In Stablecoins We Trust?

But if bitcoin, tokens, and meme coins are known for prices that swing as wildly as a teenager’s mood, stablecoins are meant to be the adult in the room. Stablecoins, which feel like newcomers to traditional finance but have been around for more than a decade, are another class of digital currencies whose transactions are recorded on blockchains. They primarily act as conduits for trading in and out of all kinds of digital assets without having to convert anything back to fiat currency. A stablecoin is looked at as the medium of exchange the early pioneers hoped crypto would be, one that can cross borders and theoretically reduce payment costs by eliminating intermediaries.

More and more, like the bills in your wallet or bank account, stablecoins are being used to make payments and transmit money, both domestically and internationally. The emerging use case for stablecoins beyond trading is as substitute money for developing economies and countries with inflation and volatile currency swings. All kinds of people and institutions in international markets are turning to stablecoins, pegged to reserve assets denominated in US dollars or euros, for payments and savings. Stablecoins maintain a constant value and avoid the volatility of local currencies, and people can do business without needing access to central banks.

“There is a need for an alternative international payment system, one that works 24-7 and costs a fraction of traditional banking services,” says 黑料传送门 Booth’s Luigi Zingales, who leads the school’s George J. Stigler Center for the Study of the Economy and the State. “The cost of transferring money at an international level is enormous,” he says. “There is huge demand from China, Russia, and Iran, for example, and so a huge demand for a system that bypasses the Fed.”

All of this is propelling growth. In July, stablecoins represented about 7 percent of the crypto market, and there were nearly 240 stablecoins circulating, collectively worth about $275 billion, according to the website CoinMarketCap. Tether and USDC (issued by Circle) made up the bulk of this market capitalization. The stablecoin from World Liberty Financial, cofounded by Trump, was the fifth largest. Global banks such as Bank of America and Standard Chartered, as well as nonbank financial firms such as Revolut, are reportedly looking at launching stablecoins. PayPal already has one.

The importance of reserves

Despite the optimism embedded in the name, a stablecoin can collapse—and has. TerraUSD (often abbreviated as UST) was a prominent one until May 2022, when it crashed and caused a chain reaction that took down two other significant market players and eventually contributed to the collapse of the crypto exchange FTX. Terra was rebranded and still trades on the Terra Classic blockchain, under the symbol USTC, but is no longer pegged to the dollar or considered a stablecoin.

That doesn’t necessarily mean that all stablecoins are destined for the same fate. Terra was inherently unstable, research explains, because of what was being used to stabilize the value.

There are three main types of stablecoins, two of which are collateralized—meaning they use reserves to maintain a stable value relative to a pegged asset such as the US dollar. The first type is backed by reserves denominated in fiat currency. Think money market funds and Treasury bonds. The second type is backed, either fully or in part, by other cryptocurrencies.

But some stablecoins are not collateralized. This is the third type, algorithmic stablecoins, which maintain a stable value or peg using an algorithm and the riskiest kind of nonstandard collateral: investment tokens of their own creation. For example, Terra was fully backed by Luna, an equity token, and used a mathematical model to maintain its peg. When Terra’s price increased over $1, the model decided when to issue more tokens to increase supply. When the price fell below $1, the model decided when to buy or burn tokens off the market to reduce supply.

Terra also had a network of arbitrageurs buying and selling Terra and Luna. In recounting the run, MIT PhD student Jiageng Liu, Makarov, and Schoar point out that Terra’s UST was supported by a smart contract that allowed an exchange of one unit of UST with $1-worth of Luna, and vice versa. “The pegging mechanism relied on traders taking advantage of an arbitrage opportunity that would present itself every time UST lost its peg in either direction,” write Liu, Makarov, and Schoar.

Terra’s stability hinged on investor beliefs in Terra-Luna’s ability to be profitable in the future, as reflected by the market value of the Luna tokens. But confidence alone couldn’t keep the price of the algorithmic stablecoin stable, finds research by Stockholm School of Economics’ Adrien d’Avernas, HEC Paris’s Vincent Maurin, and Booth’s Quentin Vandeweyer. In order for investors to be able to redeem one Terra for $1-worth of Luna, Luna needed to trade at a positive value on secondary markets. When Terra’s price fell, the issuer (Terraform Labs) created more Luna tokens, in order to buy back Terra. But that lowered the price of Luna, and mathematically speaking, Terraform had to be able to overcome a large drop in demand for Terra without becoming insolvent, even while operating at high leverage—an outcome that wasn’t guaranteed. (For more, read “How to Make Cryptocurrencies More Stable.”)

