Stablecoins Risk Repeating the Old Mistakes of Banking

Backing stablecoins with bank deposits risks replicating the same maturity transformation that makes banking inherently unstable, prompting the fragmentation of the monetary system, where not every dollar would have the same value.

By Jeff Alvares

As regulators from Washington to Brussels race to bring stablecoins into the financial mainstream, they risk hardwiring into digital finance one of the oldest weaknesses in banking — the liquidity mismatch — with consequences that could reverberate far beyond crypto markets.

The temporary depegging of USD Coin (USDC) in March 2023, after the collapse of Silicon Valley Bank, was an early warning. Despite assurances of “full backing” by cash, part of Circle’s reserves ($3.3bn) was trapped in the failed bank. Redemption demand spiked, confidence faltered, and the token traded below par until authorities stepped in. That was not a crypto-market failure but a conventional banking one: liquidity vanished when it was most needed.

Now, regulatory proposals such as the EU’s Markets in Crypto-Assets regulation and the US Genius Act would allow stablecoins to be backed by commercial bank deposits, among other assets deemed highly liquid. While this may appear prudent, it ties the liquidity of these digital tokens to the fractional-reserve model, where liabilities are redeemable on demand against assets that may not be instantly available. Without reform, stablecoins could replicate the vulnerabilities of banks, but without deposit insurance or central bank liquidity lines to mitigate panic.

Some suggest tokenised deposits — digital representations of balances held at banks — as a safer alternative. They do offer faster settlement and better interoperability, but they do not remove the underlying liquidity mismatch. Those remain claims on banks that lend out most of the funds they take in. In a shock, simultaneous redemption demands can still overwhelm available liquidity. Technology can improve speed and transparency, but it cannot replace solvency.

Financial history offers a relevant cautionary tale. In the US Free Banking Era of the 19th century, privately issued banknotes were backed by varying-quality collateral. Notes from weaker institutions traded at discounts, and traders relied on “banknote reporters” to determine their actual value. A digital equivalent is easy to imagine: stablecoins from different issuers, nominally equal, trading at different values depending on backing and credibility. The result would be fragmentation, a step backwards for a universal, stable medium of exchange.

Today’s reserve practices raise even sharper concerns. While USDC’s exposure to a failed bank was troubling, other issuers take greater liberties. Tether, the largest stablecoin with over $160bn in circulation, holds reserves including corporate debt, secured loans, and even Bitcoin, an asset that can swing by double digits in a day. Backing a supposedly risk-free token with volatile or illiquid assets invites the same destabilising feedback loops that have plagued banks and even money market funds.

If stablecoins are to serve as reliable settlement assets, their reserves must match or exceed the liquidity and credit quality of the obligations they support. The safest model would rely on central bank deposits where legal frameworks allow, short-term sovereign debt such as US Treasury bills, and fully segregated, bankruptcy-remote accounts that keep customer assets off the issuer’s balance sheet. These assets offer immediate liquidity, minimal credit risk, and stable value even in times of stress. The Bank for International Settlements has underscored the need to align backing assets with redemption promises, not only as a matter of prudence, but as a prerequisite for monetary reliability.

The attraction of stablecoins is clear: they can settle transactions in real time, lower cross-border payment costs, and enable programmable financial products. In markets with unstable banking systems or capital controls, they can even offer a degree of certainty. But these benefits will be short-lived if the instruments themselves are vulnerable to runs. A disorderly loss of confidence in a major stablecoin could spill into money markets, disrupt payment flows, and trigger fire sales of reserve assets, especially if those reserves are riskier than they appear. The scenario echoes stresses in 2008 with money market funds and, more recently, in 2020 when the dash for cash roiled even the US Treasury market.

The choice for regulators is not between innovation and caution. It is between building a resilient digital monetary foundation and repeating the mistakes of the past, this time at the speed of code. If stablecoins are to become part of the core financial infrastructure, they must be regulated in a way that reflects their monetary function. That means reserve rules as strict as those for the safest payment systems, transparency that allows users to verify compliance in near real time, and governance structures that prioritize stability over yield.

Stablecoins can be an upgrade to the global payments architecture. But without robust reserves, they risk importing the fragility of 19th-century free banking into the 21st-century digital economy.

Jeff Alvares is senior legal counsel to the Central Bank of Brazil, former counsel to the International Monetary Fund, and a former member of the Financial Stability Board's secretariat. He writes in a personal capacity.