Stablecoins are experiencing explosive growth. According to JPMorgan’s latest market review released in May 2026, the total market capitalization of stablecoins reached USD 315 billion in the first quarter of 2026, setting a new historical high. Quarterly transaction volume climbed to USD 28 trillion, representing a 51% quarter-on-quarter increase, while annualized transaction volume reached approximately USD 17.2 trillion—more than double the scale recorded in 2025. Stablecoins have evolved from marginal instruments within the crypto ecosystem into core financial infrastructure connecting on-chain DeFi lending, cross-border payments and settlement, institutional treasury management, and even segments of the traditional financial system.

Beneath this appearance of “stability,” however, lies a degree of financial fragility that far exceeds conventional understanding. The collapse of the Terra algorithmic stablecoin UST in 2022 erased USD 40 billion in market value and became one of the most devastating failures in crypto history. In 2023, the Silicon Valley Bank crisis caused USDC to temporarily de-peg to USD 0.87, exposing the counterparty risks and run vulnerabilities embedded in fiat-backed stablecoin reserve assets. In 2025, Stream Finance’s yield-bearing synthetic stablecoin xUSD lost its peg following losses of USD 93 million. These crisis episodes collectively demonstrate that stablecoins are not merely technological innovations; rather, they constitute a large-scale, highly complex, and globally interconnected “on-chain digital shadow banking system.”

The core argument of this article is that the stablecoin ecosystem, built natively on blockchain technology, fully reproduces the core functions and risk characteristics of traditional shadow banking, thereby constituting an “on-chain iteration” of shadow banking. The analytical foundation of this argument lies in the principle of “functional equivalence”: regardless of technological form, once a financial activity performs bank-like functions such as credit intermediation, maturity transformation, and liquidity transformation while remaining outside prudential regulation, its essential nature becomes structurally analogous to shadow banking. This structural characteristic implies that the stablecoin system inherently contains systemic risks including runs, credit collapse, and market contagion. This perspective is increasingly echoed in academic literature, which has conceptualized the credit, maturity, and liquidity transformation activities conducted by stablecoin issuers and centralized exchanges as a new iteration of shadow banking.

I. Why Stablecoins Have Become Digital Shadow Banking

To understand the shadow banking nature of stablecoins, it is necessary to return to the Financial Stability Board’s (FSB) classical definition of shadow banking. In its 2012 report Shadow Banking: Scoping the Issues, the FSB defined shadow banking as “credit intermediation involving entities and activities outside the regular banking system” that may generate systemic financial risks and regulatory arbitrage. Its core operational characteristics include credit intermediation, maturity transformation, liquidity transformation, credit transformation, and leverage. Traditional shadow banking—such as the short-term dollarized liabilities seen during the 1994 Mexican peso crisis, the subprime mortgage securitization chain preceding the 2008 global financial crisis, and peer-to-peer (P2P) lending platforms—essentially involved financial activities that performed core banking functions outside the formal banking system.

Although stablecoins operate through blockchain-based issuance, circulation, and application mechanisms and are embedded in digital asset ecosystems, their underlying economic functions and risk characteristics remain highly isomorphic to traditional shadow banking. This article substantiates this conclusion from three dimensions: functional isomorphism, shared risk origins, and common regulatory challenges.

(1) Functional Isomorphism: The On-Chain Replication of Banking Functions

The shadow banking characteristics of the stablecoin ecosystem can be systematically verified through its three-layer industrial structure.

Issuance Layer: The Origin and Core Manifestation of Shadow Banking Attributes

Fiat-backed stablecoins operate through a closed-loop mechanism of “issuance–circulation–application–redemption.” Users deposit fiat currency into custodial bank accounts controlled by the issuer, after which the issuer adopts a mixed reserve structure consisting of “cash + short-term government bonds (75–80%) + other assets” while minting equivalent-value stablecoins on-chain.

This mechanism essentially performs “deposit-like fund absorption” and credit intermediation functions. Stablecoin issuers absorb short-term user funds—analogous to deposits—and invest them into yield-bearing assets, thereby engaging in maturity transformation. As Federal Reserve Governor Michael S. Barr has noted, stablecoin issuers possess strong incentives to maximize reserve asset yields and may therefore “extend outward along the risk spectrum as much as possible.” This logic mirrors the behavior of traditional shadow banking institutions pursuing higher risk and higher returns.