In the wake of Terra’s collapse, only a few smaller algorithmic stablecoins persist. The larger stablecoins, the biggest being Tether and USDC, are backed by far safer reserves that include Treasurys.

But while they are safer, they may not be completely safe. Columbia’s Yiming Ma, University of Pennsylvania’s Yao Zeng, and Booth’s Anthony Lee Zhang find that even for collateralized stablecoins, the odds of a run are “economically significant.” They calculate the risk of runs on Tether and USDC based on an analysis of two years of data. Arbitrageurs play a key role in keeping value constant, but only a handful of arbitrageurs can redeem stablecoins for $1 in primary markets. Stablecoin issuers face a trade-off: Efficiency is generally desirable, but more competitive arbitrage could increase the risk of runs because it would make it easier for investors to sell. (For more, read “Could Stablecoins Destabilize Other Markets?”)

The two largest stablecoins by market capitalization, despite being collateralized, have both experienced bank-like runs and depegged from their fixed exchange rate: Tether depegged in November 2022 after FTX failed, and USDC depegged in March 2023 after the failure of Silicon Valley Bank. In a filing for its initial public offering, which took place in June, Circle described the USDC run, the depegging episode, and the risk for its investors, writing how it had initiated transfers topping $3 billion from SVB to other banks, but those failed to settle. All the funds were ultimately transferred, but when the banks were closed and the situation was unclear, people dumped Circle’s stablecoin.

“We are unable to predict the timing or severity of any runs on Circle stablecoins. For example, the collapse of one digital asset or company, including those in the traditional finance sector, such as banks, may result in contagion effects for Circle or the broader digital asset market,” reads the filing.

And the issue of safety

There’s another problem beyond risk and runs, argues Booth’s Eric Budish. According to his research, the blockchain technology as laid out by Nakamoto, upon which cryptocurrencies such as bitcoin and now stablecoins are built, is fundamentally flawed. As the industry grows, it will be impossibly expensive to keep it secure and fraud free. Even if a stablecoin is able to maintain its peg, bad actors could delete transactions from the record and steal money.

Nakamoto’s blockchain can be thought of as two separate developments, Budish explains. The first is the blockchain data structure, and the second is the trust model, which he sees as far more innovative. The idea that people trust the blockchain, despite the fact that there’s no centralized, trusted party keeping order, is widely considered a breakthrough in both computer science and economics. For centuries, the accuracy of business ledgers has been supported by what Budish considers “traditional sources” of trust—law, reputations, relationships, and collateral. With blockchain technology, the trust is based on distributed, anonymous actors. This model is known in computer science as permissionless consensus.

But there’s a potentially infinite cost to maintaining security and preventing fraud in a fully decentralized, anonymous structure as it grows, Budish finds. He writes that the cost “scales linearly with the value of the attack” and that “if cryptocurrencies were to become a more significant part of the global financial system than they have been to date, then their costs would have to grow to absurd levels.”

Imagine a bank trying to keep out criminals. It hires private security guards, but its tellers can also call the police if necessary. The bank, if robbed, can press charges, and the robbers could end up with a criminal record. The entire structure reassures depositors that their money is safe.

“In contrast, the Nakamoto model is just to have a very large number of security guards at the bank,” writes Budish. “This works, but it is very expensive and scales terribly with the stakes.”

The more people use cryptocurrencies, the more computer power is required to keep the system running free from fraud. At some point, the costs of this computation will exceed the benefits. Budish estimates—even in his most conservative scenario—that the cost to secure a permissionless-consensus blockchain against a $10 billion attack would be roughly $500 billion per year. With less conservative assumptions, the cost to secure the same blockchain rises to roughly $45 trillion.

