Stablecoins and the Limits of Existing Analogies
Why leveraging existing frameworks for stablecoin policy falls short
Stablecoins are Unique
Comparisons of stablecoins to existing institutions and products like commercial banks, money market mutual funds, etc., are shaping regulation and public perception. But ultimately stablecoins are a first-of-their-kind asset, and those analogies fail to explain the unique risk profile of stablecoin issuers adequately.
Stablecoins are different in that they:
Are a new form-factor of money: due to the programmable nature of blockchains, stablecoins enable new types of fiat transactions previously thought not possible (e.g., flash loans)
Operate outside of traditional regulatory regimes: the GENIUS Act is a start, but significant questions remain about exactly how stablecoin issuers will be regulated and whether they will be as closely scrutinized as banks or other financial institutions
Run on decentralized technical infrastructure: blockchains and smart contracts are globally accessible and permissionless, and behave differently from traditional financial technology platforms
This post will walk through a few of those comparisons and explain why stablecoins do not fit cleanly into any existing category.
Stablecoin Issuers and Commercial Banks
Both stablecoin issuers and commercial banks make two fundamental promises:
They accept fiat currency and offer a medium of exchange at par (stablecoins or bank deposits, respectively) and
They promise to maintain that par value exchange into fiat
Banks lend out deposits through maturity transformation, taking on credit and liquidity risk. In order to manage this risk, banks are highly regulated by institutions like the Federal Reserve and the Federal Deposit Insurance Corporation (FDIC). Commercial banks must meet capital requirements, liquidity coverage ratios, and leverage rules to protect depositors and the broader financial system.
By contrast, stablecoin issuers don’t lend out their reserves and therefore avoid many of the risks that would arise from transforming reserves into far less liquid assets such as loans. Instead, fiat-based stablecoin issuers typically purchase and hold low-risk and liquid assets – sometimes called reserve assets – like US Treasuries and Treasury-related repurchase agreements (repos), though some issuers purchase more volatile assets like Bitcoin and gold.
However, transforming fiat into even high-quality reserve assets still carries risk if they cannot be converted into cash at par during a crisis. And further, if reserves are held in commercial bank deposits, issuers are exposed to counterparty risk (e.g., Circle-SVB 2023).
Commercial banks protect depositors by adhering to regulations regarding their capital and liquidity based on measures such as a simple capital leverage ratio (SLR), a set of risk-weighted capital requirements, and liquidity coverage thresholds. Each of these is designed to protect against different types of risk. While none of the ratios provide a perfect fit for stablecoins, we use the SLR here as an illustrative tool to evaluate stablecoin issuers.
The SLR ensures banks have enough capital to cover unexpected losses. It essentially compares a bank’s capital to the total size of its assets (including anything held off-balance sheet), and the FDIC requires commercial banks to achieve at least a 5% ratio to be considered “well capitalized.” If the ratio is below this minimum, the bank may not have enough buffer to absorb unexpected losses, potentially putting depositors’ funds at risk. If the SLR is applied to stablecoin issuers as best as possible, many would fall short of commercial bank requirements or demonstrate wildly inconsistent results across time. Moreover, a simple leverage ratio fails to capture unique operational risks that stablecoin issuers face given the novelty of their software infrastructure compared to more established yet older legacy platforms. While it is difficult to draw definitive conclusions, the variation underscores the lack of any consensus on how stablecoin issuers should manage their balance sheets to protect their reserves, meet redemption requests, and maintain market access.
The most fundamental banking regulations were designed to address what has historically been the top risk banks face, namely credit risk – the risk that borrowers fail to repay their loans. Since stablecoin issuers do not extend credit, regulations like basic capital requirements that are intended to protect banks against unexpected credit-related losses are probably less applicable.
Still, both stablecoin issuers and banks promise a par-value exchange on demand, and hold assets that may not be immediately liquid. When the number of customers seeking redemptions exceeds what the institution can manage, this exposes these institutions to “run risk”, which creates two problems: (1) a delay in processing redemptions and (2) a forced sale of assets at a discount.
Banks have tools to manage this risk, including access to emergency lending from the Fed and deposit insurance. These protections reduce the incentives for depositors to run. Stablecoin issuers lack these protections and instead aim to prevent runs solely by holding highly liquid, high-quality assets like short-dated US Treasuries. Stablecoin issuers’ obligations to most users are unclear and, at present, less enforceable. These considerations raise questions about whether it’s appropriate to apply bank-like regulations to stablecoin issuers.
Stablecoins and Money Market Mutual Funds
A second analogy for stablecoin issuers could be money market mutual funds (MMMFs), which aim to maintain each share’s value at $1. To maintain par value exchange, both kinds of entities hold high-quality liquid assets. And both are used for cash management, transaction settlement, and liquidity (the NY Fed made this comparison last year).
Stablecoins are different from MMMFs in several ways:
Redemption Mechanics: MMMFs process customers’ redemptions once per business day. These redemptions can only occur during market hours, and settlements usually occur within T+1 days. In contrast, only institutional accounts with verified access to the stablecoin issuer can redeem stablecoins directly at par. Most users, however, lack this access, and must sell or transfer their tokens on the secondary markets, where prices may deviate from the $1 peg during times of stress (see Farhi, Goldstein, and Schnabl 2024 for more on redemption concentration and arbitrage risk).
Transferability: MMMF shares are not freely transferable between parties and are not used for payment; they must be redeemed through the fund. Stablecoins, by contrast, are transferable between parties, making them more liquid, but exposing them to a different set of operational risks.
