“No member bank shall, directly or indirectly by any device whatsoever, pay any interest on any deposit which is payable on demand.”
— Section 11(b) of the Banking Act of 1933
Money market funds — the world’s most boring financial product — terrified bankers as soon as they started to catch on in the 1970s.
When interest rates soared beyond what banks were legally allowed to pay on deposits, money market funds, which faced no such restrictions, suddenly looked like a threat to the entire banking system.
None other than Paul Volcker called money market funds a “regulatory arbitrage” that “weakens the financial system” because they “sucked deposits out of banks.”
The problem was that banks couldn’t compete with the higher interest rates on offer from money market funds because of Regulation Q — a 1933 rule explicitly designed to prevent banks from competing on interest.
In the 1920s, banks engaged in a ruinous “rate war,” offering ever-higher interest rates to attract deposits.
To pay these rates, banks had to make increasingly risky loans, creating a dangerous cycle that ultimately destabilized the banking system.
Regulation Q sought to avert such competition by banning banks from paying any interest at all on checking accounts and capping what they could pay on savings accounts and CDs.
This is why banks became famous for giving out gifts in return for new deposits: They couldn’t offer a higher interest rate than their competitors, so they offered toaster ovens and televisions instead.
In 1979, for example, depositing $1,475 with the Republic National Bank for 3.5 years earned you a 17-inch color television, and the same amount deposited for 5.5 years earned a 25-inch one.
Want an even better deal? Depositing just $950 for 5.5 years earned you a stereo with built-in disco lights.
But even disco lights weren’t enough to keep bank depositors from fleeing to unregulated money market funds.
Money market funds were able to pay those higher interest rates because they didn’t pay “interest”: They got past Regulation Q by paying dividends instead.
This was (and remains) a distinction without a difference, but regulators chose to allow it in the name of financial innovation.
Banks warned that this regulatory arbitrage would siphon away their deposits and impair their ability to make loans.
They were right, too: In the decade or so after money market funds were introduced, retail savers moved hundreds of billions of dollars out of their local banks and into the new “shadow banking system” of money markets.
As forewarned, this impaired the regulated banking system’s ability to serve its core purpose of creating the money that the US economy needed to grow.
To their credit, regulators recognized the problem and, as early as 1970, began offering banks various exemptions to Regulation Q.
By 1986, interest rate caps had been almost entirely phased out; but it wasn’t until after the Great Financial Crisis — caused in part by a panic over unregulated money market funds — that lawmakers decided to fully repeal Regulation Q.
The bell could not be unrung, however.
For better and worse, the decision to allow money market funds to pay interest while banks could not shifted the foundation of the US financial system from bank loans to capital markets.
Now, the government’s decision to allow stablecoins into the US banking system might do something similar.
The Genius Act, expected to be signed into law any moment now, legalizes stablecoins as a new form of money.
Specifically, stablecoins become non-bank money that looks eerily similar to the money market funds that were de facto legalized in the 1970s over the objection of the banking industry.
Lawmakers, however, appear to have long memories: This time around, the new form of money they’re allowing will not be interest bearing.
The Genius Act prohibits issuers from paying interest on stablecoins, in the hope of protecting the banking system from the same kind of ruinous “rate war” that Regulation Q was designed to prevent.
Interest-bearing stablecoins, it’s feared, could further drain the banking system of demand deposits, making it even harder for your friendly neighborhood community bank to give you a loan.
It might happen anyway.
If money market funds were able to innovate their way around Regulation Q, is there any doubt that crypto will be able to innovate its way around the Genius Act?
Stablecoin issuers will likely figure out an equivalent of rewarding their users with toasters instead of interest.
And even if they don’t, DeFi protocols will figure out ever more ways to pay interest.
You can already get over 5% yield on stablecoins by taking a sliver of smart contract risk with a protocol like Compound.
Tellingly, that might represent less risk than what bank depositors were initially willing to take with money market funds — and stablecoin deposits are nearly as accessible, too.
