At the end of March in East 8 Time Zone, the Federal Reserve Chair nominee Kevin Walsh put forward a proposal that could shake Wall Street's nerves: to significantly compress the current approximately $6.6 trillion Federal Reserve balance sheet in the coming years. This goal directly targets the massive reserve system built up through unconventional easing after the pandemic. In stark contrast, Stanford Business School professor Darrell Duffie issued a warning—if liquidity regulation rules are not rewritten first, rashly shrinking the balance sheet could plunge the financial system into a new stress test. The dispute over the order of “balance sheet shrinkage or reform first” is not just a technical route choice but a matter of reshaping the dollar liquidity framework, global interest rate anchors, and the pricing of risk assets, including crypto assets.

6.6 Trillion Compression Target: Where Does the Balance Sheet Return?

After the pandemic, the Federal Reserve raised its balance sheet to about $6.6 trillion through large-scale bond purchases and liquidity injections, an unprecedented level in history. A massive amount of treasury bonds and MBS are locked in the central bank's asset end, corresponding to the vast surplus reserves held by commercial banks and financial institutions, with the entire dollar system operating in this “high reserves, low turnover” environment. Walsh's proposal to significantly compress this balance sheet directly challenges the policy path centered on balance sheet expansion for the past decade.

In the eyes of the market, Walsh has quickly been labeled a “more aggressive balance sheet shrinker.” He contrasts with the current more cautious and gradual balance sheet reduction pace: one side hopes to return to a “smaller, more traditional” central bank balance sheet faster, while the other side worries about a “shock therapy” type tightening of financial institutions. This contrast is changing the market's basic assumptions about reserve supply, asset valuations, and volatility in the coming years. Particularly for institutions highly reliant on short-term liquidity and the repo market, Walsh's proposition is seen as breaking the implicit endorsement of “the central bank is always there.

The intuitive concerns about quickly returning to a smaller balance sheet center on interest rate and liquidity fluctuations. If the total amount of reserves contracts too quickly, money market rates may become more sensitive to marginal funding needs, and even slight mismatches in funds could amplify interest rate fluctuations, recreating scenarios of sudden tightness in the repo market. Higher volatility will pressure financial institutions to reduce leverage and increase liquidity buffers, weakening the risk appetite foundation for risk assets. In this chain of events, the question of “how low and how fast to compress the $6.6 trillion” becomes not just a technical issue but an open questioning of the financial ecosystem's ability to withstand stress.

Duffie's Warning: The Risks of Balance Sheet Reduction Without Rewriting Liquidity Rules

Darrell Duffie's reminder hits the nail on the head. He clearly states: "To shrink the balance sheet without triggering serious market pressure, a thorough reform of bank liquidity requirements must be promoted." The premise of this statement is to acknowledge that the current regulatory framework is deeply bound to the “massive reserves” environment—regulators assume in stress tests and liquidity coverage ratio designs that the central bank's balance sheet will long maintain a high level, and commercial banks can easily access high-quality liquid assets and central bank reserves.

The formation of this path dependency is closely related to regulatory reform after the financial crisis. To prevent a recurrence of liquidity exhaustion in the banking system, regulators raised the liquidity coverage ratio and the requirements for high-quality liquid assets, necessitating that banks hold large quantities of treasury bonds and central bank reserves to meet the rules. The expansion of the Federal Reserve's balance sheet provided an almost inexhaustible supply of “safe assets” to support this model. The result is that regulation and monetary policy environments lock each other in, with high reserves becoming a prerequisite for regulatory feasibility.

If the balance sheet is shrunk first while the rules remain almost unchanged, the problem will shift from structural ambush to overt flashpoints. A decline in reserve balances and changes in the structure of treasury supply may lead to a more frequent occurrence of marginal funding shortages in the repo market, with short-term interest rates reacting more dramatically to any risk events. Duffie also worries that the money market fund system may become unbalanced again: when banking system liquidity tightens further, some short-term funds may be forced to switch frequently between money funds, repos, and bank deposits, amplifying the pro-cyclical effects of redemptions and runs in stressful scenarios. This means that if regulatory rules lag behind the pace of balance sheet reduction, market pressures will no longer be “tail risks” but rather a fuse that is bound to ignite.

From Japanese Government Bonds to Oil Prices: Global Interest Rate Repricing

Walsh's balance sheet reduction plan does not occur in a vacuum. To the east, Japan is providing the global market with a cautionary tale regarding interest rate repricing. According to data from March 26, Japan's two-year government bond yield is approximately 1.315%, and the ten-year government bond yield is approximately 2.270%, clearly rising from a long period of ultra-low interest rates. This change is viewed by the market as a signal from major central banks, including the Bank of Japan, transitioning towards “exiting long-term extreme easing,” reminding investors that the logic of the long low-interest rate era is beginning to loosen.

At the same time, potential increases in oil prices add new uncertainties to this narrative shift. For economies where inflation has not yet fully receded, rising energy prices are nearly guaranteed to push up inflation expectations and force central banks to make more difficult choices between “maintaining relative easing to stabilize growth” and “defending price stability and currency credibility.” If monetary policy is dragged toward a tighter stance by oil prices, the long-term interest rate curve will steepen, financing costs will rise, and the discount rates for risk asset valuations will shift upward.

