The stablecoin bill may solve the national debt issue, but it could also brew shadow banking risks.

Author: Derek Hostmeier

According to some estimates, the U.S. Treasury will need to borrow an additional $15 trillion over the next decade to repay federal debt, and whenever someone sells debt, someone else must buy it.

As China no longer purchases U.S. Treasury bonds as steadily as before, the United States needs to seek other channels to digest the large amount of debt that will soon be issued. At this time, the "Genius Act" has emerged.

The bipartisan legislation, which was passed by the Senate in June, is expected to be voted on in the House this week, and is the first regulatory bill concerning stablecoins. The bill will allow private entities to issue their own stablecoins as long as these stablecoins are fully backed by U.S. Treasury securities. This will bring a brand new group of investors to U.S. Treasury securities.

This is a clever solution to the problem of excessive debt: the Treasury can leverage this emerging and rapidly growing market to issue tens of trillions of dollars in debt, with very little risk to the existing banking system.

The sooner the solution is introduced, the better. Due to concerns about the United States' ability to repay its debts, the yield on long-term U.S. Treasury bonds has soared to nearly 5% this year. Moody's downgraded the rating of U.S. Treasury bonds in May, and there are not many new potential buyers. China has been reducing its holdings of U.S. bonds for five consecutive years. As the largest foreign holder of U.S. bonds, Japan's bond yields have also risen sharply due to concerns over its own debt burden, so Japan does not have much capacity to continue increasing its holdings of U.S. bonds.

Of course, the Treasury should also weigh the negative impacts brought by stablecoins. The "Genius Act" will allow stablecoins to spread globally and permit companies to issue their own tokens, which means that more U.S. Treasury bonds and dollars will be locked in the shadow banking system, out of the direct oversight of the Federal Reserve and the Treasury.

In this case, the shadow banking system brings two problems. First, stablecoins allow non-US domestic investors—who previously found it difficult to easily hold US dollar assets—to access US dollar assets and US Treasury bonds. With stablecoins, investors in emerging markets who wish to convert their local currency assets into more stable US dollar assets can do so more easily. However, this also increases the external run risk faced by US Treasury bonds, as a larger proportion of US debt would be held by overseas individual investors.

Secondly, domestically in the United States, the "Genius Act" will allow non-bank businesses to issue their own forms of currency. Last month, Amazon and Walmart indicated plans to launch their own stablecoins to enter this market. These new types of currency will circulate between businesses and will not go through the traditional banking system during transactions.

The creation and contraction of a large amount of currency, if it occurs outside the regulated banking system, will pose significant regulatory challenges. Furthermore, smaller banks may be excluded, as most stablecoin companies only collaborate with large international banks.

It's still hard to say which scenario is better. The Treasury needs to find buyers for the large amount of new bonds that will be issued over the next decade; otherwise, it is very likely that the credit rating will be downgraded again. Without the "Genius Act," it would be nearly impossible for the Treasury to force U.S. investors and traditional sovereign nations, who are unwilling to purchase new debt, to absorb these liabilities. If the House does not pass the "Genius Act," the U.S. Treasury bond market is expected to become more volatile, and the status of "safe haven" assets will gradually diminish.

If the bill is passed, funds will flow more to regions outside the United States and to the domestic shadow banking system. In this case, the Federal Reserve will respond passively; once the next financial crisis brews within the shadow banking system like it did in 2008, the Federal Reserve may be unprepared, and by the time it reacts, it may be too late to provide financial stability for an already fragile economy.

All signs indicate that the bill is about to pass. The Federal Reserve should be prepared to request more authority to gain a deeper understanding of the operations of shadow banking in order to address the negative impacts it brings.