Tokenized deposits may be coming, but it’s not a slam-dunk

• Key takeaway: Market watchers say the groundwork has been created over the years for regulators to now establish guidelines for tokenized bank deposits.
• Expert quote: “This gives banks another tool in their toolbox to be able to compete with crypto and fintech firms, which helps banks and potentially levels the playing field.” —Graham Steele, University of North Carolina Chapel Hill School of Law
• What’s at stake: Securities and Exchange Commission Chair Paul Atkins said tokenized bank deposits could be available by next year, adding that the Securities and Exchange Commission is working with prudential regulators to make that possible.

WASHINGTON — Prudential regulators and the Securities and Exchange Commission appear to be moving closer to establishing rules for tokenized bank deposits sometime next year, which would allow banks to offer blockchain-based deposits at scale and compete more directly with crypto firms.
Market observers said that timeline is achievable and could mark a significant step forward for the banking industry, though key regulatory and operational questions remain unresolved. 

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Tokenized deposits are traditional bank deposits represented as blockchain-based digital tokens. But even though these deposits may be represented on a distributed ledger, blockchain-based deposits remain subject to traditional banking laws and regulations. 

Several banks — including JPMorganChase and Citi — have launched pilot programs for tokenized deposits using private blockchain networks. Industry participants say clear regulatory rules could eventually allow banks to expand those offerings beyond pilot programs and, in some cases, issue tokenized deposits on public blockchains, increasing their ability to compete with stablecoin issuers. 

“This gives banks another tool in their toolbox to be able to compete with crypto and fintech firms, which helps banks and potentially levels the playing field,” said Graham Steele, faculty member of University of North Carolina Chapel Hill School of Law and a Biden era Treasury official.

But regulators still face a range of issues to resolve before any framework is finalized, including transaction irreversibility, anti-money-laundering compliance and broader legal safeguards. 

SEC Chair Paul Atkins said tokenized bank deposits could be available by next year, adding that the Securities and Exchange Commission is working with prudential regulators to make that possible.

“There will be tokenized bank deposits here by next year,” Atkins said in June during an event hosted by the Economic Club of New York. “We’ll be collaborating with our friends and other bank regulators. Those sorts of things could be completely transformative.”

Why tokenized deposits are a positive for banks

Industry observers said the policy environment has shifted in ways that could make broader adoption more likely, after years in which regulators took a more cautious approach to crypto-related financial products.

“There’s been a lot more groundwork laid in the entire space between stablecoins and tokenized deposits and tokenized assets and everything else we’ve been building to this for quite some time,” said James Wester, co-head of payments research at Javelin Strategy & Research. “This is a very, very different approach than what we had in the last administration, where any application of blockchain, digital assets, crypto, or anything like it was seen as being very suspicious, or something to be discouraged.”

Benefits from using tokenized deposits include faster clearing and settlement, improved interoperability among financial institutions and a more competitive alternative to stablecoins in digital payments.

Banks have spent years investing in blockchain-based payment systems, and clearer regulations could accelerate those efforts, said Todd Phillips, director at Klaros Group.

“Tokenized payments have the potential to supercharge finance,” Phillips said. “You can have applications that conduct complex financial transactions based on real-world events and triggers. Tokenized deposits could allow banks to compete with the stablecoins that currently enable that kind of payment.”

Regarding competing with stablecoins issuers, Phillips said banks may have a structural advantage because they can pay interest on tokenized deposits.

“Clearly, banks pay yield on deposits, and so banks can pay yield on tokenized deposits, and that’s huge,” Phillips said. “What this could potentially look like is you hold a tokenized deposit in your crypto wallet, and monthly, or quarterly, the bank could air drop interest payments into your wallet.”

Issues regulators must address

Despite the potential benefits, industry participants said regulators will need to address several risks before tokenized deposits can be widely adopted.

One concern is whether tokenized deposits pose a greater risk of deposit flight than traditional deposits — meaning depositors could withdraw their holdings rapidly, leading to instability and even bank failure. That possibility could require changes to existing liquidity requirements, which are already under review.

Phillips said banks may ultimately be required to hold higher levels of liquidity if tokenized deposits become more widely used.

“It could be the case that the holders of your tokenized deposits all try to redeem at once, something akin to a bank run,” he said. “The same issue holds for stablecoins, but it’s not something that has previously been considered for banks for deposits, and that’s something policy makers need to be thinking about.”

He also said regulators will need to establish clear rules around the distribution of interest payments, particularly to ensure compliance with sanctions laws.

“You need to make sure you’re not airdropping yield to someone or a country that is on a sanctions list,” Phillips said. “Banks would need to work that out.”

Steele pointed to another challenge: how to handle errors, fraud or mistaken transactions in a system built on instant settlement.

“We might want to reverse the transaction, but you don’t have reversibility because there’s instant settlement,” he said. 

If regulators succeed in addressing those issues, industry observers say tokenized deposits could move from experimental pilots to a core part of how banks handle digital payments.

“It’s one small step, but it will eventually get us to a point where this is a technology we use for money movement, asset movement, value movement, all of that,” added Wester.