The GENIUS Act defines a payment stablecoin as a digital asset that trades on a public distributed ledger that is designed to facilitate payment. It must be redeemable for currency but is explicitly not a national currency, a bank deposit, or a security. A payment stablecoin issuer is required to hold a minimum dollar-for-dollar reserve in bank deposits, very short-term government securities or the equivalent thereof in mutual fund shares to back the issuer’s outstanding stablecoins to “create the reasonable expectation” that digital asset will maintain a stable currency redemption value. The Act specifically prohibits depository institutions from offering payment stablecoin bank deposits, but it also explicitly allows banks to digitize bank deposits and transfer them intrabank on a private distributed ledger.
It is not obvious why the GENIUS Act makes an explicit legal distinction between payment stablecoins and digitized bank deposits. As I explain below, the growth of payment stablecoins will create the demand for a parallel system of digitized bank deposits which stablecoin issuers need to manage risk. Digitized bank deposit systems already exist and have been operational since at least 2018. In fact, digitized deposits linked to crypto asset trading figured prominently in the well-publicized failure of two banks in March 2023. Given this experience, it seems likely that the Act explicitly authorizes digitized bank deposits to prevent bank regulators from discouraging the development of digitized deposit trading systems.
A payment stablecoin trade entered on public distributed ledger typically clears and settles in minutes. If a payment stablecoin trade involves a corresponding exchange of dollars, and if the dollar leg of the trade is consummated using a normal Automated Clearing House banking transaction, it would typically clear and settle overnight. The difference in timing between the settlement of a payment stablecoin trade and the settlement of the dollar leg of the trade through normal banking channels creates a delivery-versus-payment timing problem known as Herstatt risk.
On June 26, 1974, Bankhaus Herstatt failed. Before the bank failed, it had entered into a large trade of US dollars for Deutsche Marks with several US banks. Because of time zone differences and differences in payment system settlement times, Bankhaus Herstatt received Deutsche Marks from US banks before it failed, but had yet to deliver the dollars it had sold. Its failure created large losses for several US financial institutions.
If a payment stablecoin provider issues tokens in exchange for dollars, unless the issuer receives the dollars before entering the trade in the public ledger, the payment stablecoin issuer risks counterparty default on their promised dollar payment. A counterparty who sends dollars in advance faces a risk that the payment stablecoin provider never remits dollars. The mismatch in settlement timing creates a natural demand for digitized deposits that trade over a distributed ledger. Indeed, such systems are already operational including two that contributed to the March 2023 banking crisis that required Treasury Secretary Yellen, the FDIC and The Federal Reserve Board to invoke a systemic risk exception to prevent a wider banking crisis.
In 2018, Silvergate Bank launched a private blockchain ledger that allowed blockchain permissioned members to send dollar balances to other blockchain permissioned members in real time 24/7/365 without the bank’s intervention. The so-called Silvergate Exchange System (SEN) allowed crypto firms to transact the dollar side of crypto token trades in real time using the SEN blockchain. Digital deposit balances did not pay interest. The dollar leg of crypto transactions could be settled on SEN within a time interval that approximated transactions settlement on a public crypto token blockchain thereby significantly reducing the Herstatt risk associated with dollar-crypto token trades.
In 2019, Signature Bank opened its own proprietary digitized deposit blockchain trading platform called Signet and launched a program to attract digitized deposits. Signet required members to maintain a minimum of $250k in deposits, and the deposits did not pay interest. The Signet platform attracted firms active in crypto trading because, like SEN, it reduced the delivery vs. payment risk in crypto blockchain transactions involving a dollar payment leg.
Both digitized deposit trading platforms attracted a large volume of uninsured deposit balances in 2021 as the key crypto token prices of Bitcoin and Ether increased sevenfold over their 2020 values and crypto transactions volume boomed.
By June 30, 2022, 98 percent of Silvergate Bank’s deposits were uninsured. The share of uninsured deposits at Signature Bank plateaued at 92 percent in early 2022. Both banks invested a significant share of their new uninsured digitized deposits into long-maturity fixed-rate securities—many with low regulatory capital risk weights—and mortgage loans. Both asset classes subsequently experienced large unrealized interest rate driven losses as rates rose throughout 2022.
In November 2022, the cryptocurrency exchange FTX filed for bankruptcy and both banks experienced a large volume of withdrawals from their digitized deposit transfer platforms. More than half of Silvergate Bank’s deposits were withdrawn in the last quarter of December 2022 and 75 percent of their remaining deposits were withdrawn by March 2023.
Signature Bank’s deposit growth subsided in the first quarter of 2022 as crypto markets cooled and the Fed tapered its QE purchases and began raising short-term interest rates. The bank continued to lose deposits in the second and third quarter of 2022 as the Fed ratcheted-up interest rates and two crypto currencies, TerraUSD and Luna, failed. The failure of FTX in 2022Q4 coincided with an outflow of over $14 billion Signature Bank deposits.
In February 2023, Silvergate Bank and Signature Bank were named as a defendants in a class action law suit alleging money laundering violations associated with FTX trades. On March 8, 2023, Silvergate Bank announced its intention to voluntarily liquidate the bank and relinquish its charter. Allegedly, Silvergate Bank’s decision and the depositor run underway at Silicon Valley Bank unnerved Signature Bank’s depositors who withdrew $10 billion on Friday March 10. Signature’s depositor run continued over the weekend and by Sunday afternoon, Signature Bank had $7.9 billion in additional pending withdrawals but only about $3 billion in available liquid funds. The New York state regulatory authority revoked the bank’s charter and appointed the FDIC as receiver.
This long explanation is perhaps the reason why the GENIUS Act specifically authorizes banks to create digitized deposits and trade them intrabank using a private distributed ledger. Without this explicit authority, federal banking regulators likely would have discouraged the development of these systems given their past experiences. The story also highlights how this new bank power enshrined in law could create systemic risk consequences for the banking system if the inherent risks of these systems are not adequately managed.
