Here’s our response to Fred Ehrsam’s question on bountycaster

TLDR;

Will stablecoins become the Largest holder of USTs? I doubt it! Will they be a significant player? Abso-frigging-lutely.

Analyzing the potential impact of stablecoins on the US treasury market is an extremely complex task due to the depth and diversity of the market and its participants. However, I will try my best to provide context into how we think about this question.

Main challenges in tackling this question include: what you think the supply outlook will look like (i.e. growth of the debt stock) as well as the appetite of the current holders to increase/divest existing stakes and their balance sheet capacities to absorb additional issuance. Another major issue is the definition and classification of entities (for example, should the  Cayman Islands which holds 285bn in US treasuries be considered a single entity? Clearly not).

Unless deficits shrink, the supply of US Treasuries appears to be robust with SIFMA data indicating a 10% yoy increase in outstanding stock as of Feb 2024. I would point out CBOs projections estimating around $20trn Federal deficits until 2034.

The demand side is a lot more complicated. People have already broadly pointed out Fed and Foreign owners as major players. I would add that Intergovernmental holdings are also very significant (bigger than Fed) at $7trn vs $4trn on Fed.

Within Foreign ownership, holdings can be further categorized into those of countries with persistent current account surpluses (such as Japan and China) and those of financial centers (like the UK, Switzerland and the Cayman Islands). Therefore the demand from the former is quite dependent on trade balances as well as monetary policies of these countries (note that last year has seen a decline in the holdings of Japan and China). However there is also an argument that Chinese holdings are now masked under overseas accounts which are ultimately held by China (I shall refrain from going down that rabbit hole but look at Belgium - wink wink nod nod). As for the latter, I think the use of USTs as collateral in the financial markets is not going anywhere so further financialization will mean that these financial centers will continue to be major players.

Therefore, defining  the largest holder(s) becomes challenging at both the national and private levels - For instance, should the Federal Reserve and  Intragovernmental holdings be considered a single entity (i.e. the US Government, representing around a third of the market)?  Or should all JPM funds holding  treasuries be aggregated as a single entity (despite potentially having  different mandates).

With this context in mind, we should also consider the potential size of the stablecoin market and its relevance to the UST market.

First, I want to clarify my personal view that stablecoins should NOT be backed by Notes or Bonds. For me, a fiat backed stablecoin means that it should ensure that the 1-1 peg is defensible in ANY market condition. We’ve all seen the balance sheet impact of long-term holdings of bonds. Therefore, I think the addressable total market here is limited only to T-Bills, which in itself is a $6trn market. I also have a personal dislike for anything with a coupon and prefer that discounted securities are held so I will exclude any notes/bonds maturing < 12m.

Secondly, we need to understand what use cases stablecoins bring to the table. In our view, a true stablecoin will have to fulfill both the means of exchange and store of value functions of Money.

Traditional fiat-backed stablecoins have demonstrated their use case as a means of exchange within the cryptosphere - no arguments there. They are also making some inroads into remittance and settlement in some FX markets. However, we’re yet to see major inroads into some giant markets such as consumer payments or international trade. Therefore  potential there is immense (on trade financing, consider the holdings of mercantilist countries!)

As a store of value, traditional fiat-backed stablecoins have failed - they cannot pass on the risk-free rate to their holders. So a paradigm shift is needed here for them to breakthrough as an instrument that can fulfill both roles of money. If this can be done, we can categorically say that stablecoins have found a universal product-market fit.  As financialization continues to grow with its inevitable shift to the blockchain, stablecoins will likely become the default instrument  for purchasing tokenized securities. The ability to provide the store of value function will even allow stablecoins to take the place of MMFs and be used as collateral by financial institutions (now we’re looking at the market share of Cayman Islands, the UK et al, as well as a big chunk of the domestic private holders of UST).

So I believe that stablecoins have a significant opportunity to be a very large UST holder. While being the largest holder is an unlikely outcome, a more limited scope (T-Bills) will probably see them as one of the top players. We also believe that by concentrating on the short end stablecoin operators will become large marginal buyers due to short durations (entering the market constantly). With greater regulation on bank/dealer balance sheets, they could also ease some of the issues that crop up in the T-Bill auctions and become significant players in the overnight repo markets.

At parabol.fi we have been thinking long and hard about these issues and building the Parabol Protocol precisely to address the stablecoin market potential. So feel free to contact us (hi@parabol.fi) if you want to learn more or just chat about stablecoins.