The GENIUS Act and the Stablecoin Lending Loophole: A Systemic Risk for Traditional Banking and Investors?

The GENIUS Act of 2025, a landmark piece of legislation, sought to establish a federal regulatory framework for payment stablecoins in the United States. By defining stablecoins as digital assets pegged to the U.S. dollar and backed by liquid reserves, the Act aimed to mitigate risks associated with their rapid adoption while preserving the stability of the traditional banking system. However, the legislation's prohibition on yield-bearing stablecoins-banning interest payments to holders-has not fully closed the door to regulatory arbitrage. Instead, it has created a shadow ecosystem where affiliated exchanges and platforms exploit loopholes to offer yield-generating opportunities, posing systemic risks to banks and investors alike according to the bill.

The Regulatory Arbitrage Gap

The GENIUS Act explicitly prohibits stablecoin issuers from paying interest, a move designed to prevent direct competition with bank deposits. Yet, the Act does not extend this restriction to affiliated cryptoasset service providers (CASPs) or exchanges. As a result, platforms have innovated around the ban by offering yield-bearing products through re-lending, margin pools, and decentralized finance (DeFi) protocols. For example, stablecoin holders can now lend their assets on DeFi platforms to earn returns, a practice that blurs the line between payment instruments and investment vehicles. This regulatory arbitrage allows nonbank entities to bypass traditional banking oversight, creating an uneven playing field where prudential safeguards like deposit insurance and capital requirements are absent.

The Federal Reserve has warned that such practices could destabilize the financial system. If stablecoin reserves are used as collateral in high-risk lending or speculative activities, the health of the stablecoin itself-and by extension, the broader economy-could be compromised. This is particularly concerning given that stablecoins now function as a core infrastructure layer for onchain activity, connecting payments, trading, and collateralization.

Systemic Risks to Traditional Banking

The rise of yield-bearing stablecoins has intensified competition for bank deposits, a critical source of funding for traditional financial institutions. According to the ICBA, allowing intermediaries to offer interest on stablecoin holdings could reduce community bank lending by $850 billion due to a $1.3 trillion decline in deposits. This displacement of deposits alters banks' liability structures, increasing liquidity risk and funding costs, particularly for smaller institutions reliant on relationship banking.

Moreover, the potential for stablecoin issuers to access Federal Reserve master accounts-a scenario not explicitly prohibited by the GENIUS Act-could further disintermediate traditional banks. Such access would enable stablecoin entities to bypass the banking system entirely, accelerating the erosion of core banking functions like credit provision. The Fed has emphasized that this shift could redistribute credit availability, disproportionately impacting small businesses and commercial real estate lending.

Investor-Specific Risks

For investors, the risks of yield-bearing stablecoins extend beyond systemic banking concerns. While the GENIUS Act mandates that stablecoins be backed by high-quality, liquid assets, the indirect provision of yield through affiliated platforms introduces new vulnerabilities. For instance, lending stablecoins on DeFi platforms exposes investors to smart contract risks, governance instability, and the absence of deposit insurance. A single operational misstep by a stablecoin issuer or platform could trigger a cascade of losses, particularly in times of market stress.

Additionally, the regulatory ambiguity surrounding affiliated exchanges creates a misperception among investors. By offering yield-bearing products, these platforms may encourage users to treat stablecoins as investment opportunities rather than payment tools, increasing exposure to financial risks without a full understanding of the associated dangers. This is compounded by the lack of real-time transparency in stablecoin reserves, which could leave investors vulnerable to sudden depegging or reserve mismatches.

The Path Forward

The GENIUS Act's framework has laid the groundwork for a more stable stablecoin ecosystem, but its limitations highlight the need for broader regulatory clarity. Regulators must address the arbitrage gap by extending prudential oversight to affiliated platforms and exchanges, ensuring that yield-bearing activities are subject to the same safeguards as traditional banking. The Bank for International Settlements has already called for a regulatory framework that covers cryptoasset service providers, emphasizing transparency and consumer protection.

For investors, the key takeaway is to approach yield-bearing stablecoins with caution. While the potential for returns exists, the absence of deposit insurance and the risks inherent in DeFi protocols necessitate a recalibration of traditional investment models. Diversification and due diligence-particularly in assessing the governance and reserve practices of stablecoin issuers and platforms-are critical to mitigating exposure.

In the end, the GENIUS Act has not eliminated the risks of yield-bearing stablecoins but has instead shifted them into the shadows. As the market evolves, both regulators and investors must remain vigilant to ensure that innovation does not come at the cost of financial stability.