Could Allowing Interest on Stablecoins Boost Their Appeal?

Globally, stablecoins are being subjected to a relatively uniform regulatory framework, requiring them to be backed by high-quality assets, undergo regular audits, and forbidding issuers from paying interest on stablecoin balances. This prohibition is outlined in the GENIUS Act in the US, the Markets in Crypto-Assets regulation in the EU, and similar laws in Hong Kong and Singapore. However, enforcing this ban may prove challenging. One argument behind this prohibition is that it helps maintain liquidity within the traditional banking system, where regulators have better control over risk management. Whether this argument holds merit, it is unlikely to be effective and may lead to unintended consequences. Some crypto exchanges already offer 'rewards' that mimic interest rates for holding assets in stablecoins, and it is relatively simple for users to move their assets into and out of yield-bearing offerings. In Europe, MiCA regulations grant regulators more flexibility to prohibit workarounds, such as rewards and automated portfolio management, but stablecoins are considered 'bearer assets,' allowing users to move them freely. In practice, this means regulators can prohibit stablecoin issuers from paying interest but cannot prevent users from using their assets in DeFi protocols that offer interest. With current interest rates around 3-4%, even paying a small transaction fee to use a yield-bearing DeFi protocol can be worthwhile. If people frequently switch between stablecoins and interest-bearing assets, it could lead to large, sudden movements of money, potentially causing large-scale liquidations and purchases. While this risk is currently low due to the relatively small size of on-chain transactions compared to legacy banking, it may become more significant as the blockchain ecosystem grows. If a prohibition on stablecoin interest payments is effectively implemented, tokenized deposits could potentially benefit. Deposit tokens, championed by JPMorgan Chase, are a claim on a bank deposit and can offer yield, although they come with counterparty risk. The current pilot on Ethereum uses a standard ERC-20 token but restricts transfers to approved clients and partners. Interestingly, the debate over interest payments for bank deposits is not new, dating back to the aftermath of the 1929 stock market crash, when the US government implemented a prohibition on paying interest on current accounts. This prohibition lasted until 1972, when a bank in Massachusetts started offering a 'Negotiable Order of Withdrawal' account, which paid interest automatically linked to a deposit account. The widespread computerization of the banking system made such workarounds practical. In a blockchain-based world, such barriers do not exist, prompting the question of why we are repeating history instead of learning from it and allowing stablecoin providers to pay interest like traditional banks.