Barbarians at the Fed's Gate

Stablecoins are knocking and the Fed is letting them inside.

It has been an amazing few months for dollar-based stablecoins. On July 18, 2025, President Donald Trump signed the GENIUS Act into law. It passed Congress with bipartisan support—68–30 in the Senate and 308–122 in the House—and formally brought stablecoins inside the U.S. federal regulatory perimeter, adding long-awaited clarity to their future. Then, on October 21, 2025, Federal Reserve Governor Chris Waller announced that the Fed was exploring a “skinny master account” for eligible depository institutions that currently rely on third-party banks to access its payment rails. This would be a game changer for custodial institutions such as Kraken Financial and Custodia Bank, which serve as the connective tissue between stablecoins and the traditional financial system. Together, these two developments mark a turning point: the stablecoin barbarians knocking at the Fed’s gate are no longer outsiders—they are being invited inside.

Dollar-based stablecoins, with a market capitalization near $300 billion, were already projected to reach between $2 and $4 trillion in size by the end of the decade. The GENIUS Act and the prospect of skinny master accounts are likely to further accelerate this growth.

Should stablecoins become a dominant payment technology, the implications for the Federal Reserve could be significant. In this note, I focus on two key effects in particular: (1) the potential increase in the cost of the Fed’s balance sheet and (2) the potential expansion in its size. In my next note, I will explore a closely related issue. How the Fed’s balance sheet, in a stablecoin world, could become an even more central safe-asset intermediary for the global financial system.

Before we jump into those discussions, here is part of an interview Governor Waller gave after his October 21 speech. In this clip, he provides more details on his “skinny master account” proposal, including his expected timeline for its rollout.

Stablecoins and the Cost of the Fed’s Balance Sheet

One potential implication of the widespread adoption of dollar-based stablecoins is the displacement of physical currency. As digital dollars issued through stablecoins become more widely used, global demand for physical U.S. dollars will decline. This shift could prove costly for the Federal Reserve, which depends on its “currency franchise” to finance its balance sheet inexpensively.

Put differently, the Fed currently obtains zero-cost funding by issuing currency and investing the proceeds in Treasury securities that yield a positive interest rate. This spread is the Fed’s golden goose. But as digital dollars displace physical currency, that goose may be cooked—and the seigniorage will migrate from the Fed to the issuers of stablecoins.

Jim Clouse makes this point in a recent note and elaborated on it during his visit to the Macro Musings podcast. He did some calculations and came up with the following outcomes:

[U]nder plausible alternative scenarios for the path of currency in circulation over time… a significant shift away from physical currency holdings over time could reduce cumulative Federal Reserve net income over the period 2025 to 2055 by $1.5 trillion to $2.5 trillion relative to the baseline scenario.

The bottom line is that in a world with no currency, the Fed’s balance sheet becomes a matched book — one where borrowing and lending positions are aligned in maturity and rate sensitivity, leaving little or no net interest margin. In the video clip below, Jim and I discuss this point.

As Jim notes in the video clip, this issue is more than theoretical. Sweden provides a real-world example: as the use and demand for physical currency there have sharply declined, the central bank has faced the consequences firsthand. We can see this development in the two figures below. The first figure shows the decline in currency both in absolute terms and as a percent of nominal GDP.

The next figure shows the consequences for the net interest income of the Swedish central bank, the Riksbank. It too has been trending down:

The Riksbank recognizes this challenge and has introduced a requirement that all member banks and credit institutions place a portion of their deposits at the central bank into a non–interest-bearing status whenever the Riksbank’s equity falls below a certain threshold. According to the Riksbank, this measure is essential for preserving its operational independence. Here is an excerpt from the central bank:

In Sweden, cash is used to a lesser extent than in many other countries, which limits this source of funding and means that the Riksbank needs to fund its assets in other ways instead. As a rule, this funding entails an interest cost, which weakens the Riksbank’s earning capacity. Interest-free deposits provide the Riksbank with an alternative source of funding that is independent of the use of cash.