Putting the yield changes of the United States and Japan together in the same graph will clearly reveal a main thread: global capital is slowly withdrawing from the "long-term low-interest rate era." The U.S. is considering balance sheet reductions, Japanese yields are rising, and combined with Europe’s continued vigilance over inflation, the central tendency of global risk-free interest rates is increasing. For high-volatility assets like cryptocurrencies, this process has two implications: first, the reallocation of capital among global assets is becoming more rational, and relying on a “beta market built on low interest rates” is becoming unsustainable; second, valuation models are becoming more sensitive to cash flows and real applications rather than purely to narratives of liquidity flooding.

Washington and the Crypto Market: Regulatory Tightening and Business Reflow

As macro liquidity may tighten, Washington's attitude toward the crypto market is also quietly being restructured. The chair of the U.S. Commodity Futures Trading Commission (CFTC), Michael Selig, publicly stated the need to promote the “truly” crypto perpetual contract business back to the United States. This statement directly addresses the issue of many crypto derivatives and high-leverage businesses being stranded in offshore platforms and regulatory gray areas, aiming to bring the most profitable and systemic risk-laden portions into the sights of U.S. regulation.

When placing this effort in the larger context of balance sheet reduction and financial regulatory redesign, its significance becomes clearer: the return of derivatives and leverage businesses is a key part of consolidating the U.S. financial center's position. As dollar liquidity no longer expands infinitely and regulators pay more attention to cross-market risk transmission, bringing high-risk products closer to regulators is intended both to control spillover risks and to lock related revenues and innovations back into the U.S. domestic financial system. This marks a reversal for traditional financial centers like New York and Chicago from the “crypto finance outsourcing era.”

However, stronger regulation and more restrained risk appetite mean that the crypto market itself will face a dual restructuring of compliance costs and liquidity structures. On one hand, exchanges and brokers operating under a U.S. compliance framework will need to invest more resources in compliance, risk control, and customer vetting, with business boundaries being more clearly delineated; on the other hand, a significant amount of liquidity that originally depended on high leverage and high-frequency trading may shrink or migrate due to rising costs and behavioral restrictions. This will reshape the depth and volatility characteristics of order books, compressing the arbitrage opportunities accumulated during the past “unconstrained high-leverage era” into narrower spaces.

AI Tracking Dark and Grey Industries: New Regulatory Tools and Liquidity Clearing

As the regulatory outlook tightens, technological means are also rapidly upgrading. On-chain analysis company TRM Labs has launched an AI tool aimed at improving the efficiency of tracking illegal crypto transactions, reflecting the trend of regulatory technology. Leveraging machine learning and pattern recognition, these tools can quickly identify suspicious addresses, fund flows, and cross-chain money laundering paths, partially shifting previously human-dependent and post-factum compliance processes to real-time monitoring and early warning stages.

In the context of a tighter liquidity environment and stronger scrutiny, clearing of gray funds will significantly impact the liquidity pools of crypto assets. A large amount of capital accustomed to exploiting on-chain anonymity for arbitrage, money laundering, or regulatory evasion may be forced to exit mainstream chains and protocols or bear higher enforcement risks and transaction costs once their “invisibility cloak” is pulled away. In the short term, this could weaken the apparent activity of certain chains or assets, amplifying price sensitivity to single large transactions.

However, in the medium to long term, the increased proportion of compliant funds will reshape the survival models of exchanges, market makers, and on-chain protocols. Exchanges will need to manage risk profiles more finely in terms of listing, user reviews, and cross-border business; market makers will be more conservative in funding sources and counterparty choices, relying more on compliance cooperation with banks and brokers; DeFi protocols will face the decision of “whether and how to integrate compliance modules,” transitioning from permissionless pure code logic to some form of “compliance modules + decentralized execution” hybrid architectures. Projects that cannot adapt to regulatory technology upgrades will gradually be pushed out of the mainstream liquidity network.

Balance Sheet Reduction, Reform, and the New Game Coordinates for Crypto Assets

Overall, Walsh's radical balance sheet reduction proposal and Duffie's emphasis on regulatory reform form the key game axis of the U.S. dollar liquidity environment for the coming years. The former seeks to rapidly eliminate the “liquidity bubble” left by the central bank's on-balance sheet expansion, while the latter warns that bank liquidity rules must first be rewritten to avoid triggering new systemic pressures within a high-leverage, highly correlated system. The direction of this game will determine the speed and pace of global dollar reserve supply and reshape the functional division between banks and shadow banks.

In parallel, the rising Japanese yields and oil price variables will influence through the global interest rate curve and inflation expectations. The upward shift in the central tendency of risk-free interest rates compresses the imaginative space for risk asset valuations; each spike in energy prices will force central banks to re-evaluate the space for easing. For crypto assets, this signifies a transition from a “pure liquidity-driven valuation model” to a framework resonating with “macro interest rates + fundamental narratives,” where high volatility no longer equates to high returns, and risk compensation requirements are recalibrated.

Under the dual forces of regulatory technology upgrades and the reflow of crypto business back to the U.S., the crypto market is likely entering a more compliant yet more discerning era of stock competition. The inclusion of derivative and leverage business regulations, AI-driven on-chain tracking, and increased proportions of compliant funds collectively raise the entry barriers and enhance the requirements for project quality, cash flow, and real demand. For participants, the age of dividends will shift from “beta riding the upward flow of the market” to “seeking alpha under stricter rules and tighter liquidity constraints.” In the environment of Walsh-style balance sheet reduction bets and global interest rate repricing, those who truly understand macro constraints will have better chances of surviving and thriving in the next cycle.

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