Policymakers Shouldn’t Yield on Stablecoin Interest

By Phillip Basil, Director of Economic Growth and Financial Stability; Christopher Appel, Director of Banking Policy; and Amanda Fischer, Policy Director & COO

Crypto market structure legislation is stalled in Washington, in part over a crypto industry versus banking industry spat over whether stablecoin issuers or related parties should be able to pay yield to stablecoin customers. Both industries are arguing that their position would benefit consumers and the economy, but both can’t be right. The crypto industry, its lobbyists, and supporters in the administration have been pushing false claims and deceptive “analysis” to support the crypto position, but policymakers must stick to the facts and thoughtful analysis and reject their efforts for the benefit of the economy.

On the one hand, crypto firms argue that it’s only fair that they should be able to pass on some of the earnings they accrue from holding the interest-bearing reserve assets that “back” stablecoins, thereby benefitting consumers by providing them more earnings than standard bank deposits. It also so happens that this can attract more people to buy their stablecoin, increase the reserve asset base upon which they earn income, and create network effects to dominate the stablecoin market.

On the other hand, banks argue that allowing yield on stablecoin holdings will encourage deposit flight out of the banking system and into stablecoins, thereby undermining lending to the real economy and hurting economic growth. It also so happens that this could reduce bank earnings.

It’s clear that the White House favors the crypto industry in this debate and, to that end, the President’s economists at the Council of Economic Advisers (CEA) last week released a report showing that allowing stablecoins to pay yield would have a modest positive effect on bank lending. Their report finds that three-quarters of that increase derived from an increase in large bank lending and one-quarter of that increase derived from small bank lending. Therefore, so they say, stablecoins can bring about all the consumer and economic benefits being pushed by both the crypto and the banking industries.

But this utopian outcome doesn’t hold up under scrutiny. The CEA report in fact represents a case of motivated reasoning. To level set, the CEA assumes that only 12 percent of stablecoin issuer reserve asset holdings are in the form of cash and therefore are locked up and not available for lending to the economy. The other 88 percent are assumed to be held in the form of Treasury bills and repurchase agreements which, conversely, they argue entirely recirculate through the banking system as the sellers of the Treasuries redeposit the proceeds back into banks. Banks can then use these deposits to make loans. Therefore, they conclude that stablecoins don’t affect the level of deposits in the banking system but rather only the composition of deposits.

However, when these assumptions are analyzed more rigorously, it calls into question the CEA’s rosy outlook on stablecoins being able to pay their customers yield.

First, the CEA estimate of stablecoin issuers holding only 12 percent of reserve assets in cash is not a fixed, sacrosanct figure that will apply ad infinitum.

This figure is based on a single point-in-time piece of data from one current stablecoin issuer. Stablecoin issuers can change that allocation dramatically if the regulatory agencies were to impose stricter custody requirements, if stablecoin issuers were to face operational pressure to hold more cash for redemptions, or if there is more pressure in Treasury markets, among other potential changes in market structure or regulatory policy. Under any of those conditions, the 12 percent assumption could rise substantially and the lending effect would be much more negative than concluded in the CEA paper.

Second, it is unreasonable to assume that the 88 percent of stablecoin reserve holdings in the form of Treasuries and repos will entirely recirculate through the banking system, either in terms of the level or distribution of deposits.

As for the level of deposits, if all money invested into financial assets ended up as a bank deposit, then bank deposits would roughly equal the value of all financial assets, which is not even close to being the case (see data from the Federal Reserve). The reality is that a seller of assets might put the proceeds into bank deposits but also might reinvest the proceeds into other financial assets. Considering stablecoins won’t be generally intermediating with retail investors but rather with large institutional investors or even foreign governments (via some broker dealers), it’s much more likely that most of the proceeds will end up reinvested in other financial assets, not in bank deposits. This is pointed out in a thoughtful paper from a Federal Reserve economist (see section 2.2).

Third, all deposits and loans are not created equal.

Deposit composition matters a lot to the type of lending that banks do. Banks primarily use insured and other more stable deposits for the type of long-term lending that benefits individuals and businesses, i.e., mortgages and long-term corporate loans (including small business loans) that often are used for capital investments. If all of a sudden there are a lot of flighty, unstable wholesale deposits from the large sellers of assets to stablecoin issuers, banks would have to simultaneously increase their liquidity buffers and shorten the duration of their lending. Increasing liquidity buffers would reduce overall lending, because liquidity buffers mean the money is not being lent but rather held for liquidity. And shortening the duration of lending means redirecting deposits towards short-term lending and away from long-term lending, e.g., away from long-term corporate loans that are used by companies for capital investments and towards short-term corporate lines of credit that are used for short-term cash needs. This is also covered in the same Federal Reserve paper noted earlier (section 2.3).

Fourth, deposit outflows disproportionately harm community bank lending to Main Street.

Community banks are more reliant on core deposits to fund their lending than large banks, which have access to capital markets and wholesale funding. Research from Better Markets has confirmed that the correlation between deposit growth and loan growth is significantly stronger at small banks, precisely because they focus on the traditional model of deposit-taking and lending. Community banks also punch above their weight in credit provision to small businesses and farms, with the FDIC finding that banks under $1 billion in assets direct roughly 78 percent of their commercial and industrial loan books to small businesses. When deposits leave these institutions, the lending contraction hits Main Street hardest—small businesses, agriculture, and commercial real estate projects that large banks are much less likely to underwrite.

Compounding this concern, the GENIUS Act opens the door for non-financial corporations—including firms like Amazon or Walmart—to issue payment stablecoins. These issuers are required to back their stablecoins 1:1 with reserves consisting primarily of short-term Treasuries, cash, and government money market fund shares. It is highly unlikely that a large technology or retail corporation purchasing Treasury bills to collateralize its stablecoin will recirculate those funds as deposits back into the community banking system. The result is a one-way street: deposits flowing from community banks and into Treasury-backed stablecoin reserves held by largest corporations, permanently removing that funding from the institutions best positioned to lend it into local economies.

Conclusion

Policymakers should pause before incorporating any of the CEA’s conclusions into their decision-making. With community banks already facing a long period of retrenchment, policies that favor stablecoin issuers would only hasten current trends. Finally, it’s also important to consider the regulatory environment: though the bank supervision and regulatory regime suffers from important gaps, especially in the current Administration (highlighted by Better Markets in many fact sheets and comment letters), it is still substantially more robust than the prudential regime applying to stablecoin issuers and related parties that may seek to pay yield. History is rife with examples of firms outside the banking regulatory perimeter engaging in bank-like functions like offering demand deposits and paying interest, and the result is often disastrous for financial stability.

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