According to the Sveriges Riksbank Act, the Riksbank may decide on interest-free deposits if the Riksbank’s equity falls below the so-called target level... As the Riksbank makes profits and builds up its equity, both the need and the scope for interest-free deposits will decrease.

In short, as dollar-based stablecoins displace physical currency, the Fed could face a gradual erosion of its seigniorage income and, by extension, its financial independence much like the Riksbank’s experience in Sweden. One potential, though unintended, remedy lies in Governor Waller’s proposal for skinny master accounts. These accounts, designed to give nonbank payment providers limited access to the Fed’s balance sheet, would pay zero interest and thus provide the central bank with a new source of zero-cost funding. While Waller’s proposal was not motivated by concerns over seigniorage loss, its implementation could incidentally restore some of the cheap funding that disappearing physical currency once supplied.

Stablecoins and the Size of the Fed’s Balance Sheet

A second potential implication of the widespread adoption of dollar-based stablecoins is a larger Fed balance sheet. Stablecoins as money will interact with the Fed’s balance sheet in at least three ways: by replacing currency, by replacing bank deposits, and by creating net new demand for Fed liabilities.

Stablecoins Replace Currency

Consider first the case where people exchange cash for stablecoins backed by reserves, ON RRP balances, or Treasury securities. Suppose, for example, that I deposit $1,000 in cash at my bank, which returns the currency to the Fed. Currency in circulation falls by $1,000 while reserves rise by $1,000, leaving the size of the Fed’s balance sheet unchanged. I then use my new bank deposit to purchase a stablecoin, transferring reserves from my bank to the stablecoin’s bank—again, no change in total Fed assets or liabilities. Finally, the stablecoin issuer uses those reserves to purchase a Treasury bill in the secondary market, shifting reserves among banks but not altering the Fed’s overall balance sheet size. In short, the total size of the Fed’s balance sheet remains constant, but its composition shifts from currency to reserves.

A similar dynamic would occur if the stablecoin issuer invested in government money market funds parked at the ON RRP facility or, if granted direct access, in a skinny master account. In each case, the Fed’s total balance sheet would stay roughly the same, but the composition of its liabilities would change.

Whatever the configuration, this mechanical reallocation—if it became persistent—would alter the structural demand for Fed liabilities and, over time, compel the Fed to adjust its target level of reserves, ON RRP balances, or skinny master accounts to accommodate the new monetary environment.

Stablecoins Replace Bank Deposits

Now consider the case where people move their funds from banks into stablecoins backed by reserves, ON RRP balances, or Treasury securities. If stablecoin issuers hold their backing assets indirectly through a custodian bank, reserves simply shift from one bank to another as users convert deposits into stablecoins. The aggregate level of reserves across the system remains the same—unless the stablecoin uses a government money market fund as collateral that, in turn, parks funds in ON RRP balances. Either way, the total size of the Fed’s balance sheet remains unchanged, though the composition of liabilities across banks and nonbanks evolves.

The story is likely to change, however, if stablecoin issuers are granted skinny master accounts. Depositors are effectively moving funds from the banking system into a new class of nonbank Fed liability. Initially, this is a one-for-one swap, reserves at banks fall while balances in skinny accounts rise. But over time, as banks lose deposit funding—especially from large, uninsured balances above the $250,000 FDIC limit—the Fed may need to step in to offset disintermediation pressures, which would raise total reserves and expand the overall balance sheet.

Stablecoins Create Net New Demand for Fed Liabilities

Now consider the case where domestic nonbank investors or foreign users outside the U.S. banking system acquire dollar stablecoins to access the dollar payment network. In this case, stablecoin growth channels new demand into dollar-denominated safe assets, increasing the global appetite for Fed liabilities. The Fed’s balance sheet must expand to accommodate this demand if the private markets cannot fully absorb the inflows. The effect is amplified if stablecoin issuers have direct Fed access through skinny master accounts, since each new dollar of stablecoin issuance corresponds directly to a new Fed liability. In that world, the growth of stablecoins would translate mechanically into a larger Fed balance sheet, placing the central bank even closer to the center of global dollar intermediation.

