The Banque de France published a note last week examining tokenized money market funds (MMFs) from a financial stability perspective, suggesting regulators may be considering new safeguards. The market has expanded dramatically from $100 million at the end of 2022 to over $7 billion today, four times what it was a year ago.

The central bank’s primary concern centers on interconnectedness with traditional markets. Most stablecoins are backed by government debt, particularly US Treasuries, with dollar stablecoins comprising 99% of the market. This relationship means turbulence in tokenization markets could create spillover effects in broader financial systems.

The note identifies several specific risks. Tokenized versions could deviate in price from their underlying assets, and the 24/7 trading nature creates potential liquidity mismatches. Additional concerns include fragmented liquidity across multiple ledgers and the possibility that automated smart contracts could trigger contagion events.

Regarding regulation, the central bank notes that tokenized funds in the EU fall under Money Market Fund Regulation (MMFR) rather than MiCA, as they are classified as financial instruments. The bank recommends the Financial Stability Board assess whether current regulatory frameworks adequately address the unique characteristics of different tokenized financial assets while enhancing data collection on tokenization developments.

Missing pieces of the tokenization puzzle

Several important factors weren’t taken into account in the analysis. Some could either increase or reduce risks, others most certainly mitigate them. For example, much of the recent growth stems from demand by stablecoin issuers and other tokenized money market funds. Many stablecoins involved are specialized for crypto and DeFi purposes, such as those from Sky, Ethena and Usual. Ondo Finance manages $1.4 billion in yield bearing tokens and MMFs, mostly invested in other tokenized MMFs.

This interconnectedness presents a double-edged scenario. While it could amplify contagion risks, it might also provide stabilizing effects during crises. When users sell tokenized MMFs, they typically switch to stablecoins, potentially balancing stablecoin demand. Given the current crypto market’s relative isolation, most users would likely remain within the ecosystem rather than exit entirely, keeping underlying government debt markets stable.

Governments could mitigate risks through native digital debt issuance. Hong Kong has made two substantial digital bond offerings and plans regular issuances to support its stablecoin and tokenization initiatives. Widespread government digital tokens could compete directly with tokenized MMFs.

Tokenization can also significantly reduce financial stability risks. The 2022 UK gilts crisis illustrates this potential. The crisis was triggered by margin calls that forced gilt sales, creating a downward price spiral until the Bank of England intervened. This might have been prevented with widely available tokenized collateral. Tokenized gilts could have been transferred instantly to meet margin calls, avoiding the destructive price spiral.

While tokenized money market funds carry risks, the potential for risk reduction likely outweighs the additional concerns they introduce.