U.S. Treasuries have long stood as the bedrock of the traditional financial system, serving as collateral across various transactions, from repurchase (repo) agreements to derivatives trading. With an estimated $7.5 trillion in foreign holdings and daily repo transactions exceeding $4 trillion, these secure and liquid assets play a vital role in maintaining market stability and facilitating liquidity.

Recently, tokenized Treasuries have significantly evolved past earlier versions that were typically non-transferable or had inadequate liquidation processes incompatible with new products. The total value of tokenized Treasuries on-chain has reached an all-time high of $2.24 billion. In contrast, stablecoins (tokenized dollars) command a substantial $170+ billion, indicating that tokenized Treasuries are just scratching the surface and poised for rapid growth.

How Treasuries are used in traditional finance

In the traditional financial system, Treasuries are extensively used as collateral due to their safety, liquidity, lower credit risk, and stability, enabling vast amounts of leverage and liquidity across global markets. Here are some of the key markets where Treasuries play a pivotal role:

A new opportunity for crypto markets

The cryptocurrency and decentralized finance (DeFi) ecosystems currently lack access to stable, high-quality collateral besides stablecoin. Crypto and DeFi traders typically rely on volatile assets like bitcoin or ether as collateral for loans, staking, and liquidity pools. While effective, this system introduces significant risks, as the value of these assets can fluctuate wildly within short time frames, leading to over collateralization to mitigate risks. The alternative is to post stable coins that only earn a yield to the stablecoin issuers or selected market participants through opaque yield-sharing agreements.

Introducing tokenized Treasuries as collateral provides a better pathway for crypto, similar to what companies do in the previously described TradFi world. Since Treasuries are U.S. government debt, they don’t suffer from the extreme price swings of crypto or the lack of transparent yield and counterparty risks of using stablecoins. Using tokenized Treasuries can fundamentally reduce risk, expand liquidity, enhance transparency and improve returns by earning yield on the collateral.

Innovations in tokenized treasury products lead to efficiency in ways often lacking in traditional finance. Blockchain technology makes it possible for fully on-chain tokenized treasury funds to allow for rapid issuance, instant redemptions, and instant peer-to-peer trading. This capability makes traditional assets more productive within the crypto ecosystem, opening up new pools of capital.

Factor in all these elements, and you see how tokenized Treasuries can provide a familiar and secure asset that traditional investors already trust. Other potential new types of financial products that could emerge include:

Tokenizing U.S. Treasuries and using them as collateral in crypto markets presents a significant opportunity to merge the best aspects of traditional finance with the innovation of DeFi. By reducing volatility, deepening liquidity, and attracting institutional capital, tokenized Treasuries could revolutionize both markets, unlocking a new era of hybrid finance.

- Carlos Domingo, founder and CEO, Securitize

In recent years, cryptocurrency has evolved from a fringe investment into a mainstream digital asset class that is increasingly being included in diversified portfolios. For investors looking to enhance their portfolio's risk-adjusted returns, adding a crypto allocation can be a compelling strategy. A well-balanced portfolio that includes cryptocurrencies like bitcoin or ether has the potential to offer superior returns and a higher Sharpe ratio compared to traditional portfolios made up solely of equities, bonds, or other assets. Let’s break down why this is the case and look at metrics that demonstrate the advantages of including crypto from a risk/return perspective.

Enhanced returns

Crypto markets have shown explosive growth, far outpacing traditional asset classes in terms of returns. For example, bitcoin has delivered an annualized return of 230% over the past decade, compared to the S&P 500’s annualized return of around 11%. Ether, another dominant cryptocurrency, has also offered triple-digit annual growth rates in its early years. Even with their volatility, these digital assets provide investors with the potential for significantly higher returns, particularly during periods of market expansion.

By including a small allocation of crypto — let’s say between 2% and 10% — in a diversified portfolio, investors can capture some of these gains. Historical data shows that portfolios with even modest exposure to crypto have experienced an uptick in overall performance. For example, a traditional 60/40 portfolio (60% stocks and 40% bonds) might have returned 8% annually over the past decade, but a similar portfolio that allocates 5% to bitcoin could have seen annualized returns closer to 12% or more, all without a significant increase in risk.

Better risk-adjusted returns: the Sharpe ratio advantage

While cryptocurrencies are notorious for their volatility, their inclusion in a portfolio can still improve risk-adjusted returns when managed appropriately. One of the key metrics to assess this is the Sharpe ratio, which measures the return per unit of risk taken. A higher Sharpe ratio indicates that the portfolio is delivering better risk-adjusted returns.

When analyzing data from 2015 to 2023, portfolios with a small crypto allocation show a Sharpe ratio improvement of 0.5 to 0.8 points compared to traditional portfolios. For instance, a traditional portfolio might have a Sharpe ratio of 0.75, but adding 5% bitcoin can elevate it to around 1.2, signifying an optimized balance between risk and reward. The increase in the Sharpe ratio occurs because cryptocurrencies' price movements often have low or negative correlations with traditional asset classes, thus offering better diversification.

Risk mitigation through diversification

Cryptocurrencies are also known for their role as a hedge against inflation and traditional financial market downturns. Since bitcoin in particular has a finite supply, it is often compared to digital gold. During inflationary periods or times of economic instability, having crypto in a portfolio can help offset losses in traditional assets like stocks or bonds.

In conclusion, adding crypto to a portfolio can significantly enhance returns and improve risk-adjusted performance, as evidenced by increased Sharpe ratios. While there is inherent volatility, the proper allocation of this digital asset class can provide a strategic advantage for investors seeking to optimize their risk/return profile.

- Timothy Burgess, founder and CEO, WealthAgile

As always, get the latest crypto news from coindesk.com and market updates from coindeskmarkets.com.