A Bigger Fed Balance Sheet

Taken together, these three cases point in a clear direction: stablecoins generally raise the structural demand for Fed liabilities. When they replace currency, the effect is size-neutral for the Fed’s balance sheet even as the composition shifts from currency to reserves. When they replace bank deposits, the result is mostly neutral at first, but growing use of skinny master accounts could nudge reserves and the overall balance sheet higher. And when stablecoins create net new demand for dollar-denominated safe assets, particularly from foreign users seeking access to the U.S. payment system, the Fed’s balance sheet must expand to absorb that demand.

A fully on-chain stablecoin world is simply the limiting case of this trend—a world where stablecoin circulation and settlement occur entirely on Fed liabilities, placing the central bank even more squarely at the center of global dollar intermediation. In that scenario, the Fed’s balance sheet would expand to M2-like proportions, as private bank deposits are replaced by digital claims on the Fed. While such an outcome is currently unlikely, the thought experiment highlights the directional pull of stablecoin adoption: even modest digitalization tends to push the system toward a larger share of publicly intermediated Fed liabilities.

Are Stablecoins the Future of the Payments System?

So far, my analysis has assumed the widespread adoption of stablecoins. But is this realistic? Despite the current momentum behind dollar-based stablecoins, they face three major challenges.

First, dollar-based stablecoins are effectively a form of narrow banking, where revenue derives almost entirely from interest on their safe-asset collateral. This means the current stablecoin business model depends heavily on the persistence of a high-interest-rate environment. Bring back the zero lower bound, and watch out!

Second, in today’s world—where most payments are still settled in bank money—stablecoins must contend with the additional friction of on- and off-ramps to settle transactions. In a fully on-chain world, this would not be an issue. Indeed, some, like Charlie Calomiris, see such a world as inevitable as payment and lending activities increasingly decouple. But for now, stablecoins operate at a competitive disadvantage.

Third, the perceived threat of stablecoins has prompted banks to tokenize their own deposits, turning a potential disruption into a strategic opportunity. By issuing “tokenized deposits,” banks can offer many of the same advantages that make stablecoins attractive—on-chain speed, programmability, transparency, and 24/7 settlement—while maintaining a sustainable business model. JPMorgan’s new JPMD deposit token on Coinbase’s Base blockchain underscores this trend: banks can now harness public blockchains for near-instant, compliant settlement. Similarly, Custodia Bank and Vantage Bank have launched tokenized-deposit platforms that enable stablecoins and tokenized deposits to interact within a framework bridging blockchain finance and the traditional banking system.

Taken together, these developments suggest that stablecoins may not dominate the future but will instead complement tokenized deposits within an emerging digital-money ecosystem. In this future, tokenized deposits will anchor the regulated, bank-based core of the system, while stablecoins will thrive at its more open, global edge. To the extent that stablecoins attract new demand for dollars from abroad, they will likely expand the Fed’s balance sheet but far less than if stablecoins alone were the dominant dollar instrument.

Conclusion

Dollar-based stablecoins have entered a new era of legitimacy and momentum, propelled by the GENIUS Act and the Fed’s exploration of skinny master accounts. Their rise promises to expand the reach of digital dollars but also poses new challenges for the Federal Reserve. As stablecoins displace physical currency, they threaten to erode the Fed’s low-cost “currency franchise,” raising the effective cost of funding its balance sheet. At the same time, the spread of stablecoins—especially those held abroad—will increase the structural demand for Fed liabilities, gradually pulling the central bank toward a larger balance sheet. These twin pressures—on cost and size—underscore how the barbarians at the gate may ultimately reshape the Fed and the architecture of modern money. In my next essay, I will explore how these developments could make the Fed’s balance sheet an even more central safe-asset intermediary for the global financial system.