Simon Mayer discusses how conventional regulatory proposals focusing on low-risk reserve asset restrictions fail to resolve stablecoin instability due to a "risk paradox," and that capital requirements are a more effective tool to ensure stability and welfare when combined with overcollateralization using higher-return assets.
The rapid growth of stablecoins in market capitalization and the regulatory momentum in major economies have drawn enormous attention. Governments view stablecoins as instruments to extend the international reach of their currencies, while major financial institutions are examining the competitive threats posed by stablecoin issuers. Stablecoins are digital assets on a blockchain, pegged to the value of a national or fiat currency (like the US dollar) and usually backed by cash or other assets held by the issuer. The risk profile of these reserves is central to ongoing debates, with restrictions on risk-taking a primary regulatory focus, as exemplified by the Guiding and Establishing National Innovation for U.S. Stablecoins (GENIUS) Act in the U.S.1
In our working paper, “Financial Intermediation with Fragile Seigniorage: A Dynamic Model of Stablecoin Issuers,” my fellow researcher Ye Li and I focus on a few key questions: How do risks in reserve assets affect stablecoin users? When do stablecoins lose their peg? What tradeoffs do issuers face in managing stability? How can stablecoins be managed most effectively? And which regulatory approaches best balance stability with growth?
To address these, we develop a framework for analyzing optimal stablecoin issuance, design, and management. This framework offers policy guidance, generates practical insights, supports the evaluation of regulatory proposals, and provides a foundation for valuing stablecoin issuers.
The model has key implications for regulation. Mainstream proposals that require stablecoins to be backed only by low-risk assets may not resolve underlying instability, due to a novel “risk paradox” that our paper highlights. Forcing issuers to hold perfectly risk-free assets with low returns reduces profitability and can significantly harm users, since issuers may respond by raising fees. By contrast, capital requirements are effective tools for improving stability and welfare. Our model shows that capital requirements alone can be an effective regulatory tool, without the need to pair them with restrictions on reserve asset composition.
Overall, we show that stablecoins backed by higher-return but riskier assets can remain stable if they are overcollateralized—an approach that can lower user costs and foster adoption, compared with fully fiat-backed stablecoins.
Recently, Circle Internet Group went public via an IPO. A major takeaway is that access to public equity markets can play a stabilizing role, as it provides issuers with additional financing to manage their stablecoins and maintain price stability. We also highlight the implications of our model for issuers’ equity valuation under different demand growth rates. Since most stablecoin issuers other than Circle are private and hard to value, our model provides a framework for the valuation of stablecoin issuers.
As reported by Cointelegraph.com, a recent market analysis estimated the valuation of Tether—the issuer of USDT, the largest stablecoin by market capitalization—at $515 billion. That figure would make Tether the 19th most valuable company globally, ahead of firms like Costco and Coca-Cola. Tether’s CEO, Paolo Ardoino, however, suggested that the $515 billion estimate might be “a bit bearish,” or too low. In line with that, Tether has reportedly raised about $20 billion in equity at a $500 billion valuation, according to CNBC.
Our model informs this valuation debate by providing a structured approach based on a quantitative model. Calibrating it to Tether’s balance sheet and reserve data, we estimate the demand growth rate required to support a valuation above $500 billion at roughly 12 percent—a figure broadly consistent with expected overall sector growth, though tempered by rising competition.2
Overall, our analysis explains the economic factors behind stablecoin issuance, how to optimally manage them, their depegging risk and stability, and the regulatory tools that can improve their stability. We highlight that stablecoin issuers are a novel type of financial intermediary – different from banks. We provide a formal economic framework to assess depegging risk and regulatory approaches, which also lends itself to valuing stablecoin issuers’ equity.
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