Stablecoin Systemic Risks and the Looming Need for Regulatory Reforms

The rise of stablecoins has transformed global finance, offering speed, efficiency, and accessibility. Yet, beneath their veneer of stability lies a growing web of systemic risks that threaten to destabilize both crypto and traditional markets. As the market capitalization of stablecoins surpassed $250 billion by 2025 [2], their integration into cross-border payments, retirement accounts, and even Treasury markets has exposed vulnerabilities that demand urgent regulatory attention.

The Fire Sale Dilemma

Stablecoins, particularly those backed by short-term Treasury securities or uninsured bank deposits, face a critical flaw: their inability to withstand sudden loss of confidence. The Bank for International Settlements (BIS) has repeatedly warned that stablecoins fail the "three key tests" of a monetary system—singleness, elasticity, and integrity [1]. When panic strikes, as seen during the 2023 collapse of Silicon Valley Bank (SVB), stablecoin reserves held in volatile assets can trigger fire sales of safe assets, amplifying market stress. The U.S. government’s $15.8 billion bailout of Circle, a major stablecoin issuer, after its exposure to SVB’s collapse, underscores this risk [3]. Such scenarios mirror the 2008 financial crisis, where interconnectedness between shadow banking and traditional finance led to cascading failures.

The GENIUS Act: A Flawed Framework

The 2025 GENIUS Act, hailed as the first federal stablecoin regulation in the U.S., mandates that stablecoins be fully backed by fiat reserves or short-duration Treasuries [4]. On paper, this seems robust. However, critics argue the Act creates dangerous loopholes. For instance, it permits nonbank entities like Amazon or Meta to issue stablecoins without the same safeguards as banks, exposing the system to unregulated risk-taking [1]. Arthur Wilmarth, a law professor, warns that this structure could "trigger systemic financial crises and require costly government bailouts" by enabling leveraged bets akin to pre-2008 mortgage-backed securities [3].

Moreover, the Act’s leniency toward stablecoin reserves—allowing them to be sold en masse during crises—risks destabilizing Treasury markets. If a major stablecoin issuer faces a redemption run, the rapid liquidation of its Treasury holdings could spike yields and trigger broader financial instability [5]. This dynamic was evident in the 2020 bond market turmoil, where panic-driven selling required government intervention to restore order.

Investment Implications: Herding, FOMO, and Systemic Exposure

Investor behavior in the stablecoin space is shaped by psychological biases that amplify risks. The "reflection effect" in behavioral economics explains how investors become risk-averse during gains but risk-seeking during losses [2]. For example, when stablecoin-linked equities like Coinbase’s stock surge—fueled by high yields on USDC—investors often adopt conservative strategies. Conversely, during liquidity crises, they may double down on speculative bets like yield farming or RWA restaking, exacerbating market volatility.

Goldman Sachs’ allocation of $79.2 billion to stablecoin reserves has further fueled a "herding" effect, with retail investors following institutional leads into crowded trades [2]. This concentration of risk increases the likelihood of a systemic shock, particularly if stablecoin reserves are overexposed to low-liquidity assets.

Global Implications: Dollarization and Emerging Market Vulnerabilities

The GENIUS Act’s emphasis on USD-backed stablecoins could accelerate dollarization in emerging markets, where local currencies are increasingly displaced by stablecoins [5]. While this might reduce inflationary pressures, it also tightens domestic financial conditions and increases vulnerability to external shocks. Central banks in these regions may be forced to raise interest rates or impose capital controls to counter capital outflows, stifling economic growth.

The Path Forward: Strengthening Oversight

The lessons from past crises are clear: weak oversight invites instability. Regulators must close loopholes in the GENIUS Act, such as imposing stricter reserve diversification requirements and extending fraud protections like Regulation E to stablecoin users [3]. Additionally, international coordination is needed to harmonize cross-border stablecoin regulations, reducing fragmentation that hampers enforcement.

For investors, the message is equally urgent. Diversifying exposure to stablecoin-linked assets, hedging against liquidity risks, and advocating for stronger safeguards are critical steps. As stablecoins grow in scale, the cost of inaction—both for markets and governments—will only rise.

Source:
[1] The Crypto Stablecoin GENIUS Act Hurts All Americans by ... [https://bettermarkets.org/analysis/the-crypto-stablecoin-genius-act-hurts-all-americans-by-undermining-the-economy-financial-system-and-monetary-policy]
[2] Stablecoin Stocks and the Reflection Effect [https://www.ainvest.com/news/stablecoin-stocks-reflection-effect-navigating-behavioral-biases-volatile-market-2509/]
[3] The Crypto Bill Could Lead to Another Financial Crisis [https://nymag.com/intelligencer/article/crypto-bill-stablecoins-treasuries-bitcoin-congress-tether-terra-circle.html]
[4] GENIUS Act Establishes Federal Regulatory Oversight of ... [https://www.alston.com/en/insights/publications/2025/07/genius-act-oversight-stablecoin-industry]
[5] How will the GENIUS Act work in the US and impact ... [https://www.weforum.org/stories/2025/07/stablecoin-regulation-genius-act/]