Surging Yields: A Review of U.S. Treasury "Tokenized" Fixed-Income Products, Operational Models, and Concerns

The yield on the 10-year U.S. Treasury note has surged past 5%, raising questions about the future of yield stablecoins in the tokenized U.S. Treasury market - will they continue to thrive, or will their “brutal joy” end in brutality?

“Crypto Market Benchmark Rate”? In 2022, UST/Anchor achieved a 20% fixed annual yield using a self-destructive method, destroying its grand vision and triggering a painful period of declining interest rates in the DeFi market.

As time changes, the 10-year U.S. Treasury yield, known as the “global asset pricing anchor,” has been climbing steadily over the past two quarters. Last night it even broke through the 5% mark, reaching a 16-year high since July 2007. However, with a sudden shift from major U.S. Treasury bears like Bill Ackman and “Bond King” Bill Gross, Treasury yields quickly dropped during the day and closed below 5%.

Amidst these dynamics, the soaring U.S. Treasury yields have stimulated numerous institutions to launch a plethora of “tokenized” projects supported by U.S. Treasuries, ushering in a golden era for the fixed-income segment of the crypto market.

Foresight News aims to provide an overview of current DeFi fixed-income projects that leverage U.S. Treasuries and explore the sources of their 4%, 5%, or even higher yields, as well as potential future concerns amidst rising U.S. Treasury rates.

Overview of Treasury “Tokenized” Fixed-Income Products:

Projects involving the “tokenization” of U.S. Treasuries primarily link cryptocurrencies with U.S. Treasury assets. Holding a token on the blockchain equates to owning the underlying financial asset - U.S. Treasuries. These underlying assets are usually custodied by institutions to ensure redemption, while tokenization on the blockchain enhances their liquidity and opportunities for further financialization (leverage, loans, etc.) through other DeFi components. In addition to established projects like MakerDAO and Frax Finance expanding their scope, newcomers such as Mountain Protocol and Ondo Finance have also entered the arena.

MakerDAO’s EDSR

MakerDAO, the leading project in the RWA track, limits the proportion of assets that can be used to purchase Treasuries. Previously, MakerDAO used USDC in its PSM module to cash out and buy Treasuries. However, if too many users store DAI to earn interest, the interest rate could even fall below that of Treasuries.

Currently, the Enhanced DAI Savings Rate (EDSR) is 5%, with 1.73 billion DAI in DSR, making the overall utilization rate of the DSR contract (DAI in the DSR contract / total DAI supply) exceed the 20% threshold, reaching 31%.

If the DSR utilization rate later exceeds 35%, the EDSR yield will continue to drop:

1. Between 35% and 50%, the EDSR multiplier is 1.35 times the base DAI savings rate, about 4.15%.
2. Over 50%, EDSR becomes ineffective, and only the base DSR value of 3.19% is used.

Mountain Protocol’s USDM

As a yield-stablecoin protocol invested in by Coinbase Ventures, has launched its yield-stablecoin, USDM, primarily backed by short-term U.S. Treasury bonds. After completing the KYB verification, investors worldwide can access and share in the returns of U.S. Treasury bonds.

Moreover, USDM offers daily rewards to its users in the form of Rebase, similar to the mechanism of stETH. The current annual interest rate is 5%. USDM has also been listed on Curve, launching the crvUSD-USDM liquidity pool. This means that non-U.S. users can indirectly purchase and hold USDM to earn profits.

According to OKLink data, the current total circulating supply of USDM is approximately 4.81 million, with a total of 116 holding addresses.

The official documentation states that at least 99.5% of its total assets are invested in cash, U.S. Treasury bonds, notes, and other debts issued or guaranteed by the U.S. Department of Treasury for both principal and interest, as well as repurchase agreements backed by such debts or cash. Therefore, it is considered fully supported by U.S. Treasuries, and the specific details of the assets are updated monthly.

Angle Protocol’s stEUR

As a Euro savings solution introduced by the decentralized stablecoin protocol Angle Protocol, allows users to stake Euro stablecoin agEUR to earn stEUR, while also earning an annualized return of 4% paid in agEUR. However, this 4% return is an initial setting and will be updated periodically based on the usage of the contract. It primarily backs the short-term Euro debts with a theoretical yield of around 3.6%, but the protocol distributes a portion of the income to agEUR holders, with the current protocol asset return rate at about 1.6%.

