Tokenization and Monetary Policy: How Digital Assets Are Changing Central Banking

Monetary policy transmission is the process by which central bank decisions — changes in the benchmark interest rate — flow through the financial system to affect economic activity. The mechanism runs roughly as follows: the central bank raises rates, commercial banks’ cost of borrowing increases, banks raise lending rates to businesses and households, credit becomes more expensive, investment and consumption slow, and inflationary pressure eases.

This transmission mechanism assumes that the financial system through which monetary policy flows is predominantly composed of chartered banks operating within the central bank’s sphere of influence. When significant financial activity occurs outside this sphere — in money market funds, shadow banks, or now in crypto markets — the transmission mechanism becomes less reliable. The rate increase that was supposed to cool the economy has less effect when a growing share of credit and savings exists outside the banking system.

Tokenization is beginning to create exactly this dynamic.

The Stablecoin Challenge to Monetary Transmission

The stablecoin market exceeded $200 billion in 2025. The dominant stablecoins — USDT and USDC — are backed by dollar-denominated assets, primarily short-term US Treasury bills. They function as money market instruments that are also instant settlement tokens on blockchain networks.

This creates a subtle but important monetary policy complication. When the Federal Reserve raises rates, bank deposit rates typically rise as well, though more slowly than the Fed funds rate. The spread between bank deposit rates and Treasury bill yields narrows as rates rise, making bank deposits more competitive relative to higher-yielding alternatives.

But stablecoins backed by Treasury bills capture the rate rise automatically. USDC, for example, holds a portfolio of short-term Treasury bills. When the Fed raises rates, the yield on those Treasury bills increases, and Circle (USDC’s issuer) captures that yield. If yield-bearing stablecoin products become common — Circle’s USDC yield product, which passes Treasury bill yield through to holders — stablecoin holders effectively receive market rates rather than bank deposit rates. This is deposit substitution occurring outside the banking system, reducing the effectiveness of rate increases in slowing bank credit creation.

The effect at $200 billion is manageable. At $2 trillion — a scale that is plausible within a decade if dollar-denominated stablecoin adoption continues its current trajectory — the monetary policy implications become structurally significant.

Tokenized Money Market Funds as Deposit Substitutes

The emergence of tokenized money market funds represents an even more direct challenge to monetary transmission. BlackRock’s BUIDL fund — Blockchain USD Institutional Digital Liquidity Fund — reached $531 million in assets under management, investing in Treasury bills, repurchase agreements, and cash equivalents while issuing blockchain tokens that represent fund shares. Franklin Templeton’s FOBXX fund predates BUIDL and operates on multiple blockchains.

Tokenized money market funds offer something that neither bank deposits nor traditional money market funds can: instant, 24/7 settlement in a format that integrates directly with DeFi protocols and crypto trading infrastructure. An institutional investor can hold BUIDL tokens as near-cash yield-bearing collateral, use them as margin in a derivatives protocol, and convert them to stablecoin for settlement, all without touching the traditional banking system.

For monetary policy, this creates two effects. First, it accelerates the migration of corporate treasury and institutional cash management away from bank deposits toward non-bank instruments, reducing banks’ funding base and their capacity to respond to rate signals. Second, it creates a category of money-like instruments — yield-bearing, highly liquid, blockchain-native — that neither traditional bank regulation nor money market fund regulation fully covers.

The scale is still small relative to the overall money market. But money market fund outflows in the US were a significant factor in the March 2023 banking stress, demonstrating that rapid migration of institutional liquidity can amplify financial instability. Tokenized equivalents that are even more frictionless to transfer could accelerate these dynamics.

DeFi Yields and the Rate Transmission Problem

DeFi lending protocols — Aave, Compound, and their successors — allow users to lend stablecoins and other crypto assets to borrowers, receiving variable yields determined by supply and demand within the protocol. These yields have at times significantly exceeded bank deposit rates and even Treasury bill yields.

When DeFi yields exceed traditional alternatives, capital migrates on-chain. This capital migration is real and documented: during periods of high DeFi yields in 2020-2021, billions of dollars moved from traditional savings products into DeFi protocols. The reverse migration occurs when DeFi yields compress — typically when crypto markets decline and leverage unwinds.

For monetary policy, this creates a new variable: when the Fed raises rates to slow credit creation and encourage saving in traditional instruments, the competing DeFi yield environment can absorb some of the capital that would otherwise flow into bank deposits. This partially offsets the rate increase’s intended effect on bank funding costs.

The Fed has no direct mechanism to influence DeFi lending rates. DeFi rates are set algorithmically by protocol utilisation ratios, not by the federal funds rate. If DeFi represents a meaningful alternative savings venue for retail or institutional capital, the Fed’s rate signals are diluted in proportion to DeFi’s share of the overall savings market.

The Systemic Implications

If stablecoins grew to $2 trillion and tokenized money market instruments added another trillion, the combined effect on monetary policy transmission would be significant enough to concern central banks. The Fed raises rates — but $3 trillion in dollar-denominated assets sits in blockchain-based instruments whose yields are set by market mechanisms, not rate guidance. The transmission channel from policy rate to household and business borrowing costs would be materially impaired.

BIS research has identified this as an emerging concern rather than an acute problem. The BIS and IMF have both published analysis noting that large-scale crypto adoption could weaken monetary policy effectiveness, particularly in smaller economies where crypto adoption is high relative to the formal banking sector. El Salvador’s Bitcoin legal tender experiment, while modest in economic scale, provides a real-world demonstration of what happens to monetary sovereignty when a parallel monetary system operates alongside the official one.

For large developed economies, the risk is more gradual — a slow erosion of monetary transmission effectiveness as the non-bank, non-regulated share of dollar-denominated financial activity grows.

CBDC as the Central Bank’s Response

One logic underlying central bank interest in CBDCs is precisely this monetary transmission concern. A central bank that issues its own digital currency maintains direct monetary relationships with all holders of that currency. Rate changes can be programmed directly into CBDC holding costs or yields, transmitting policy instantaneously rather than through the banking system’s intermediary channels.

Christine Lagarde at the ECB and her predecessors have explicitly framed the digital euro partly in monetary sovereignty terms: the ECB must maintain the ability to conduct effective monetary policy in a digital economy, and a European digital currency is one tool for doing so.

The irony is that CBDC-as-monetary-policy-tool is the very design feature that generates the most political opposition. Programmable monetary policy — CBDCs that automatically adjust yield based on central bank targets — is the most efficient implementation of monetary transmission and the most surveillance-capable implementation of CBDC. The same feature that makes CBDC attractive to central bankers makes it alarming to privacy advocates.

The monetary policy implications of tokenization will not resolve themselves. As tokenized assets grow, the choice facing central banks is between adapting their policy tools to reach new financial infrastructure or watching their transmission mechanism weaken. Neither the BIS nor the IMF believes this is an acute problem today. Both believe it will be if current trends continue unchecked.