This makes it unlikely that the decentralized trust models as currently designed can play a large role in traditional finance. However well cryptocurrencies are perceived to have worked so far by those speculating and even using them for black-market activity, Budish’s theoretical research suggests that the clock is ticking as they grow. The upshot is “that—at least in its pure form, without any implicit protection from rule of law—Nakamoto’s novel form of trust faces serious economic limits,” Budish writes.

Perhaps this flaw could be somehow overcome, whether through regulation, more transparency, or an as-yet-unknown development. If that were to happen, Budish does see value to blockchains. In the United States, the typical equity transaction settles after two days, Treasury transactions take two days, corporate bond transactions can take up to five days, and loan transactions can take up to 21 days. Some crypto transactions, however, can be settled in just 15 minutes. The gross gains and losses—the total interest on cash in limbo—from quicker settlement are potentially huge, Budish and Harvard’s Adi Sunderam argue in a separate paper.

In their research, Budish and Sunderam focus on an “idealized” data structure for stablecoins that are not just backed “by truly safe claims (i.e., central bank reserves or short-term Treasuries) to maintain stability” but are also backed by rule of law. In this case, they find, blockchain technology could reduce the costs of existing transactions and enable new ones. An idealized blockchain could also significantly lower back-office costs in the financial world by automating and speeding up transaction settlement. And it could reduce costs by creating more competition.

“One interpretation of our analysis, which seems intuitively appealing to us, is that blockchain-like technologies will be valuable for finance in an analogous way to how other computational technologies have turned out to be valuable in finance. It is likely to create small efficiencies in the near term, but if there are large efficiencies they will develop slowly over time,” the researchers write. But, according to Budish, those gains require first overcoming the fundamental issue of trust.

The role of regulation

There is, as Budish notes, an existing structure in which we all place trust: the legal and financial system that has developed over centuries. A movement has grown to marry that to crypto. Booth’s Zingales says that despite the original libertarian crypto vision of a government-free utopia, the death of intermediaries has been exaggerated. The crypto industry not only needs regulation to survive, he says, but is seeking it out in order to grow. And because stablecoins are growing faster in traditional environments than crypto in general, they’re the target of the most active efforts to regulate.

President Trump this past January issued an executive order that created a working group at the Treasury department to propose a framework governing digital assets. In July, he signed into law a bipartisan bill, the Guiding and Establishing National Innovation for U.S. Stablecoins Act, which establishes a federal framework to regulate stablecoins intended to be used in the payments system and to improve transparency into reserves. The GENIUS Act includes reserve requirements intended to ensure that stablecoins pegged to the dollar don’t lose that one-for-one relationship.

Of course, details matter greatly—take the idea of an interest-bearing stablecoin, for example. Stablecoins have operated so far largely without securities or banking regulation, and in guidance published this April, the SEC defined “covered stablecoins” and deemed them not securities when offered or sold.

But a covered stablecoin can’t pay interest, according to the SEC. If a stablecoin were to do that, it wouldn’t meet the definition of an exempt stablecoin and would be regulated as a security. Indeed, there is a relatively new yield-bearing stablecoin, trading as YLDS.

And yet there’s a remarkably similar type of financial product already on the market, notes Zingales. “We already have a stablecoin paying interest. It’s called bank deposits,” he says. “There’s nothing new under the sun. Stablecoins are basically a form of deposits.”

Should yield-bearing stablecoins be regulated like securities or like bank deposits? Amanda Fischer of the advocacy organization Better Markets argues the latter and tweeted, “The fact that Congress is even debating a legislative structure for something clearly impermissible under 21(a) (2) Glass-Steagall”—the Banking Act of 1933, officially, which separated commercial banking from investment banking—“is a testament to the power of the crypto lobby.” When the Financial Times’s Robert Armstrong reached her for a piece about crypto, she pointed him to research by Yale’s Gary B. Gorton and University of Michigan’s Jeffrey Y. Zhang. Gorton and Zhang write that “depositors are creditors, yet holders of money market fund shares are owners. The investor in a money market fund experiences capital gains and losses, and the investor’s ability to ‘redeem’ is simply a way for the investor to transfer ownership.”

What’s more, if a stablecoin is like a bank product, why not consider issuance by central banks? “Let’s imagine that we had a central-bank digital currency, essentially a stablecoin backed by the Federal Reserve, but that paid interest,” Budish says.

