Trust & Clearing Corporation). DTCC then tracks ownership of the approximately 6,000 accounts that interact with it, which in turn manage their respective ownership ledgers for their end users. For private companies, the model is slightly different: companies like Carta only manage the enterprise's ledger.

Both models involve highly centralized ledgers. The DTCC model has a “Russian doll” of ledgers where an individual may need to go through 1 to 4 different entities to get to the actual ledger entry at DTCC. These entities may include the brokerage firm or bank where the investor has an account, the brokerage firm’s custodian or clearing firm, and DTCC itself. While the average end user (retail investor) is not subject to this hierarchy, it creates a lot of due diligence work and legal risk for institutions. If DTCC itself tokenized its assets in a native way, the reliance on these entities would be reduced because it would become easier to interact directly with the clearing house - but this is not the model proposed in the current popular discussion.

The current tokenization model involves an entity holding an underlying asset as a line item in its primary ledger (e.g., as a subset of entries in DTCC or Carta), and then creating new, tokenized representations of its holdings for use on-chain. This model is inherently inefficient because it creates another entity that can extract value, incur counterparty risk, and cause settlement/clearing delays. Introducing another entity undermines composability because it results in an extra step to “wrap and unwrap” the security in order to interact with the rest of TradFi or DeFi, which can cause delays.