FRB Staff Describes Tokenization, Related Risks and Benefits

In a working paper, Federal Reserve Board ("FRB") staff considered the potential benefits and financial stability implications of "tokenizations."

FRB staff described tokenization as the process by which digital representations, known as crypto tokens, are constructed for non-crypto assets. FRB staff said that tokenizations vary widely in design and typically have the following features: (1) a blockchain; (2) a reference asset; (3) a mechanism to determine the reference asset value; (4) a method for providing custody for the reference asset; and (5) a mechanism to facilitate redemptions.

FRB staff said that the current overall value for tokenized markets "remains small" and does not present a "material financial stability concern". However, they estimated that continued growth of tokenizations in both number and scale has the potential to "introduce fragilities to crypto asset markets" and create financial stability vulnerabilities in the larger financial system. They highlighted that tokenization creates interconnectedness between the digital asset market and traditional financial system, which risks potential shocks/volatility and potentially increases incentives for runs on issuers of tokenized assets.

FRB staff also pointed to benefits created by tokenizations including increased access to markets that would otherwise be inaccessible or cost prohibitive. They said that the programmability of crypto tokens and the ability to leverage smart contracts are attributes that may "lower barriers to entry" for a greater set of investors, creating more competition and liquidity in otherwise inaccessible markets.