Stablecoin "Backing" by Bank Deposits: A Regulatory Mismatch?

Circle, the issuer of USD Coin, had $3.3 billion of its reserves held at Silicon Valley Bank when the bank collapsed.

There is a regulatory trend towards allowing stablecoin issuers to back their coins 1:1 with bank deposits. That's what the EU MiCA regulation does and what the US Genius Act intends to do. But here’s the problem: bank deposits themselves are only fractionally reserved.

As a general rule, the backing asset should be safer and more reliable than the liability it is meant to secure. If a stablecoin is fully backed by bank deposits, but those deposits themselves are only fractionally reserved (meaning banks do not hold 100% of deposited funds in liquid form), this creates a potential mismatch in safety and liquidity.

Key Issues with Fractional Backing of Stablecoins via Bank Deposits:

1. Fractional Reserve Banking Risk:

• Banks operate on fractional reserves, meaning they lend out most deposits while keeping only a fraction in reserve.

• If many depositors (including stablecoin issuers) demand withdrawals simultaneously, banks may face liquidity crises (bank runs).

• This makes bank deposits inherently less safe than, say, central bank reserves or short-term government securities.

2. Stablecoin Redemption Risk:

• If a stablecoin issuer promises 1:1 redeemability but holds only fractional-backed deposits, it may fail to meet mass redemption demands during stress (as nearly happened to Circle when Silicon Valley Bank collapsed, leading to a temporary depegging of USD Coin).

• This defeats the purpose of "full backing" if the underlying asset (bank deposits) is itself not fully liquid.

3. Regulatory Arbitrage:

• Mandating bank deposits as backing may give a false sense of security, as the stability of the stablecoin then depends on the solvency and liquidity of the banking system.

• This could shift risk rather than eliminate it.

What Would Be Safer Backing Assets?

For stablecoins to be truly robust, they should ideally be backed by:

• Central bank reserves (if accessible to the issuer, e.g., via a licensed narrow bank).

• Short-term Treasury bills (T-bills) (highly liquid, sovereign credit risk).

• Deposits at fully reserved institutions (if such exist in the jurisdiction).

Conclusion

Mandating bank deposits as backing for stablecoins introduces a fragility mismatch. A well-designed stablecoin regime should require backing assets that are at least as liquid and safe as the stablecoin itself, preferably better. Fractional reserve bank deposits do not meet this standard.

This suggests either:

• A flaw in the regulatory approach, or

• An implicit reliance on backstops (e.g., deposit insurance, lender-of-last-resort), which ultimately transfers risk to taxpayers.

Thoughts? Is this a regulatory oversight or an intentional reliance on bank stability (and bailouts)?