As we approach Thanksgiving, let us be thankful that the collapse of cryptocurrency prices over the past year, culminating in the recent surrender of crypto exchange FTX, did not spill into the traditional financial system and threaten financial stability. This outcome is a result of limited connections between crypto-assets and the traditional financial system. But as the US Financial Stability Oversight Council noted in a report last month, “these interconnections have been increasing and could rapidly increase further.”
Unfortunately, a proposal for regulating stablecoins from the Treasury Department and bank regulatory agencies would deepen and accelerate such interconnections, thereby increasing crypto’s risk to financial stability.
Stablecoins are cryptocurrencies that attempt to peg their value to a reference asset, typically the US dollar, at a 1:1 ratio. The largest stablecoins maintain their peg by holding a reserve of dollar-denominated assets, typically some combination of bank deposits, Treasury securities or commercial paper. If stablecoin holders have reason to doubt the quantity and quality of these reserves, they may sell their holdings en masse to get dollars, thereby triggering a classic “run” that could lead to the collapse of one or more stablecoin issuers.
To prevent a run on stablecoins, regulators want Congress to pass legislation that would require fiat currency-backed stablecoin issuers to be insured depository institutions subject to federal supervision and regulation. But this approach ignores present reality in favor of an imagined future where stablecoins are a widely used payment instrument. In doing so, it risks importing crypto’s problems into the banking system, increasing the odds that the next crypto winter would freeze our banking system.
Despite the claims of stablecoin issuers and their supporters, stablecoins are rarely used for payments. Instead, they are used to trade other cryptocurrencies and participate in decentralized finance (DeFi) protocols, which are financial products and services that operate on a blockchain without an intermediary like a bank or broker. This is why Securities and Exchange Commission (SEC) Chairman Gary Gensler likes stablecoins to poker chips at the casino — if you want to speculate in the crypto economy, you need stablecoins.
If stablecoin issuers are forced to become banks, it would give stablecoins instant credibility and propel the growth of DeFi, which is a new form of shadow banking. It would also deepen connections between the highly regulated banking system and the unregulated crypto economy, thereby increasing the chances that a problem in one would spill into the other. How would taxpayers feel if a bank that is highly exposed to cryptocurrency, perhaps by issuing stablecoins, got into trouble and had to borrow from the Federal Reserve or was taken over by the FDIC? Furthermore, if stablecoin issuers were forced to become banks, they would be subject to stringent rules around the quality of their reserves. This would increase demand for safe assets and exacerbate current illiquidity problems in the Treasury market.
It is natural for bank regulators to worry about a bank-like run on stablecoins. But in this instance, their fears are misplaced. Runs are problematic for two reasons. First, the entity being run on could fail and cease its intermediating function. Second, to meet liability outflows, the entity would be forced to sell assets at discounted prices, which could trigger a fire sale that impacts the price of the assets being sold and the solvency of other institutions that hold similar assets.
The latter is why the Fed backstopped money market mutual funds twice in a 12-year period (first during the 2008 finance crisis and then again at the onset of the pandemic in March 2020). Because money market funds hold short-term commercial paper issued by US companies to fund their day-to-day operations, there was justifiable concern that a run on money market funds would lead to a fire sale of commercial paper that would make it more difficult for companies in the non-financial sector to fund themselves.
Because stablecoins are primarily used to speculate on crypto, a run would have no impact on credit or payments intermediation in the real economy. Nor would a run on stablecoins produce a damaging fire sale. The total supply of fiat-currency backed stableocins is roughly $140 billion, with the majority of these reserves consisting of bank deposits and Treasury securities. The market would easily absorb any sale of these reserves should a run on stablecoins occur.
Stablecoins do present risks to their users but that does not necessarily mean they need to be subject to bank-like regulation. In fact, most users are well aware of the potential risks and don’t seem to care. Just look at the example of Tether, the largest stablecoin in circulation with a market capitalization of approximately $69 trillion. Last year, Tether settled separate charges with the Commodity Futures Trading Commission and the New York Attorney General’s office that it misrepresented to customers that it maintained sufficient US dollar reserves to cover every Tether stablecoin in circulation.
And Tether has still not conducted a full independent audit of its reserves, despite promising one since at least 2017. Given Tether’s well-known issues, if a run hasn’t occurred yet, what would it take?
The truth is that stablecoins like Tether maintain their peg because crypto traders need them to. This reflects the fundamental essence of financial runs — they are psychologically driven. Bringing stablecoins into the banking system may marginally improve investors’ confidence in their ability to redeem one stablecoin for one US dollar, but it does so at the expense of introducing new risks to financial stability and the expansion of the federal safety net to the crypto sector .
Regulators should instead attempt to shore up investor psychology by ensuring stablecoin issuers are providing timely and detailed information about the composition of their reserves. This would provide needed market discipline and lead investors to use those stablecoins that are backed by high-quality liquid assets. Stablecoins do present problems, but not all problems require a regulatory solution.
Lee Reiners is policy director at the Duke Financial Economics Center and a lecturing fellow at Duke University School of Law. At Duke, Reiners teaches courses on cryptocurrency and financial regulatory policy and he is a frequent commentator on cryptocurrency policy issues.