The Proliferation of Private Digital Money
Don’t say you didn’t see this financial crisis coming.
Note: This piece is co-authored with Gary Gorton.
In a previous Briefing Book post, we observed that “[s]tablecoins pose systemic dangers to the economy, and they are not going to disappear by themselves.” That is even more true today, as Congress has laid the groundwork for proliferation in the Senate-passed GENIUS Act. While the legislation takes steps to improve the resiliency of stablecoin issuers, it falls short of preventing systemic risk.
New Legislation, Old Mistakes
In a new research project titled “Why Financial Crises Recur,” we argue that lawmakers typically make two types of mistakes in crafting financial regulation. These mistakes are not made in bad faith but rather occur because the correct actions are counterintuitive.
First, lawmakers fail to understand that “banks”—both traditional commercial banks and, as we soon discuss, shadow banks like stablecoin issuers—produce runnable short-term debt, which facilitates market transactions. For the short-term debt to become money, its price must be fixed. And for that to happen, the banks’ assets must be opaque so that the price of the short-term debt does not fluctuate with the awareness of negative news. This is particularly true for maintaining price stability during periods of financial stress. Yet commonly received wisdom suggests that firms can be, and should be, disciplined by the market. Transparency is of paramount importance, as sunlight is often considered to be the best disinfectant.
Second, there is a difference between a “systemic crisis” and the failure of individual institutions. Strengthening individual institutions is not sufficient for panic-proofing the system. Our regulatory framework has focused too much on preventing the failure of individual institutions without consideration of the system as a whole. It is certainly possible, as the demise of Silicon Valley Bank vividly reminded everyone, to have strong individual banks yet still have the risk of failures spreading.
If lawmakers and regulators can correct the two conceptual errors, then modern economies may enjoy a period free of crises.
Opacity—yes, opacity—can enhance financial stability
To set the stage, we start by introducing an apparent paradox: the market economy needs short-term debt created by banks and bank-like entities—oftentimes referred to as “money”—but that short-term debt is vulnerable to destabilizing runs. In other words, money in the form of short-term debt is needed for the economy to function, but that money can lead to system-wide crashes when holders of the debt start questioning its value (e.g., when depositors panic during a bank run). Recognizing this paradox allows one to understand that banks and producers of such short-term debt are special and that opacity is beneficial for maintaining stability.
As we have previously written, to make short-term debt effective as money, its price should not fluctuate. For example, a one-dollar banknote should always hold its price at one dollar. Similarly, withdrawals from a bank account should always be one-for-one. But how is that possible? In a market economy, the price of a good or service moves to equate supply and demand. Prices move in response to new information.
The answer is that, ideally, no one should have an incentive to produce information about the backing for the money (i.e., the banks’ assets); and everyone should know that no one has an incentive to produce that information. If that is the case, then we say that the money is “information insensitive.” This is why heightened opacity is, perhaps counterintuitively, beneficial for stability.
What’s notable is that this insight is seemingly forgotten by every generation, with each new form of runnable short-term debt that is invented by the financial sector. In the 18th and 19th centuries, lawmakers had to learn this lesson with respect to privately issued “banknotes” that circulated as money. In the late 19th century and early 20th century, regulators had to relearn this lesson with respect to “demand deposits” that proliferated as account-based money in the aftermath of the Civil War. In the Global Financial Crisis, the runnable debt was repurchase agreements (“repos”). Now, this current generation of lawmakers is in the process of relearning the lesson with respect to digital money in the form of circulating stablecoins and various account-based crypto demand deposits.
Stablecoins, as widely discussed in the literature, are a subset of cryptocurrencies. They are digital tokens designed to trade at par and backed by an asset or a basket of assets. The most popular versions of stablecoins are pegged to the U.S. dollar, meaning that one stablecoin can be redeemed for one U.S. dollar. While stablecoins are viewed through the novel lens of cryptocurrencies, they represent a classic form of runnable short-term debt. When holders of stablecoins begin to question the health of the stablecoin issuer, they will seek redemptions from the issuer, just as nervous depositors will seek redemptions from their bank if they perceive their bank to be weak.
