The market capitalization of stablecoins has increased by 90% since late 2023, surpassing $230 billion. These digital tokens maintain a stable value by being backed by reserves.
While their increasing use in international transactions reinforces the U.S. dollar's status as the dominant global currency, critics warn that stablecoins may also pose systemic risks reminiscent of past financial crises.
Stablecoins and the risk of a new financial crisis
During market turmoil, stablecoin holders may rush to redeem their tokens for cash, forcing issuers to sell their reserve assets quickly. This could create instability in financial markets.
The same thing happened in 2008. At that time, the Reserve Primary Fund, a major money market fund (MMF), broke its peg to the dollar due to exposure to the collapsed Lehman Brothers. That event led to widespread panic and a broader run on money market funds, disrupting the global financial system.
According to Federal Reserve Governor Lisa D. Cook, the same risks can apply to stablecoins.
"If a run occurs on a major stablecoin, the liquidation of the assets backing the stablecoin could be devastating, especially if those assets are tied to other financing markets," she said at a recent financial conference.
Lawmakers are now pushing to regulate stablecoins through legislative efforts such as the GENIUS Act and the STABLE Act. These laws aim to integrate stablecoins into the financial system. Issuers must obtain a license and back their tokens with approved assets such as cash, U.S. Treasury bonds, and money market funds to do so.
However, critics argue that the GENIUS Act lacks key safeguards to prevent financial instability. Senator Elizabeth Warren has been particularly outspoken, warning that the law would allow stablecoin issuers to invest in risky assets.
"Under this law, stablecoin issuers can invest in the assets that were bailed out in 2008. Anyone who thinks American taxpayers won't be asked to bail these people out is laughing at themselves," Bloomberg reported, citing Warren's remarks during a recent Senate hearing.
China and the European Union are pushing back against the U.S. dollar's dominance in stablecoins.
While the risks are clear, stablecoins have also been instrumental in reinforcing the dominance of the U.S. dollar. Large global transactions in stablecoins occur in dollar-backed tokens such as Tether.
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and USD Coin
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This widespread reliance bolsters the dollar's role in international trade, increasing demand for U.S. assets. However, China has expressed concerns that the growing U.S. influence in digital currencies may undermine its financial sovereignty.
"Once the stable U.S. dollar closely links the international credit of the U.S. dollar with virtual world application scenarios, it may significantly enhance the dominance of the U.S. dollar," said Chang Ming, a Chinese economist.
In this context, Beijing has accelerated the development of the digital yuan. This aims to reduce reliance on dollar-based stablecoins in cross-border transactions. The European Union shares the same sentiment.
The stablecoin industry also faces disruption from traditional financial institutions. Major banks, including Bank of America, are exploring offering stablecoin products. This comes after recent regulatory developments allowing U.S. banks to provide cryptocurrency and stablecoin services.
This new competition may erode the market dominance of private issuers like Tether and Circle. However, it may also integrate stablecoins more deeply into the mainstream financial system.
As stablecoins expand, their influence on the financial system significantly increases. On one hand, they offer benefits such as enhanced payment efficiency and cross-border transactions. On the other hand, their potential to provoke financial instability cannot be ignored.
Policymakers and financial institutions must exercise caution to ensure that regulatory frameworks promote innovation while mitigating risks.
The lessons of 2008 starkly remind us that financial instruments that seem stable can collapse at a troubling speed.