Circulation Layer: Liquidity Transformation and Risk Transmission Hub

The circulation layer performs liquidity transformation and acts as a channel for risk transmission. Centralized exchanges (CEXs) provide internal ledgers and leveraged trading mechanisms that generate multiple layers of trading exposure based on limited client assets, resembling a hybrid structure combining securities brokerage and shadow banking. Decentralized exchanges (DEXs) utilize automated market makers (AMMs) to provide liquidity and create an “illusion of liquidity,” which may evaporate rapidly under market stress. Cross-chain bridges facilitate asset transfers across chains, jurisdictions, and markets, thereby circumventing traditional financial oversight of cross-border payments.

BIS General Manager Pablo Hernández de Cos has argued that stablecoins “currently operate more like exchange-traded funds than money,” particularly because redemption frictions frequently lead to deviations from par value. This observation accurately captures the liquidity risks embedded within the circulation layer.

Application Layer: Credit Creation and Leverage Amplification

The application layer is where credit creation and leverage expansion become most active. DeFi lending protocols such as Aave and Compound allow users to repeatedly borrow and lend against stablecoin collateral, thereby generating multiple layers of on-chain credit based on limited collateral.

In January 2026, JPMorgan CFO Jeremy Barnum argued that yield-bearing stablecoins “replicate the economic functions of deposits while bypassing prudential safeguards developed over centuries within the banking system,” including capital adequacy requirements, liquidity buffers, and lender-of-last-resort mechanisms.

These three layers interact dynamically: the issuance layer provides “base money,” the circulation layer performs liquidity transformation, and the application layer expands credit and leverage. Together they form a comprehensive “digital shadow banking” risk chain that strongly resembles the securitization chains characterizing pre-2008 shadow banking—albeit operating in a more digitalized, automated, and globalized form.

(2) Shared Risk Origins: Structural Similarities in Financial Fragility

The stablecoin ecosystem and traditional shadow banking exhibit strong similarities in both risk categories and transmission mechanisms.

Credit Risk

Stablecoin issuers may invest reserve assets in risky commercial paper or engage in improper asset management practices, leading to deterioration in asset quality. Nobel laureate Paul Krugman has compared stablecoin issuers to “19th-century U.S. private banknotes,” whose redemption capacity depended entirely on the actual value of reserve assets.

Liquidity and Run Risks

On the liability side, stablecoins promise redemption at par on demand, while reserve assets are invested in instruments such as Treasury securities and commercial paper that contain market risk. Once confidence in the issuer weakens, concentrated redemption requests may emerge, while reserve assets cannot be liquidated rapidly enough to meet withdrawals.

This mechanism essentially replicates the 2008 money market fund crisis, when funds “broke the buck.” Barr traced such risks back to the U.S. “Free Banking Era” of the 19th century, when private banknotes “often traded at discounts” and experienced recurrent bank runs and financial panics.

Leverage Risk

Traditional shadow banking generated substantial hidden leverage through securitization chains and repurchase agreements. The stablecoin ecosystem achieves even more extreme forms of automated collateral recursion through composable DeFi protocols, with greater speed and opacity than traditional shadow banking.

The transmission mechanism follows a familiar sequence: structural fragility emerges → market confidence weakens → liquidity runs erupt → distressed asset sales occur → the credit foundation deteriorates → cross-market contagion spreads. Once runs begin, issuers may be forced into fire sales of reserve assets, further reducing reserve size, weakening redemption capacity, and undermining confidence, thereby creating a self-reinforcing “death spiral” between liquidity exhaustion and credit collapse.

(3) Shared Regulatory Challenges: Different Temporal Forms of the Same Problem

From a regulatory perspective, stablecoins and traditional shadow banking face the same fundamental challenge: how to regulate credit intermediation activities outside the prudential banking framework in order to prevent credit mismatches, redemption failures, and systemic contagion.

This similarity arises because both involve financial activities performing credit intermediation functions beyond the traditional banking system.

Accordingly, global regulators have elevated stablecoin oversight to a central policy issue. In November 2025, the FSB explicitly warned that stablecoins, while potentially improving payment efficiency, also create run risks and cross-jurisdictional regulatory challenges. In its 2026 work program, the FSB identified coordinated international regulatory frameworks and anti-money laundering/counter-terrorism financing governance as key priorities.

The global regulatory dilemma surrounding stablecoins is therefore fundamentally a digital-space extension of the traditional shadow banking problem—only amplified significantly through digitalization.

