Making stablecoins stable(r): can regulation help?
Summary
Focus
Stablecoins have grown rapidly over the past five years, and large issuers now hold sizeable portfolios of short-dated government bonds. This growth has placed a spotlight on liquidity transformation by stablecoin issuers – they back demandable coins subject to volatile redemptions with a mix of cash and less-liquid bonds. This mismatch creates two types of risk: (i) default risk for coin-holders, because large redemptions can trigger bond fire sales that erode capital; and (ii) spillovers to money markets, because these bond sales can depress prices. We ask how regulation can induce changes in issuers' behaviour to reduce both risks.
Contribution
Many jurisdictions are designing regulatory frameworks to stem the risks posed by stablecoins. Among the tools being considered are liquidity and capital requirements. Liquidity requirements set a minimum level of liquid assets (ie assets that can be quickly sold or cashed out). Capital requirements set a minimum level of equity capital (ie the issuer's own funds that can absorb losses). There is little consensus on how these requirements should be designed, how they interact and how they should be calibrated. We offer a practical framework to help inform policy discussions.
Findings
In the absence of regulation, stablecoin issuers hold little capital and favour interest-bearing bonds over cash. This amplifies default risk and the price impact from forced bond sales. We show that liquidity and capital thresholds lower these risks when designed as usable buffers. That is, the thresholds can be breached during stress, but they discipline issuers by triggering additional redemptions, creating incentives to build buffers during normal times. By contrast, imposing strict minimum requirements can backfire by forcing premature bond sales and raising default risk. The thresholds work through distinct channels: while the liquidity threshold raises only cash holdings, the issuer responds to the capital threshold by raising both capital and cash. Ultimately, both thresholds reduce both default and spillover risks, suggesting they are substitutes. But both tools are needed to address the two risks jointly. We derive and calibrate a two-way mapping that links threshold pairs to chosen regulatory risk targets and vice versa.
Abstract
We model a stablecoin issuer that optimises capital, cash and bond holdings under persistent stablecoin flows. Absent regulation, the issuer holds little capital and favours interest-bearing but less-liquid bonds over cash. This exposes coin-holders to default risks and poses systemic spillovers via price impact of bond fire-sales. How can regulation mitigate these risks? We consider capital and liquidity thresholds as usable buffers. They can be breached in stress but discipline issuers by triggering additional redemptions, thus endogenising stablecoin flows. The thresholds work through asymmetric channels. While the liquidity threshold only raises cash holdings, the capital threshold increases both capital and cash. Both thresholds mitigate default and spillover risks, suggesting they are substitutes. However, they are complements for regulators targeting both risks. Using stablecoin flows and US Treasury market depth, we calibrate a two-way mapping that enables regulators to recover capital-liquidity threshold combinations implied by chosen risk targets (and vice-versa).
JEL classification: G2, G28, C6
Keywords: capital regulation, liquidity regulation, stablecoins, crypto, money market funds, financial stability, buffer usability