The approach to profit distribution is straightforward: supplement the earnings of staked users with the returns of non-staked agEUR holders. Since not all agEUR holders will stake for stEUR, the return for stEUR users will definitely exceed 1.6%. For instance, if only 50% of the circulating agEUR is in the stEUR contract, it means that 50% of the stEUR is earning the total return of agEUR, which is 3.2%.

Frax Finance’s sFRAX

Frax Finance, has always been one of the most proactive DeFi projects in aligning with the Federal Reserve — including applying for a Federal Reserve master account (FMA) (as noted by Foresight News, the FMA allows holding dollars and direct transactions with the Fed), thereby breaking free from the limitations of using USDC as collateral and the risks of bank failures, making FRAX the closest thing to a risk-free dollar.

On the 12th of this month, Frax Finance also launched its Treasury Bond Yield Vault, sFRAX, in collaboration with Lead Bank in Kansas City, by opening a brokerage account to purchase U.S. Treasury bonds, allowing it to track the Fed rate to maintain relevance. Users can deposit funds into sFRAX and receive a 10% yield rate. As the scale increases, the corresponding yield rate will gradually shrink to the current IORB rate of the Fed, which is around 5.4%.

As of the time of writing, the total staking amount for sFRAX has exceeded 43.46 million coins. Achieving such a feat in less than half a month can be described as a remarkably rapid growth. Meanwhile, the current annualized interest rate has dropped to 6.18%.

Ondo Finance USDY

In August, Ondo Finance launched a tokenized note, USD Yield (USDY), backed by short-term U.S. Treasury bonds and bank demand deposits. However, U.S. users and institutions are unable to use USDY, and it can be transferred on the blockchain 40 to 50 days after purchase.

As a bearer note, USDY can pay a variable interest rate to its holders, starting from 5% annually. Both individuals and institutions can directly collaborate with Ondo without any certification requirements, allowing for daily minting or redemption of USDY.

Ondo has currently launched four types of bond funds: U.S. Money Market Fund (OMMF), Short-Term U.S. Treasury Bond Fund (OUSG), Short-Term Investment-Grade Bond Fund (OSTB), and High-Yield Corporate Bond Fund (OHYG). Among these, OMMF offers an annual yield of 4.7%, while OUSG can yield up to 5.5%.

Most projects mainly invest in short-term government bonds and reverse repurchase agreements of government bonds, offering interest rates mostly concentrated between 4%-5%. This aligns with the current yield space of U.S. Treasury bonds. Higher yields are often supplemented by other revenues (such as EDSR) or by sacrificing some non-second-tier staking users to compensate staking users (like stEUR).

Where does the high yield come from?

Where does the high yield come from? It’s simple: it originates from the increasingly high ‘risk-free interest’ of U.S. Treasury bonds (with a few projects like stEUR anchored to government bonds of their respective countries or regions).

It’s important to clarify that as of now, the likelihood of the U.S. national debt defaulting is still very small. Therefore, the yield of U.S. Treasury bonds is often considered a risk-free rate by the capital market. This means that holding U.S. Treasury bonds is similar in risk to holding U.S. dollars, but with the added benefit of interest income.

So, to summarize the core idea of these fixed-income projects: they collect U.S. dollars from users, invest in U.S. Treasury bonds, and share a portion of the interest generated with the users.

In essence, these fixed-income projects introduce stablecoins backed by U.S. Treasury bonds. Holders of these stablecoins, by holding them as a certificate, can enjoy the ‘interest income’ from the underlying financial asset, the U.S. Treasury bonds:

Users who complete KYC/KYB can mint/exchange with 1 USD, and the project party purchases corresponding treasury bonds, allowing stablecoin holders to enjoy the benefits of Treasury bond yields, thereby maximizing the interest transmission to stablecoin depositors.

Currently, the yields of short to medium-term U.S. Treasury bonds are close to or exceed 5%. Therefore, the interest rates for most fixed-income projects supported by U.S. Treasury bonds also fall within the 4%-5% range.