II. New Characteristics and Evolving Risks of Digital Shadow Banking

The stablecoin ecosystem is not simply a reproduction of traditional shadow banking. Enabled by blockchain and smart contract technologies, it exhibits four distinctive “digitally native” characteristics that mutually reinforce and amplify one another.

First, Digital-Native Operations and the Replication of “Narrow Banking”

Stablecoin issuance, circulation, and redemption processes are executed automatically through smart contracts, enabling uninterrupted 24/7 operation. This digital feature allows capital flows to move much faster than in traditional shadow banking systems, meaning that runs can occur almost instantaneously.

More importantly, the stablecoin system replicates the long-rejected “narrow banking” model. Narrow banking proposes that demand deposits be fully backed by central bank reserves or government bonds and prohibited from supporting lending activities, thereby separating money creation from credit risk.

Although this framework theoretically eliminates bank runs, regulators have historically resisted it because it would drain deposits from commercial banks, concentrate safe collateral, and weaken the fractional reserve system’s role in supporting credit creation for the real economy.

Fiat-backed stablecoins effectively recreate this rejected model: large volumes of funds become locked in reserve assets such as short-term Treasuries rather than circulating into productive credit markets. As a result, stablecoins weaken the traditional banking system’s credit creation function and generate economic consequences distinct from those of traditional shadow banking.

Second, Cross-Border Credit Transmission and the Rise of the “Shadow Dollar”

Traditional shadow banking systems largely transmitted credit risks within individual national or regional markets. By contrast, the digital nature of stablecoins enables borderless cross-border transmission.

Currently, approximately 98% of global stablecoin market capitalization is denominated in U.S. dollars, while over 80% of stablecoin transactions occur outside the United States. Dollar-backed stablecoins are effectively becoming “on-chain claims to offshore dollars,” thereby accelerating digital dollarization.

Former People’s Bank of China Governor Zhou Xiaochuan has noted that this mechanism reinforces dollar hegemony while increasingly binding global dollar credibility to the fiscal sustainability of the United States.

The opacity of this transmission mechanism exceeds that of traditional shadow banking. Blockchain transaction anonymity complicates the tracing of capital flows and creates serious anti-money laundering challenges. According to Chainalysis, stablecoins accounted for 84% of the USD 154 billion in illicit virtual asset transactions recorded in 2025.

Third, the “Liquidity Black Hole” Effect and Procyclical Risk Resonance

Stablecoin issuers act as persistent net purchasers of short-term U.S. Treasury securities. Every newly issued dollar-backed stablecoin requires the issuer to hold an equivalent amount of highly liquid reserve assets, which remain locked within custodial accounts throughout the stablecoin’s circulation.

These assets therefore do not re-enter traditional financial circulation, cannot be rehypothecated, and cannot support repo market activity. Stablecoin issuers thus become one-way liquidity “black holes” that continuously absorb U.S. Treasuries while rarely releasing them back into financial markets.

This dynamic reduces the availability of high-quality collateral and contributes to tighter funding conditions. BIS research indicates that when USD 3.5 billion in stablecoins are newly minted, yields on three-month U.S. Treasury bills decline by approximately five basis points, directly demonstrating stablecoins’ influence on traditional financial markets.

This “liquidity black hole” effect is also highly procyclical. During market booms, rising stablecoin demand accelerates liquidity extraction and inflates risk asset prices. During market downturns, panic-driven redemptions trigger concentrated reserve asset sales and intensify market volatility.

Unlike traditional shadow banking, where risks often emerge through broader economic channels, stablecoin risks may arise purely from shifts in market confidence and may be executed automatically through smart contracts without human intervention. Federal Reserve analyses have shown that after USDC de-pegged, the sequence from banking crisis to stablecoin instability and contagion to other stablecoins unfolded within hours—an unimaginable speed within traditional financial systems.

Fourth, Regulatory Ambiguity and Regulatory Arbitrage

Traditional regulation emphasizes institution-based and jurisdiction-based supervision. Stablecoins, however, are decentralized, borderless, and automated, making them fundamentally incompatible with conventional regulatory frameworks.

Because stablecoins do not depend on physical branches or traditional financial intermediaries, they transcend institutional and territorial boundaries. Traditional supervisory tools—including licensing systems and on-site inspections—struggle to cover their cross-sectoral and cross-border operations.

Even more concerning is the fragmentation of global regulation, which encourages regulatory arbitrage. In April 2026, the BIS warned that inconsistent stablecoin regulatory frameworks across jurisdictions could produce severe market fragmentation and harmful regulatory arbitrage.

