Fragility of the dollar system: balance sheets to blockchains

By Arjun Sethi, Kraken co-CEO The illusion of liquidity It happened in September 2019 when overnight repo rates spiked to 10%. It happened in March 2020 when Treasury markets seized and the world’s benchmark “risk free” asset had no ￰0￱ happened again in March 2023 when regional banks failed and the Fed had to create a new emergency facility just to keep collateral ￰1￱ time, the diagnosis is familiar. A sudden shortage of liquidity, collateral or ￰2￱ those are surface ￰3￱ real cause is structural: too few participants, too much concentration and too much dependence on a handful of balance ￰4￱ call these markets deep, but they are not ￰5￱ are highly centralized networks pretending to be decentralized ￰6￱ repo market, the Treasury market and the FX market together make up the operating system of global finance, and that system now runs on a few ￰7￱ have built a financial supercomputer with a single cooling ￰8￱ works brilliantly until it does ￰9￱ architecture of concentration Start with the repo ￰10￱ paper it is vast, roughly 12 trillion dollars in daily outstanding ￰11￱ practice, it is dominated by four or five ￰12￱ same firms intermediate most bilateral trades, supply tri-party liquidity and sit between nearly every large buyer and seller of Treasury ￰13￱ one dealer hesitates, the whole chain ￰14￱ the bond market, the story is the same.

A handful of primary dealers stand between the Treasury and the rest of the ￰15￱ making in Treasuries, once distributed among dozens of firms, is now concentrated in less than ￰16￱ buy side is not any more ￰17￱ asset managers control over a quarter of global fixed income ￰18￱ trading venues themselves, from Tradeweb to MarketAxess, have network effects that reinforce the same pattern: a small number of nodes carrying a massive volume of ￰19￱ looks global, but it follows the same ￰20￱ Bank for International Settlements estimates that the majority of daily FX turnover, roughly 7.5 trillion dollars, passes through fewer than a dozen global ￰21￱ interdealer market is dense, but the customer market depends almost entirely on those same banks for ￰22￱ liquidity providers have grown, but they connect through the same ￰23￱ each case, liquidity appears to be a property of the ￰24￱ reality, it is a property of dealer balance ￰25￱ those balance sheets are constrained by regulation, by risk appetite or by fear, liquidity ￰26￱ did not build markets as ￰27￱ built them as star systems, a few massive suns with everyone else orbiting their ￰28￱ as a feature, then a bug This structure was not an ￰29￱ was efficient when computation, trust and capital were ￰30￱ simplified coordination.

A small number of intermediaries made it easier for the Fed to transmit policy, for the Treasury to issue debt and for global investors to access dollar ￰31￱ decades, that efficiency looked like ￰32￱ over time, every stress episode revealed the same ￰33￱ 2019 repo spike happened because balance sheet capacity was maxed ￰34￱ 2020 Treasury selloff happened because the biggest dealers could not warehouse ￰35￱ time, the Fed stepped in, expanding its role, building new facilities and absorbing more of the market’s ￰36￱ is not policy ￰37￱ is ￰38￱ logic of centralization compounds ￰39￱ liquidity dries up, everyone runs to the only balance sheet big enough to backstop the ￰40￱ rescue reinforces the ￰41￱ are now in a regime where the central bank is not just a lender of last ￰42￱ is a dealer of first ￰43￱ Treasury and the Fed together are the two sides of the same balance sheet, one issuing collateral, the other providing leverage against ￰44￱ modern financial system has become a state backed utility, not a distributed ￰45￱ sheet capitalism This is the real definition of our era: balance sheet ￰46￱ balance sheet capitalism, markets do not clear through price ￰47￱ clear through balance sheet ￰48￱ is not the flow of buyers and ￰49￱ is the willingness of a few intermediaries to expand their ￰50￱ plumbing of the global dollar system, repo, Treasuries and FX now depends on the same limited ￰51￱ paradox is that every regulation meant to reduce systemic risk has made this concentration ￰52￱ rules, liquidity ratios and clearing mandates all push intermediation into fewer, larger ￰53￱ system is safer in isolation but more correlated in ￰54￱ every dollar of liquidity depends on the same two balance sheets, the Fed’s and JPMorgan’s, you no longer have a ￰55￱ have a ￰56￱ have financialized trust into a single ￰57￱ this world, systemic risk does not come from leverage ￰58￱ comes from architecture.

