Will Interest Payments Make Stablecoins More Interesting?

Around the world, stablecoins are coming under a fairly consistent and convergent regulatory regime. They must be backed by real, high-quality assets, are subject to regular audits, and issuers are prohibited from paying interest upon stablecoin balances. The prohibition on interest payments appears in the GENIUS Act in the U.S., Markets in Crypto-Assets regulation (MiCA) in the European Union as well as similar legislation in Hong Kong and Singapore.

Making the prohibition on interest payments stick may prove difficult. One much-discussed driver of this prohibition on interest payments is the idea that it will help to keep liquidity inside the traditional banking system, where regulators and supervisors have a better grasp on risk management. Whether or not the argument is a good one, however, it’s unlikely to be effective, and worse, efforts to get around could have some unintended consequences.

While they don’t call it “interest”, some crypto exchanges are already offering ‘rewards’ that seem to approximate interest rates for holding assets in stablecoins. Additionally, if no rewards are offered, it’s also simple enough to quickly move assets into and out of yield bearing offerings like AAVE. Some payment services, like Metamask’s Mastercard debit card, will even do this instantly and automatically for you when making a purchase so you can just leave your assets in a yield bearing offering at all times.

In Europe, the rules embedded in MiCA give regulators wider latitude to prohibit end-runs around the prohibition on interest payments such as rewards and automated portfolio management. This would prohibit stablecoin providers from bundling these types of solutions together or offering rewards. However, stablecoins are considered “bearers assets” (e.g. very much like cash) in most major markets and that means, among other things, that users can move them around and do with them as they please. Unlike bank deposits, which remain at least partly under the control of the bank in which they are deposited.

In practical terms, this means that regulators can prohibit stablecoin issuers from paying interest but they cannot stop the owners of the coins from plugging those assets into DeFi protocols that do pay interest.

Right now, with U.S. and European interest rates even for basic accounts at around 3-4%, even paying a small transaction fee to put your assets into a yield bearing DeFi protocol is worth it. Earning 4% APR on $1,000 for 28 days is worth $3.07, far more than the likely cost of conversion to and from stablecoins, at least on the most efficient blockchain networks. Obviously, if we return to a zero-interest rate era, the value proposition gradually disappears.

If people do end up switching back and forth between stablecoins and interest-bearing assets, one concern that could arise in the future is large, sudden movements of money between stablecoins and yield accounts. You could imagine large scale liquidations as people pay their bills each month followed by large scale purchases as people receive income.

Right now, there’s little risk of this as the value of assets and the volume of transactions on-chain is still small compared to legacy banking. That may not be the case in a few years. As the blockchain ecosystem continues to mature, the ability to execute millions (or billions) of these automated transactions looks more feasible by the day. The Ethereum ecosystem already handles about 400,000 complex DeFi transactions each day and thanks to all the Layer 2 networks running on top of the mainnet, there’s an enormous amount of excess capacity that remains available for growth.

If, somehow, a prohibition on stablecoin interest payments gets effectively implemented, one possible beneficiary onchain could be tokenized deposits. Deposit tokens have been overshadowed by the focus on stablecoins, but they are an interesting idea championed by JPMorgan Chase (JPMC). Where stablecoins are a bearer asset, a deposit token is a claim on a bank deposit. Since deposit tokens are an onchain presentation of a bank account, they can offer yield, though they come with counterparty risk.

The current JPMC pilot on Ethereum uses a standard ERC-20 token for the coin but restricts transfers to an approved list of clients and partners. Users will have to balance the benefits of built-in yield with the restrictions that come with trying to use a permissioned asset on a permissionless network.

Interestingly, fights over interest payments for bank deposits are not new. In the aftermath of the 1929 stock market crash, the US government drastically tightened banking and financial regulations. One of the new rules implemented in the Banking Act of 1933 — a.k.a Glass-Steagall — was a prohibition on paying interest on current accounts.

This prohibition lasted until 1972 when the Consumer Savings Bank of Worcester, Massachusetts started offering a “Negotiable Order of Withdrawal” account. Basically, a savings account that paid interest automatically linked to a deposit account. Within a couple of years, these accounts were generally available nationally in the US.

What took so long for banks to come up with this work-around? It just was not practical before widespread computerization of the banking system. No such barrier will exist in a blockchain-based world.

Either way, the restriction on paying interest to stablecoin users looks easy to circumvent. Which does leave me wondering – why are we choosing to repeat history instead of learning from it and just letting stablecoin providers pay interest the same as any bank would?

The views reflected in this article are the views of the author and do not necessarily reflect the views of the global EY organization or its member firms.