The Bank for International Settlements (BIS) has published a bulletin on the rise of tokenized money market funds (TMMFs), highlighting potential risks similar to those associated with stablecoins, including operational and anti-money laundering/countering the financing of terrorism (AML/CFT) risks.
TMMFs are regulated fund shares issued and settled as blockchain-based tokens. As noted by the BIS report, they are “a rapidly growing segment of decentralised finance (DeFi)” that has grown from a $770 million sector at the end of 2023 to now holding approximately $9 billion in assets.
This rapid growth has naturally piqued interest and concern in equal measure amongst traditional financial institutions.
One such concerned entity is the BIS—an international financial institution made up of member central banks ;that aims to boost global monetary and financial stability—which argued in its latest report that:
“TMMFs give rise to risks that mirror, and potentially amplify, those found in conventional money market funds, such as liquidity mismatches, as well as the operational and anti-money laundering / countering the financing of terrorism-related risks associated with stablecoins.”
Heightened risk of runs
For the BIS, at the heart of the risks associated with TMMFs lies the “liquidity mismatch” between the daily redemption capabilities of the tokenized shares and the underlying assets, which remain subject to traditional settlement cycles.
As explained in the bulletin, “this creates the potential for stress during periods of heightened demand for liquidity in a market environment without resort to the financial safety net of traditional finance.” Furthermore, it argued that the transparency of blockchain-based transactions “further compounds liquidity risk by acting as a coordination device among investors.”
In other words, sudden movements in the market or the assets—for example, if confidence wanes in the TMMFs—can more easily cause a run, as redemptions are immediately visible to all market participants.
“This dynamic could become more acute if, as the market expands, new types of TMMFs are launched that move away from the current focus on short-term government bonds,” added the BIS. “In such cases, the absence of robust liquidity buffers may leave funds more vulnerable to sudden surges in redemption requests.”
Another concern related more specifically to TMMFs’ links to stablecoins.
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The stablecoin problem
According to the BIS, interlinkages between TMMFs and stablecoins “introduce additional channels for contagion.”
For example, some TMMFs have established instant redemption facilities in partnership with stablecoin issuers, enabling certain investors (so-called ‘allow-list’ traders) to exchange fund tokens for stablecoins.
Regulatory compliance requires that TMMF tokens do not flow freely between wallets of unknown beneficiaries on blockchains. As such, investors need to be onboarded by the fund administrator, who creates an “allow list” of wallets that comply with AML/CFT rules and meet any additional fund-specific requirements. Such lists are maintained and regularly updated by the fund administrator.
The BIS bulletin warned that wrapping TMMF tokens into stablecoins, or the possibility of trading them freely on platforms, can allow investors to bypass allow-lists.
It also raised concerns that, while exchanging fund tokens for stablecoins can alleviate short-term liquidity pressure on the fund, it also creates the potential for shocks to spread between the TMMF and stablecoin markets.
Thus, the practice of repackaging TMMF shares into stablecoins, or other digital assets, raises the risk of “broader disruption within the crypto ecosystem.”
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Operational risks
The bulletin also warned of certain operational and technological risks inherent to TMMFs.
Firstly, the reliance on public blockchain infrastructure “exposes funds to cyber-attacks, smart contract vulnerabilities and service outages,” which could hamper the functioning of the fund or limit investor access to their shares. This could, in turn, lead to uncertainty or even panic amongst investors.
Another concern related to the current ‘allow-listing’ approach, which the BIS said poses additional operational challenges in the form of duplication, as each fund must maintain its own list.
“It [allow listing] is impractical for funds with a large investor base and restricts TMMF liquidity, limiting their wider use for margining,” argued the bulletin. “It also fragments the blockchain environment into controlled and uncontrolled compartments, potentially reducing market efficiency.”
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Swings and roundabouts
More broadly, the BIS said that the expansion of TMMFs highlights challenges for authorities internationally.
Specifically, the increase in adoption of TMMFs exemplifies the speed with which tokenized finance can transition from theory to mainstream adoption, creating crucial points of contact between “jurisdiction-bound” traditional finance and global or borderless DeFi. This presents a problem because regulatory frameworks remain fragmented across jurisdictions.
“Without agreed standards, risks of regulatory arbitrage, capital flow volatility and challenges for AML/CFT compliance could grow, raising risks for consumers and financial stability,” warned the BIS.
Despite its various concerns, the BIS did have some positive words for TMMFs.
“TMMFs are demonstrating some of the new technological capabilities that tokenisation could bring to the financial system,” said the bulletin. “In providing a tokenised representation of a government bond portfolio, current TMMFs mimic some of the features of tokenised government bonds, which could become the backbone of the future financial system.”
However, if TMMFs are to become a cornerstone of future finance, the BIS reiterated that “ensuring prudent risk management will remain key to sustain trust in the system.”
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Source: https://coingeek.com/bis-highlights-potential-risks-of-tokenized-money-market-funds/