A network that looks decentralized on paper but behaves as a single organism in ￰59￱ more the system grows, the more its stability depends on the political and operational capacity of those core ￰60￱ is not ￰61￱ is ￰62￱ as code The next evolution of markets will not come from ￰63￱ will come from ￰64￱ you move markets onchain, you refactor the ￰65￱ replace balance sheets with state ￰66￱ markets change three fundamental properties of liquidity: Transparency . Collateral, leverage and exposure are visible in real ￰67￱ is not a quarterly ￰68￱ is a live ￰69￱ trust . Margin, clearing and settlement rules are executed by code, not negotiated by ￰70￱ risk becomes ￰71￱ ￰72￱ with capital can provide or consume ￰73￱ access becomes a function of software, not ￰74￱ properties turn liquidity into something structural, not ￰75￱ is no longer a function of who is willing to take your ￰76￱ is a property of the network ￰77￱ chain repo markets already exist in prototype ￰78￱ Treasury collateral, automated lending pools and stablecoins acting as cash ￰79￱ same mechanics that govern traditional repo, collateral, margin and rollover can be encoded directly into smart ￰80￱ swaps, yield curves and derivatives can follow the same ￰81￱ difference is not ￰82￱ is ￰83￱ is cheaper, faster and safer to compute trust than to regulate ￰84￱ markets are what finance looks like when liquidity stops being a privilege and becomes a ￰85￱ parallel dollar system The first real version of this world is already ￰86￱ are the onchain descendants of repo collateral, dollar denominated liabilities backed by short term ￰87￱ Treasuries are the first transparent collateral instruments in financial ￰88￱ onchain money markets, from protocol-based lending pools to tokenized reverse repo facilities, are beginning to act as the new funding layer for global capital.

Together, these components form a parallel dollar system, one that still references the ￰89￱ and the Fed but operates with radically different ￰90￱ the traditional system, information is private, leverage is opaque and liquidity is ￰91￱ the onchain system, information is public, leverage is observable and liquidity is ￰92￱ stress hits, this transparency changes the entire ￰93￱ do not have to guess who is ￰94￱ can see ￰95￱ does not disappear into balance sheet black ￰96￱ can move instantly to where it is ￰97￱ global dollar system is moving, piece by piece, to a public ￰98￱ T-bills now exceed two billion dollars in circulation and are growing faster than most traditional money ￰99￱ stablecoin settlement volumes already rival major card ￰100￱ as institutional adoption accelerates, these numbers will ￰101￱ is not a fringe system ￰102￱ is a mirror system; smaller, faster and more transparent than the one it is quietly ￰103￱ time, the line between onchain and offchain will ￰104￱ deepest collateral, the most efficient funding and the most liquid FX will migrate to where transparency and composability are ￰105￱ because of ideology, but because that is where capital efficiency is ￰106￱ architecture of trust The dollar system is not going ￰107￱ is ￰108￱ financial system we built in the twentieth century was centralized because computation was ￰109￱ needed trust hierarchies, banks, dealers and clearinghouses to coordinate risk and ￰110￱ twenty first century system does not need those hierarchies in the same ￰111￱ is now ￰112￱ is ￰113￱ can be ￰114￱ banks will still ￰115￱ markets will still ￰116￱ the architecture will be ￰117￱ Fed will not need to be the single cooling fan of the financial ￰118￱ will be one of many nodes in a network that can ￰119￱ markets do not eliminate ￰120￱ distribute ￰121￱ make it visible, auditable and ￰122￱ turn liquidity into code, trust into infrastructure and systemic risk into a design variable rather than a ￰123￱ decades, we have been adding complexity to hide fragility, new facilities, new intermediaries and new ￰124￱ next step is to remove opacity to reveal ￰125￱ began as a speculative experiment in crypto is evolving into the next monetary infrastructure, an open, programmable foundation for global ￰126￱ transition will not be ￰127￱ will happen gradually, then suddenly, the way all systemic upgrades ￰128￱ day, most of the world’s collateral will settle on open ledgers, and nobody will call it crypto ￰129￱ will just be the ￰130￱ that happens, liquidity will stop depending on who owns the biggest balance ￰131￱ will depend on who runs the best ￰132￱ that is how finance will finally evolve from a hierarchy into a ￰133￱ Started with Kraken