Over the past few years, the largest stablecoin issuers have already experienced episodes akin to bank runs, so this is not a concern that exists only in theory. Most recently, Circle faced a run on its stablecoin when Silicon Valley Bank collapsed in early 2023. These episodes are not one-off events, and they show that stablecoin issuers are susceptible to the same run risk as traditional banks and other issuers of short-term debt.
In order to address this risk, lawmakers must relearn the first lesson: the production of runnable short-term debt is a special activity that must be regulated in ways to enhance opacity. Otherwise, runs will continue to occur and, once stablecoin issuers become sufficiently large, the consequences for the rest of the economy may be devastating.
Improving microprudential safety and soundness is not sufficient to mitigate systemic risk
System-wide financial crises are vastly different from the failure of individual financial institutions. Regulating with the intent to enhance the safety and soundness of individual banks is not sufficient to produce system-wide stability. In our latest project, we analyze several historical examples to illustrate the point: the National Bank Act of 1863 and the creation of a national currency; the double liability regime for banks prior to 1933; the Banking Act of 1933 and the establishment of federal deposit insurance; the Basel Accord of 1988 and the pivot to bank capital regulation. Here, we focus on the so-called GENIUS Act of 2025.
It is now apparent that Congress believes the path forward is stablecoin circulation in the broader economy. Lawmakers’ latest attempt to regulate these run-prone digital assets was introduced in the Senate on May 1, 2025. After several weeks of debate, the bill passed on June 17. As it stands, the bill would require stablecoin issuers to hold “reserves backing the outstanding payment stablecoins of the permitted payment stablecoin issuer on an at least 1 to 1 basis.” Such reserves may include U.S. dollars, funds held as demand deposits or insured shares at IDIs, short-term Treasuries, repos and reverse repos, securities issued by MMFs holding those assets, or “any other similarly liquid Federal Government-issued asset approved by the primary Federal payment stablecoin regulator.”
Now, it is certainly a step in the right direction to have stablecoins backed by safe assets like short-term Treasuries. However, the underlying presumption is that, because the backing assets are of high-quality and there would be regular reports, systemic risk would not be a problem. Not so. While the legislation would improve microprudential safety and soundness, it is not sufficient to mitigate systemic risk.
What happened in the spring of 2023 once again serves as a useful case study. Suppose each stablecoin issuer holds only Treasuries in its portfolio. Play out the macroeconomic shock that hit Silicon Valley Bank. If interest rates rise, then the value of the Treasuries—the assets meant to back the stablecoin’s peg—will fall. And if this happens to all stablecoin issuers, then they will seek to buy new Treasuries that are of higher value. As bond prices fall, issuers will need to buy more Treasuries. When interest rates are sufficiently high and the value of Treasuries are sufficiently low, holders of stablecoins will have to decide if their issuer has the cash to buy more Treasuries. At that point, holders of stablecoins might ask questions about what is in the rest of their issuer’s portfolio and if the issuer is able to hedge any risk. Once the “No Questions Asked” condition is violated, holders of stablecoins will begin to run.
To be sure, rising interest rates is only one scenario where a common factor could affect all stablecoin issuers. There are other scenarios as well. Perhaps money market funds are misvalued and stablecoin holders do not know which issuers are most affected. Or perhaps there is a shortage of safe assets, and other firms have a demand for the exact same securities. In short, the GENIUS Act may be able to guard against idiosyncratic risk, but it does not prevent systemic risk.
Conclusion
Financial crises have recurred for centuries, and they are very costly. When a crisis hits, businesses fail, unemployment spikes, and human capital is destroyed. In the United States, the cost of the Global Financial Crisis was estimated to be as high as $30 trillion. So why do crises recur, despite the shared goal of preventing them and the deployment of considerable legal and economic effort to do so? Our answer would start and end with this observation: “Lawmakers take actions that appear to be intuitive and beneficial but are actually detrimental.”
Without understanding the two conceptual errors we highlighted above, every crisis appears to be idiosyncratic. This is why some policymakers and scholars hold the view that crises cannot be prevented. Crises materialize from unpredictable sources, and one must deal with the aftershocks.
We disagree. Crises can be prevented with the right regulatory interventions. Doing so would require a course correction along two fronts—a course correction that is likely to strike many as counterintuitive. But if these two counterintuitive lessons can be internalized, society can move toward true financial stability. Otherwise, financial crises will recur every generation, with every new form of private money created.