Stablecoins: a threat to the banking system? (Part 3)

Fewer deposits means more expensive credit

Are stablecoins a danger to the banking system? Yes – potentially – if they grow large enough to compete with banks. Every dollar that flows into a stablecoin is one less in the banks’ funding pool. Fewer deposits mean more expensive credit, which is undesirable. That is why current regulations prohibit stablecoins from paying interest.

Another difference is that the U.S. central bank does not guarantee deposits held by stablecoin issuers. (Stablecoins are currently primarily a U.S. phenomenon, a fact reinforced by the GENIUS Act.) The Fed’s liquidity tap also remains closed. A sudden surge in redemptions could spiral out of control, and that day will undoubtedly come.

Are foreign central banks being sidelined?

The fact that stablecoins cannot offer interest makes them less attractive to foreign institutions that have access to interest-bearing products. However, in countries with unstable currencies, holding digital dollars remains appealing for individuals, even without returns. This could lead to dollarisation, effectively rendering the local central bank redundant.

Still, it is not all doom and gloom for emerging markets. Many of these countries implement credible monetary (inflation) and fiscal policies today, often stricter than the U.S. (admittedly, the bar there has been lowered). Countries such as India and Brazil, for example, are showing how a modern payments infrastructure can remain under government control. India’s Unified Payments Interface processes 75% of all digital retail payments, around 20 billion (!) transactions per month, while Brazil’s Pix reaches 93% of the population.

Are stablecoin issuers banks?

Not according to the GENIUS Act. The regulator wants to replicate banking functions without calling it ‘banking’. Although there is 100% reserve backing and regular audits, there is no deposit insurance or access to the Fed’s discount window, though there is priority in the event of insolvency. Yet the issuers behave like banks. They receive money, invest it, and issue a callable obligation at par. ‘If it walks like a duck and quacks like a duck…’

It is expected that banks will start issuing their own tokens – tokenised deposits – to avoid being sidelined. At the same time, the bridge between blockchain and the real economy, the so-called on/off ramp where money is converted into and out of stablecoins, remains under the control of banks. The system is free within the chain, but as soon as money enters or exits the conventional banking system, it inevitably passes through the financial sector.

‘Wildcat banking’, but digital

The creation of stablecoins essentially involves the creation of private money. And while it is not legal tender, it functions like money: it can be saved, traded and used for payments. This resembles the ‘free banking’ era from 1837 to 1863, when individual U.S. banks issued their own banknotes. Nowadays, approved stablecoin issuers can mint their own currency.

Back then, trust was based on a bank’s reputation, whereas today it depends on the quality of reserves and audits. In that time, there was no central authority, and again today, regulation is once again lagging behind. The U.S. Bureau of Industry and Security (BIS) warns: ‘History is repeating itself with the privatised issuance of competing stablecoins.’

How did that end? Badly, in most cases. Some banks set up in remote areas, issued banknotes, and then disappeared when customers tried to exchange them for gold. The creation of many different notes, each with its own value, led to a fragmented and unstable monetary system. Then there were the classic ‘bank runs’. The collapse of one bank dragged down others, including healthy ones.

Do stablecoins make the financial system less stable?

The risk is real.

• Run risk and ‘singleness’: If trust falters, the price of a stablecoin drops. A $1 stablecoin would no longer be worth $1, whereas a ‘real’ dollar always would be (this is known as ‘singleness’). Doubts about one issuer could quickly spread to others, prompting a run on the system. Even supposedly ‘stable’ coins may not hold their value in a crisis.
• Regulatory gaps and emergency support: Banks facing a liquidity crunch can borrow from the Fed via the ‘discount window’, providing assets as collateral. The Fed supplies cash immediately at a slightly higher rate, and the bank repays it once the panic subsides. Stablecoins have no access to this discount window. The GENIUS Act also provides no deposit insurance. It does require full backing, but that is not the same thing.
• Domino effect: “Who intervenes when a stablecoin issuer gets into trouble, and with what authority, to prevent the problems from spilling over into the real economy, as in the 1930s?” asks Nobel laureate Simon Johnson in an opinion piece. Applying bankruptcy law to failed stablecoin issuers is possible, “but this will inevitably mean high costs for investors, including long delays in recovering any remaining funds. And it will almost certainly worsen the runs on other stablecoin issuers.”
• Asset mismatch: According to its promoters, the GENIUS Act aims to strengthen the dollar’s role as a reserve currency. However, it also permits foreign issuers to hold reserves in their own government bonds rather than in dollars. If the dollar rises, those issuers will encounter difficulties. Liquidity stress, bankruptcies and runs then become likely. If we return to the zero interest rate policies of a few years ago, stablecoin issuers’ business models will collapse.
• Money market fund dynamics: Stablecoins invest heavily in short-term U.S. Treasury bills, much like money market funds. According to the BIS, every $3.5 billion increase in their market capitalisation pushes down the yield on short-term debt by 2.5 to 5 basis points. In 2024, stablecoins collectively purchased $40 billion worth of Treasury bills, which is equivalent to the purchases of major money market funds and countries. During sell-offs, the effects on interest rates are three times greater. Fire sales are no longer a theoretical risk.
• Disintermediation of the Fed: Stablecoins bypass the correspondent banking system. In a traditional international bank transaction, payments go through correspondent banks and pass through the Fed’s balance sheet. However, a U.S. company can use stablecoins to pay a foreign supplier directly in digital dollars, meaning the Fed doesn’t see the transaction. This both removes the central bank from the payments system, and undermines its geopolitical power, including its ability to impose sanctions.

While stablecoins are speeding up innovation, they are also removing the safety rails of the public financial system. ‘In practice,’ the BIS notes dryly, ‘stablecoins are particularly attractive to criminals and terrorist organisations.’

The alternative: tokenised deposits and the Unified Ledger

The BIS proposes tokenised bank deposits and a ‘Unified Ledger’ – a single, uniform, programmable network on which central bank reserves, bank deposits and government bonds would coexist as digital claims.

This system combines the speed of stablecoins with the security of traditional banking, public settlement, deposit guarantees and oversight, while making transactions instant and programmable.

Is it less sexy than stablecoins? Absolutely. But far more reliable. Stablecoins are the fintechs of money, whereas tokenised deposits are the compliance department.