The Myth of the 1 Dollar Peg: Can Stablecoins Escape the Curse of Bank Runs?
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The Myth of the 1 Dollar Peg: Can Stablecoins Escape the Curse of Bank Runs?
The magic of traditional banking lies in the fact that 1 dollar in a bank account is实实在在ly 1 dollar. Stablecoins, however, have given up this magic.
Navigating Web3 tides with focused insightsBy Matt Levine
Translated by Yanan, BitpushNews
One point I often make is that crypto is rapidly relearning the lessons of traditional finance, and this process is fascinating. First, it sometimes goes through comical or even disastrous episodes to rediscover these lessons. Second, it tends to internalize them in a very clear, concise, and systematic way. In fact, crypto can be an excellent teaching tool. For example, if you want to understand credit crises, you could study the causes and dynamics of the 2008 global financial crisis—but that would be complex and messy. Alternatively, you could examine the causes and progression of the 2022 crypto financial crisis, which is comparatively simpler, clearer, and more entertaining. During that crisis, all key players were posting live updates on Twitter and doing YouTube interviews. The intuitions gained from studying crypto crises are highly transferable to understanding real-world financial crises—and they’re presented in a simpler, more engaging, and far more transparent manner. I once wrote: “Crypto is what happens when you take the smart, ambitious interns at traditional financial firms and put them in charge of their own game.” This is precisely why crypto holds such unique educational value.
Stablecoins are a special kind of crypto product—essentially an abstraction of banking. When you deposit $1 with a stablecoin issuer, you receive a receipt—a stablecoin—marked as “worth $1.” You can then use this stablecoin as $1 within the crypto ecosystem, such as on blockchains or cryptocurrency exchanges. It functions like money: for instance, you can buy $1 worth of bitcoin with your $1 stablecoin, and the seller receives your stablecoin in return.
In the meantime, the stablecoin issuer holds your dollar and invests it to generate profit. These profits typically cover operational expenses, executive compensation, etc. You—or any stablecoin holder—can usually return the stablecoin to the issuer at any time and redeem it for $1 in cash. At that point, the issuer must deliver that $1.
Overall, this process closely resembles bank deposits, although there are some differences. If you understand how banks work, you can anticipate certain ways this model might go wrong. Specifically, two main issues arise:
First, the bank or stablecoin issuer has the right to invest your deposited funds and keep the resulting profits. The more profit they earn from depositors’ money, the more they get to keep. However, if those investments lose money and the entire fund is wiped out, depositors bear most of the loss. Since the issuer’s capital mostly comes from depositors, there’s little left to compensate them when losses occur.
Thus, issuers have an incentive to take risks: if risky investments succeed, they reap large profits; if they fail, someone else’s money is lost.
This setup can lead to a “run.” A stablecoin issuer might invest your full deposit into seemingly safe but long-term assets. But if all depositors demand their money back on the same day, the issuer may not be able to meet those demands immediately. They might have to sell long-term holdings at fire-sale prices, ultimately ending up short and unable to repay everyone.
Because this logic is widely understood, it becomes self-fulfilling: if you expect a run to happen, you’ll want to withdraw your funds early (before the issuer runs out of money). And if everyone does this, a run inevitably occurs.
These two problems are often linked, since a common cause of bank runs is poor investment decisions made with depositor funds. Yet they don’t always coincide. A bank could suffer major losses on bad investments and collapse before anyone realizes it or has time to queue for withdrawals. Conversely, a run could occur even without direct investment losses—purely due to liquidity mismatch between the bank’s immediate liabilities and its illiquid assets.
In traditional banking, there’s a standard set of procedures (SOPs) to address these challenges. For investment risk, the main strategies are:
1. Prudential regulation: Regulators closely monitor banks’ investment activities to prevent reckless decisions.
2. Capital regulation: Banks are required to hold a buffer of equity capital so that, even if investments lose money, non-depositor funds can absorb the losses.
For runs, the primary solutions are:
1. Liquidity regulation: Banks must maintain sufficient cash reserves to meet sudden withdrawal demands.
2. Lender of last resort: If a bank holds high-quality illiquid assets but faces mass withdrawal requests, the Federal Reserve can lend against those assets, trusting the bank will eventually repay.
3. Deposit insurance: The government promises to reimburse depositors up to a limit “if the bank fails,” discouraging panic-driven runs.
In the stablecoin space, are most of these safeguards generally missing? Yes. While there have been industry proposals covering some of these measures, consider Tether—the largest stablecoin issuer—which got into trouble in 2019 for making extremely risky investments with customer funds, once reporting a capital ratio as low as 0.2% (though it has since improved). Then there was TerraUSD, a stablecoin whose investment strategy amounted to “a large portfolio of highly correlated risky assets,” which collapsed completely during a 2022 run.
So what should ideal stablecoin regulation look like? “Deposit insurance and access to the Fed’s discount window” sounds like a plausible and practical demand—and as I write this, I suddenly realize it might actually become reality within the first year of the next Trump administration.
A more direct and fundamental answer is: “Stablecoin issuers should invest in relatively safe and highly liquid assets, and they should hold meaningful amounts of their own capital. That way, even if investments lose money, the issuer still has enough resources to repay depositors.” Of course, the details need further refinement.