Regulation: Circuit Breakers, Redemptions, Disclosures, and Liquidity Facilities: MMMFs have historically been regulated to prevent “breaking the buck” (i.e., the value of a MMMF falling below $1 value). Following the 2008 crisis, Rule 2a-7 implemented new, strict requirements for MMMFs to help them weather potential runs:
Liquidity Buffers: Ensure that 25% of assets are liquid within 1 day and that 50% of assets must be liquid within 7 days
Redemption Gates and Fees: Prevent fire-selling assets at a discount to honor high spikes in redemptions. (In 2023, the ability for MMMFs to pause redemptions was rolled back and funds could only charge liquidity fees. Still, MMMFs operate with clearer protections and contingency tools to manage redemptions and preserve par value during times of stress, which stablecoin issuers lack.)
Daily Net Asset Value (NAV) Disclosures: Prove to investors that the MMMF value is maintained at $1
And most importantly, in March 2020, when outflows for MMMFs spiked, the Federal Reserve launched the Money Market Mutual Fund Liquidity Facility (MMLF) to provide indirect, emergency liquidity to MMMFs, by allowing banks to purchase assets from MMMFs and pledge them to the Fed for liquidity. While it was effective at the time (the MMLF expired in March 2021), it signaled to investors that MMMFs could potentially benefit from federally-coordinated backstops. Today, the Standing Repo Facility (SRF) exists to support MMMFs, although it does not guarantee MMMF redemption rights.
Stablecoin issuers, by contrast, have no required parallel legislation regarding redemptions and thus play by their own rules. Currently, issuers have:
No access to emergency lending or backstop facilities
No requirement to impose gates or liquidity fees
No obligation to honor redemptions for retail users
Some stablecoin issuers have discretionary rights to suspend or delay redemptions, but the conditions under which this occurs are murky. For instance, Circle exclusively reserves the right to “change, suspend or discontinue any aspect of the platform” (Circle ToS Section 16).Tether likewise “reserves the right to delay the redemption or withdrawal of Tether Tokens if such delay is necessitated by the illiquidity or unavailability or loss of any Reserves” (Tether ToS Section 4.1).
While MMMFs and stablecoins may appear similar in purpose and reserve composition, the redemption mechanics, transferability, and regulatory protection to prevent breaking the buck (or lack thereof) results in significantly differing operational behaviors.
(Another useful analogy is Eurodollars and the maintenance of par-value exchange between offshore and onshore dollars. We will explore this more fully in our forthcoming paper.)
Novel Technical Risks for Stablecoins
Probably the biggest difference between stablecoins and traditional financial instruments is their foundation: decentralized vs. centralized infrastructure. The novel decentralized infrastructure introduces new categories of risk. Stablecoin issuers must not only manage familiar financial risks, but also mitigate software risks.
Unlike conventional financial infrastructure systems like SWIFT or Fedwire, which are centralized, permissioned, and supported by extensive institutional safeguards, stablecoins run on public blockchains (e.g., Ethereum, Solana, Tron). These blockchains enable automated logic and require coordinating global consensus to change transaction history and undo mistakes. While this architecture enables innovation, it also means the operational resilience of stablecoins depends more on novel software systems than is the case with traditional financial assets.
Below are some of the novel technology risks associated with stablecoins:
Smart contracts are the core logic determining how stablecoins are created, destroyed, and transferred, and they enforce the rules of the stablecoin ecosystem. However, if the logic in this code is incorrect, tokens can become stuck or stolen, or unintended inflation may result. Furthermore, since these systems are open access, any vulnerabilities may be exploited by bad actors.
Bridges help users move stablecoins from one blockchain to another. They are also smart contracts, and suffer from the same risks. One of the biggest catastrophes related to stablecoins stemmed from a bridge vulnerability (i.e., Wormhole’s $326M attack).
Cryptographic keys enable stablecoin issuers to control special smart contract administrative functions, including halting transactions or upgrading the smart contract code. If these keys are somehow compromised, attackers could mint unlimited tokens, halt the smart contract, add or remove users from the blacklist, or block redemptions.
The underlying blockchain processes stablecoin transactions and enforces the contract logic. However, congestion or consensus-level attacks, such as ones resulting in chain splits, can impede or block transactions. Furthermore, if a blockchain has high transaction volume, the fees required to interact on the blockchain could skyrocket.
The aforementioned risks are just a few examples of real, technical dependencies that disrupted stablecoin operations in the past. No amount of liquidity buffers or capital requirements can secure a stablecoin’s infrastructure stack against hackers or poorly written code.
Conclusion
Neither commercial banks nor MMMFs are perfect analogies for stablecoins. There are several areas where we can learn from each to determine how to properly operate and regulate stablecoins, but there are also real differences, like the new technology stack based on smart contracts and decentralized blockchains, that will require new thinking on how to protect consumers.
As we noted, most stablecoin issuers invest in US Treasuries and related securities and a few stablecoin issuers have become major participants in that market. In our next post, we will explore the impact of stablecoin issuers’ emerging and growing position in the US Treasury Market.
Authors: Ashwanth Samuel, Jenny Jin, Dan Aronoff, Anders Brownworth, Neha Narula
This post is the second in a summer blog series from the MIT Digital Currency Initiative exploring the financial and technical risks of stablecoins. These posts preview findings from a forthcoming research paper, written in collaboration with MITRE, that will be released later this year. The views expressed are those of the authors and do not necessarily reflect the positions of MIT or any other affiliated institution.