To offer a more intuitive example, these yield-bearing stablecoins essentially distribute the government bond interest earnings, which Tether/USDT monopolizes, to the broader stablecoin holders:

It’s important to recognize that the process of Tether issuing USDT is fundamentally about crypto users using dollars to ‘purchase’ USDT—when Tether issues 10 billion USDT, it implies that crypto users have deposited 10 billion dollars with Tether to acquire this 10 billion USDT.

Once Tether receives this 10 billion dollars, it doesn’t need to pay interest to the corresponding users. This equates to obtaining tangible U.S. dollar funds from crypto users at zero cost. If invested in U.S. government bonds, this would result in a no-cost, risk-free interest income.

According to Tether’s disclosed second-quarter attestation report, it directly holds 55.8 billion dollars in U.S. government bonds. With the current government bond yield rate of about 5%, this means that Tether earns approximately 2.8 billion dollars annually (about 700 million dollars per quarter) in pure profit. The data showing Tether’s operating profit exceeding 1 billion dollars in the second quarter also confirms the lucrative nature of this model.

Additionally, these stablecoins can be freely used in DeFi, including derivative needs in scenarios such as leveraging, borrowing, etc., through other DeFi protocol components.

Concerns about the U.S. Treasury Bond Turmoil

Overall, the potential risks faced by such fixed-income projects supported by government bonds and their issued stablecoins mainly stem from three aspects:

1. Psychological risk of continuous decline in U.S. Treasury bond prices. When the value of the bonds (U.S. Treasury value) fails to cover the debt (stablecoin market value), a psychological threshold may be reached, potentially triggering a de-pegging avalanche.

2. Liquidity risk due to mismatch in maturities. If significant fluctuations occur in the crypto market, and users sell stablecoins to replenish liquidity, a run on these coins leading to a stampede is highly possible.

3. Custodial institution risk. Overall, there is still a significant reliance on the trust in institutions custodialing the underlying government bonds.

The Risk of U.S. Treasury Bonds Falling

As is well known, bond yields and prices are two sides of the same coin. As mentioned above, the continuous rise in U.S. Treasury bond yields, reaching new highs, implies that the prices of U.S. Treasury bonds are continuously falling, reaching new lows.

This includes the breakthrough of the 10-year U.S. Treasury yield surpassing 5%, as mentioned at the beginning of the article. The underlying cause cannot be separated from the fact that since the debt ceiling negotiations were passed in June this year, the scale of U.S. Treasury issuances has far exceeded historical levels for the same period:

Looking at the data, as of the end of May, the size of U.S. government debt was 31.4 trillion dollars. After the debt ceiling was lifted in June, the total debt size has now broken through 33 trillion dollars, leading to disturbances in the market liquidity due to changes in the supply and demand of government bonds.

This also means that the market value of the underlying financial assets supporting these yield stablecoins (i.e., U.S. Treasuries) is actually depreciating continuously as yields rise. This devaluation is only a notional loss on paper as long as they are not actually sold, presenting a hidden state of “assets insufficient to cover liabilities.” According to forecasts, U.S. Treasury issuance may remain high in the fourth quarter. If this supply-demand mismatch continues, U.S. Treasury prices will undoubtedly remain under pressure. This is a critical point for risk accumulation—if U.S. Treasury yields continue to rise, their prices will keep falling. Once users realize that the asset prices behind them have shrunk to an unacceptable level, reaching a psychological threshold and triggering redemptions, then “notional losses become actual losses,” and the situation of assets not covering liabilities becomes a reality, ultimately leading to a collapse.

Liquidity Risk

Liquidity risk is another potential technical risk worth attention. If U.S. Treasury prices fall, leading to a decrease in the asset value behind yield stablecoins, it exacerbates the issue through an imbalance in the asset-liability structure. The core issue is that project operators receive U.S. Treasury yields only upon maturity, but users holding the ‘tokenized’ RWA assets (i.e., the stablecoins they issue) can redeem them without waiting for the Treasuries to mature. Where does the money come from? For example, even if project operators buy 10-year U.S. Treasuries with yields just breaking 5%, they need to wait until maturity in 10 years to secure the average annual yield of 5%. Meanwhile, token holders on the blockchain can redeem almost instantly—why is this?