Gordon Liao, Dan Fishman, and Jeremy Fox-Geen—affiliated with Circle Internet Financial, a stablecoin issuer—co-authored a paper titled “Risk-Based Capital for Stable Value Tokens.” While Circle has a vested interest in advocating for lighter-touch stablecoin regulation, the paper offers insightful analysis on the relationship between stablecoins and banking. One key observation is that stablecoins are far more transparent than banks in many ways—an undeniably positive trait, especially for crypto enthusiasts skeptical of traditional finance’s opacity. Yet, that opacity exists for a reason.
Liao, Fishman, and Fox-Geen argue that, all else being equal, tokenization increases the risk of coordinated runs on stable value claims. Tokenization allows underlying value to be transferred and traded outside the issuer’s direct control. This creates a secondary market price, providing a visible signal to the market. Real-time price visibility can amplify investor reactions, making issuers more vulnerable to runs. If the ledger is public, transfer activity also becomes observable. Public signals can trigger “overreactions” in financial markets and enable coordination among participants during global games (Morris & Shin, 2001). In other words, if token holders observe a sharp drop in secondary market prices or a surge in redemptions, they may panic and choose to sell or redeem tokens regardless of the underlying asset fundamentals.
In traditional banking, the main reason for a bank run is often the belief that others will run too. Where does this perception come from? From rumors, weak earnings reports, nervous TV appearances, etc. A falling bank stock price might be interpreted as a sign of deposit outflows. But it’s an imprecise science. By contrast, stablecoins trade in open markets, and their price directly reflects confidence levels. For example, if a stablecoin trades at $1.0002, a run likely isn’t happening; if it trades at $0.85, one probably is.
The main solution to this issue is for stablecoin issuers to keep most of their funds highly liquid.
Due to increased run risk, managing financial risk requires different approaches than in traditional banking. Fiat-backed stablecoins typically hold highly liquid assets, minimizing maturity mismatch and credit risk compared to banks. As a result, even though the segregated asset pool may be resilient, the capital buffer available to absorb financial losses in stablecoins is effectively smaller than in banks. Even with identical underlying assets, tokenizing deposits may increase an institution’s susceptibility to runs. Tokenized deposits can be withdrawn faster and at larger scale, and token holders may react more sharply to market signals. Therefore, institutions offering tokenized deposits may need to hold more capital to offset this heightened risk—even if their asset base mirrors that of traditional banks. In essence, tokenized deposits introduce balance-sheet mismatches similar to those inherent in banking, suggesting they may require analogous capital and solvency frameworks.
Now let’s turn to the “blockchain” aspect of stablecoins:
Beyond financial risk, tokenization and distributed ledgers introduce additional risks related to technology, infrastructure, and operations. These non-financial risks have been emphasized in regulatory consultations and policy proposals. While advanced cryptography, permanent recordkeeping, and traceable transactions reduce certain security and compliance risks, assessing “operational risk”—a term widely used in traditional banking—remains challenging when determining required capital. This is mainly due to insufficient historical data on operational losses and the heavy dependence of assessments on specific technological choices. In a fast-evolving environment with continuous infrastructure upgrades, the issuer’s technology selection can significantly impact the level of loss-absorbing capital needed.
In other words, we can plausibly imagine that stablecoin issuers are less likely than traditional banks to lose user funds—thanks to blockchain-based transparency, traceability, and digital-native design absent in traditional banking. Yet, for the very same reasons, we can also plausibly imagine they are more likely to lose those funds.
Last year, the U.S. experienced a small-scale banking crisis, which prompted me to reflect deeply on banking. I wrote:
Banking, in effect, is a mechanism that lets people unknowingly make long-term, risky bets. It pools risks so that everyone feels safer and better off. You and I are willing to deposit money in banks because we believe “money in the bank” is perfectly safe—we can use it tomorrow to pay rent or buy a sandwich. Then the bank uses those deposits to make 30-year fixed-rate mortgage loans. A homeowner could never borrow 30-year money directly from me, because I might need that cash tomorrow to buy a sandwich. But they can borrow collectively from all of us, because the bank diversifies liquidity risk across many depositors. Similarly, banks lend to small businesses that might go bankrupt. Those businesses could never borrow directly from me—I need my money and don’t want to risk losing it—but they can borrow collectively from all of us, because the bank diversifies credit risk across many depositors and borrowers.
Yet, traditional banking’s opacity enables greater risk-taking with customer funds. Part of last year’s regional banking crisis may stem from this opacity no longer functioning as effectively as before. Today, more information is publicly accessible online, rumors and panic spread electronically around the world instantly, and there’s greater expectation of mark-to-market valuation. As one FDIC regulator said last year: “The rules haven’t changed, but the game has gotten tougher.”
The magic of traditional banking lies in its ability to make risky investments, pool them together, and issue senior claims against that portfolio—claims we call “dollars.” That $1 in your bank account is treated as exactly $1, even if it’s backed by a bundle of risky assets. Stablecoins, however, give up this magic: while a dollar-pegged stablecoin is close enough to $1 for most crypto purposes, it has its own trading price. In good times, it might trade at $1.0002 or $0.9998; in bad times, well, it might fall to $0.85. This is banking without the guarantee that “$1 in the bank equals $1,” with a 24/7 real-time market price constantly signaling how close it really is to $1. This undoubtedly creates new regulatory challenges—and may also foreshadow new developments in conventional banking.
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