The Stablecoin Lending Displacement Risk and Its Implications for Traditional Banking: Assessing the Regulatory and Market Risks Under the GENIUS Act

The U.S. stablecoin landscape has undergone a seismic shift with the passage of the GENIUS Act in July 2025. While the law aims to establish a clear regulatory framework for stablecoins, its provisions have inadvertently created a paradox: they seek to mitigate systemic risks while simultaneously enabling new avenues for financial disintermediation. At the heart of this tension lies the lending displacement risk-the threat that yield-generating stablecoins could siphon deposits from traditional banks, destabilizing the credit ecosystem. This article dissects the regulatory and market risks posed by the GENIUS Act, focusing on how its design may inadvertently fuel a race between innovation and stability.

The GENIUS Act: A Double-Edged Sword

The GENIUS Act explicitly prohibits stablecoin issuers from paying interest, yield, or rewards to prevent direct competition with bank deposits according to the law. On the surface, this appears to insulate traditional banks from disintermediation. However, the law's enforcement hinges on a narrow definition of "interest," leaving loopholes for indirect incentives. For instance, stablecoin issuers or affiliated platforms can offer rewards through exchanges or wallets, effectively replicating yield-bearing mechanisms. According to a report, such indirect incentives could displace $6.6 trillion in bank deposits, a sum critical for funding small business loans, mortgages, and agricultural credit.

The Act's requirement for 1:1 reserve backing in cash or short-term U.S. Treasuries is a step toward stability, but it also introduces new risks. By allowing reserves to be held in uninsured bank deposits, the law creates a feedback loop: stablecoins amplify liquidity strains on banks during crises, while stressed banks threaten stablecoin solvency as research shows. This interdependence mirrors the 2008 fire-sale dynamics seen in prime money market funds, where asset liquidation cascaded into broader financial instability according to Brookings analysis.

Regulatory Gaps and the "Race to the Bottom"

The GENIUS Act's fragmented oversight model further exacerbates risks. While it mandates federal supervision for stablecoin issuers exceeding $50 billion in issuance, it permits states to establish divergent regimes as noted in AICPA analysis. This has sparked concerns about a "race to the bottom," where states loosen reserve or AML requirements to attract stablecoin businesses. For example, states like Wyoming and Delaware-known for crypto-friendly policies-could create regulatory arbitrage opportunities, undermining the Act's uniformity.

Compounding this issue is the Act's exclusion of digital-asset intermediaries and decentralized protocols from AML/CFT obligations. As noted by the Center for Strategic and International Studies (CSIS), this omission creates a "dark zone" for illicit finance, enabling adversaries to exploit stablecoins for sanctions evasion or money laundering. The absence of liquidity stress-testing requirements also leaves stablecoins vulnerable to sudden redemptions, potentially triggering chaotic liquidations rather than orderly restructuring.

Market Risks: Disintermediation and Systemic Spillovers

The Act's indirect yield mechanisms are already reshaping market dynamics. Nonbank issuers like Circle and PayPal have leveraged the Act to expand stablecoin offerings, partnering with crypto exchanges to provide yield-bearing products. This has intensified competition in the digital payments space, with major tech firms and financial institutions exploring stablecoin integration to enhance user returns. According to the Federal Reserve, such trends could erode banks' traditional role as intermediaries, reducing their capacity to fund community lending.

Moreover, the Act's ambiguity around central bank access for stablecoin issuers raises existential risks. If nonbank entities gain access to central bank accounts-a possibility under the Act-they could bypass the banking system entirely, accelerating deposit flight and liquidity strains. This scenario mirrors the 2023 collapse of TerraUSD, where algorithmic stablecoins collapsed due to leverage and lack of reserves, but with the added systemic weight of U.S.-dollar-backed counterparts.

The Path Forward: Balancing Innovation and Stability

The Federal Reserve and Treasury now face a critical 18-month window to address these gaps. As highlighted in a JAMSADR analysis, regulators must prioritize liquidity requirements, stress-testing frameworks, and cross-border AML enforcement to prevent stablecoins from becoming a vector for financial instability according to JAMSADR research. However, overregulation risks stifling innovation, as crypto advocates argue that U.S. inaction could cede global leadership to jurisdictions like the EU, which under MiCA has adopted a more harmonized approach as JAMSADR analysis indicates.

For traditional banks, the challenge is twofold: adapting to a world where deposits are increasingly digitized and competing with nonbank players for customer loyalty. The FDIC and OCC must also clarify how to insulate the banking system from stablecoin-induced liquidity shocks, particularly if reserves remain in uninsured deposits as Grant Thornton notes.

Conclusion

The GENIUS Act represents a pivotal but incomplete step in stabilizing the stablecoin ecosystem. While its reserve requirements and consumer protections are commendable, its regulatory gaps-particularly around indirect yield mechanisms, state-level arbitrage, and AML enforcement-pose significant risks to traditional banking. As the Fed and Treasury finalize rules, the financial sector must brace for a future where stablecoins are not just a technological innovation but a systemic force. The question is no longer whether stablecoins will displace bank deposits, but how regulators and institutions will adapt to a world where the lines between digital and traditional finance blur irreversibly.