Maturity Mismatch

As analyzed above, the high yields come from the fact that the primary use of stablecoins issued by various companies is not as a medium of exchange but to provide returns to holders. Therefore, the underlying financial assets are mainly government bonds of varying maturities. To ensure a matching risk-reward profile for the investment portfolio and offer as high a fixed yield as possible to token holders (temporarily setting aside the inversion of short and long-term U.S. Treasury yields), a combination of “long-term bonds” and “short-term bonds” is used to balance liquidity (to prevent redemptions) and yield (to provide a fixed return). Financial mismatches like these are inherent to the industry and a primary source of earnings, but they are also a significant source of liquidity risk. Consider a scenario where the crypto market experiences significant volatility, leading to widespread margin calls or near margin calls among investors. Holders may then sell off RWA to replenish liquidity. Under such liquidity pressure, project operators can only sell U.S. Treasuries to recover liquidity, starting with the more liquid, less discounted short-term bonds. However, if redemption demands exceed the short-term bond reserves, they may have to sell long-term bonds at a discount before maturity. Especially since the underlying financial assets (i.e., U.S. Treasuries) are traded only during working hours, while tokenized assets on the blockchain trade 24/7, this mismatch in trading hours can prevent project operators from selling U.S. Treasuries in time to recover liquidity, further exacerbating market pressures during volatile periods. At this point, project operators either have to lower their advertised fixed yield rates or silently accrue losses. However, lowering the fixed yield rate could trigger a trust crisis and a run on the bank, exacerbating selling pressure and potentially leading to stablecoin de-pegging and increased liquidity risk.

Does this scenario seem familiar? Indeed, it closely resembles the risk chain and transmission pathways that began in March this year during the Silicon Valley Bank crisis. This crisis led to the bankruptcy of several banks, including Silicon Valley Bank and Signature Bank, nearly causing a systemic risk.

Custodian Institution Risk

To some extent, the link between the crypto market’s U.S. Treasury ‘tokenization’ fixed-income projects and the traditional financial market is bidirectional. Extreme fluctuations in the crypto market could transmit to the traditional financial market through the “RWA-Treasury” channel. However, the scale of such fixed-income projects is still quite limited, and the liquidity of the U.S. Treasury market is more than sufficient to handle such shocks, so this selling pressure is unlikely to affect the prices of the underlying financial assets. This leads to another potential risk—the reliability of custodian institutions. For top crypto projects like Circle, holding massive amounts of U.S. Treasuries, custody is typically with U.S. financial institutions like BlackRock (Circle Reserve Fund), which is relatively safe. The stablecoins backed by fixed-income treasury bonds still largely depend on trust in the custodian institutions for the underlying treasury assets, with limited disclosure of information, another risk that cannot be ignored.

Conclusion

Amidst the festivities of rising interest rates, will this brutal pleasure ultimately end in brutality? For the majority of ordinary investors, fixed-income projects that tokenize U.S. Treasury bonds through RWA channels offer a rare opportunity to share in the profits of U.S. government bonds, despite certain entry thresholds. This also brings a richer influx of capital and underlying high-quality assets to the DeFi and crypto markets, a positive development for the entire crypto sector.

However, as the saying goes, “the cicada senses the autumn breeze before it stirs.” Since June, the surge in short-term U.S. Treasury supply suggests that the U.S. government has navigated past the awkward phase of issuing bonds to bridge funding gaps. The aforementioned psychological threshold of 5% interest rate, while significant, also implies that such high actual yields are unlikely to be sustained over the long term.

For users currently hoping to profit through tokenized U.S. Treasury bonds, expectation management and risk control are essential. On one hand, no one can guarantee the continuation of 4%, 5%, or even higher U.S. bond yields, and there exists a critical value in the “yield-price” dynamic. Once U.S. bond prices fall below a certain point, the scenario where the value of the bonds (U.S. bond value) fails to cover the debt (stablecoin value) could lead to a rapid de-pegging and avalanche effect.

On the other hand, the higher fixed yields above 5% offered by project parties may indicate more complex “long-short debt” mismatches in duration. As mentioned earlier, this also means that the higher the fixed yield, the higher the potential liquidity risk, and the likelihood of a bank run rises proportionately.

There are no eternal feasts in financial markets, and the crypto industry is no exception. Gain and loss are two sides of the same coin. Having experienced the UST/Anchor saga, we should be more aware that grand narratives of high returns, if not fully reversible, are merely illusory. Time will give us the answer.

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