Why Stablecoin Issuers Are Actually Shadow Banks

• Published date: 29 January 2024
• Subject Matter: Finance and Banking, Technology, Financial Services, Fin Tech
• Law Firm: Geronimo Law
• Author: Mr Russell Geronimo

What makes a bank, a bank? Is it deposit-taking, credit operations, or payment facilitation? While these are all important components of traditional banking, they are just parts of a bank's master function: money creation. At its core, banking is about increasing the money supply. It's a misconception to view banks as mere intermediaries for the flow of money in the economy. Rather, banks actively participate in and drive the creation of new money. ‍

When we think of money creation, we often imagine coins being minted or bills being printed, but these physical forms of currency represent only a small fraction of the overall money supply. In reality, the majority of money is created through the operations of private commercial banks.

When Bob deposits a lone US$1 bill in a bank, the bank can use that deposit to make loans and earn interest. Let's say that the bank uses the US$1 deposit to make a loan to Alice, who wants to buy a widget. Alice uses the US$1 loan to purchase the widget from a store, which in turn deposits the money in their own bank account. The total amount of money in circulation now is US$2. And yet, there was only a lone US$1 bill in this whole process, without the central bank having to print another bill to increase the money supply to US$2. ‍

This is the miracle of the money multiplier. Not so different from the biblical multiplication of bread, right?

Of course, in reality, banks are subject to reserve requirements that limit the amount of loans they can make relative to their deposits. If the reserve requirement is 10%, the bank can only lend out 90 cents for every US$1 deposited. Nevertheless, this example helps to illustrate the basic principles of how money can be created through lending and deposit-taking activities, and how the banking system can expand the money supply beyond the amount of physical currency in circulation.

And so, we turn our attention to stablecoins and their issuers.

A stablecoin is a type of cryptocurrency that is designed to maintain a stable value relative to a pegged fiat currency, typically at a 1:1 ratio. For example, a stablecoin that is pegged to the US dollar at a 1:1 ratio means that each stablecoin will always be worth one US dollar. So if someone purchases 100 stablecoins, they will have the equivalent value of US$100. The goal is to create a substitute instrument that can function like fiat, but without being subject to the same restrictions and limitations as fiat. This allows stablecoins to...