“Perhaps there’s a version that would enable a consumer payments system that’s cheaper and lower friction than the current consumer payment system,” he continues. “Crypto could be a source of competition for the traditional financial system. And if that leads the traditional financial system to become more efficient, lower cost, and more user friendly, that would be a great.” Despite his reservations about the use case for cryptocurrencies and the sustainability of blockchains, he believes that central-bank digital currencies—which would be “anchored in traditional trust from rule of law and the reputation of central banks, and thus not face the scaling problem of Nakamoto trust”—could have high economic value.

That’s exactly what the European Central Bank is working on. Introducing a digital euro could strengthen Europe’s strategic autonomy, Piero Cipollone, a member of the ECB’s executive board, told the European Parliament in April.

Yet US regulation is going in the opposite direction. Trump’s executive order explicitly prohibits the Fed from establishing, issuing, or circulating a central-bank digital currency, because such CBDCs “threaten the stability of the financial system, individual privacy, and the sovereignty of the United States.” Meanwhile, despite the SEC’s registration of YLDS, the GENIUS Act prohibits stablecoin issuers from paying any form of interest or yield to stablecoin holders.

And what about systemic risk?

While regulation could help lead stablecoins from the Wild West to Wall Street, many people still have deep concerns.

“Stablecoins continue to represent a potential risk to financial stability because they are acutely vulnerable to runs absent appropriate risk management standards,” says the 2024 annual report of the Financial Stability Oversight Council, which was established by the 2010 Dodd-Frank Act.

The Treasury Borrowing Advisory Committee of the US Treasury is made up of fixed-income market leaders from BlackRock, Bridgewater, Citigroup, Goldman Sachs, Millennium, PIMCO, and other finance powerhouses. A TBAC presentation to Treasury officials in April highlighted issues of interest and concern, such as the potential impact on bank deposits. If stablecoins pay interest or offer other features that compete with bank products, “banks may be required to increase interest rates to maintain funding or find alternative funding sources (i.e., expand their wholesale funding activity),” according to the presentation.

The growth of stablecoins could also affect the market for Treasury securities. Reserve requirements outlined in the GENIUS Act may provide an additional and growing source of demand for Treasurys—particularly short-term ones. The legislation requires stablecoin issuers to hold reserves, preferably made up of risk-free and low-risk government assets, which is expected to drive demand for short-term Treasurys and change the yield curve.

The TBAC also raised the question of whether stablecoin issuers should have access to emergency funding in times of stress and volatility via the window through which banks borrow directly from the Fed.

Hundreds or even thousands of companies and banks could potentially issue their own stablecoins under the rules laid out in the GENIUS legislation, writes University of California at Berkeley’s Barry Eichengreen in The New York Times. “The Trump administration argues that the Genius Act would take our country to a modern future. But what they seem to forget is that America had a similar banking system more than 150 years ago, and it unleashed chaos and financial ruin,” he wrote in June.

Zingales studies regulatory capture, crony capitalism, and the potential for subversion of competition by special interest groups such as the crypto lobby. He predicts that as regulation becomes real, some stablecoin issuers will eventually assume implicit government backing, which could introduce moral hazard.

“These institutions want some form of regulation, some form of intermingling with traditional finance and the government, because it gives them legitimacy and gives them an ability to ask for a bailout, if needed,” he says.

Let’s say that Tether, which had a market capitalization in July of about $150 billion, were to grow by five or 10 times. People could feel reassured by its size and use it to conduct all types of transactions, from grocery purchases to business investments. But, then, if something were to go wrong—such as a depegging, or a ledger hack—the US government could feel forced to bail out Tether, regardless of the coin’s regulatory status. As such, it would be providing implicit support for a company headquartered in El Salvador that has a mixed record with regulatory compliance and state and federal law enforcement.

“Depositors now know that these issuers are too big to fail,” says Zingales. “I can’t see the Trump administration letting any stablecoins go under, creating a weakening effect to the system,” he continues. “They are going to rescue it. The systemic risk has not gone away.”

As the industry develops, regulators should build some separation between crypto and the traditional financial system, Zingales says. “If one of the two fails, the other one saves us. What we don’t want is them to intermingle so they both go down.”