Although USDT and USDC account for approximately 98% of the global stablecoin market, they are registered in different jurisdictions, maintain reserves in different regions, and operate globally. Any regulatory gap can therefore become an opportunity for regulatory evasion.

When multinational firms are free to choose the “optimal” regulatory environment, the foundations of international regulatory coordination are gradually undermined.

III. Conclusion and Policy Recommendations

As of the first quarter of 2026, the global stablecoin market exceeded USD 315 billion in capitalization, with annualized transaction volumes approaching USD 17.2 trillion. Stablecoins have thus become a significant new variable within the global financial system.

Using the FSB’s definition of shadow banking as a benchmark, the stablecoin industrial chain—spanning issuance, circulation, and application—has already developed multiple forms of shadow banking-style credit intermediation and leverage expansion. In essence, the stablecoin ecosystem constitutes an “on-chain replication” of traditional shadow banking.

At the level of functional isomorphism, the issuance layer acts as the primary hub for “deposit-like fund absorption + reserve asset investment,” the circulation layer performs repo-like liquidity transformation through AMMs and cross-chain bridges, and the application layer facilitates explicit on-chain credit expansion through collateralized lending and rehypothecation cycles.

At the level of shared risk origins, stablecoins reproduce the core risk architecture of traditional shadow banking: credit risk stemming from reserve asset quality, redemption pressure arising from maturity mismatches, leverage amplification through collateral recursion, and cascading confidence collapses.

At the regulatory level, policymakers worldwide must confront the same central question: how to regulate credit intermediation activities beyond the prudential banking perimeter in order to prevent systemic contagion and preserve financial stability.

Operating in an on-chain environment gives stablecoins four new characteristics—digital nativeness and narrow-bank replication, cross-border credit transmission and “shadow dollar” dominance, liquidity black hole effects and procyclical resonance, and regulatory ambiguity combined with regulatory arbitrage—which collectively amplify the complexity and speed of risk transmission.

Based on this analysis, and considering China’s current policy environment in which cryptocurrency trading remains prohibited while dollar stablecoins continue to penetrate cross-border activities, this article proposes a governance framework summarized as “strictly blocking the back door while opening the front door.”

First, Strict Domestic Regulation Must Remain the Bottom Line

Any form of stablecoin-related business activity remains illegal within mainland China. Authorities should continue strengthening on-chain monitoring and cross-border law enforcement cooperation, focusing on capital flow supervision to block stablecoin payment channels.

China should also intensify coordinated crackdowns on illegal domestic crypto intermediaries and gray-market payment channels in order to disrupt underground networks facilitating the internal circulation and arbitrage of dollar-backed stablecoins.

Second, Accelerate the Expansion of the Digital RMB (e-CNY)

China should actively expand the application of the digital RMB in high-frequency scenarios such as cross-border payments, programmable payments, and corporate treasury management.

By providing compliant and efficient digital payment tools through the central bank system, China can counterbalance stablecoins’ encroachment on digital payment markets and replace private stablecoins with sovereign digital currency infrastructure.

This is not merely a competitive instrument but also a strategic imperative. The rapid global expansion of dollar stablecoins reflects a broader U.S. strategy to reinforce dollar dominance through digital means. China must therefore not only “block” risks but also fundamentally enhance the international attractiveness and coverage of RMB-denominated payment and settlement systems.

Third, Position Hong Kong as a National-Level “Front Door” for Compliant Stablecoin Experimentation

Leveraging Hong Kong’s independent regulatory framework under “One Country, Two Systems” and its role as an offshore international financial center, China could establish sandbox-based compliant stablecoin pilot programs to accumulate experience in global digital finance governance.

By clearly distinguishing the “shadow banking” functions of stablecoins from their pure payment functions, Hong Kong pilots could define clear operational boundaries and support real-economy payment needs while effectively controlling risks.

Pilot projects in Hong Kong could generate valuable operational data, risk management models, and cross-border regulatory coordination experience, which may later inform broader national implementation.

This “dual-system complementarity” framework would simultaneously maintain strict mainland supervision and allow regulated innovation in Hong Kong, while also strengthening China’s influence in shaping global digital finance rules.

Fourth, Securing International Rule-Making Power Is Urgent

Stablecoins differ fundamentally from earlier P2P lending platforms. They serve as foundational infrastructure for value transfer in the digital economy and represent a frontier of international competition in digital currency systems.

If international rules continue to be shaped solely by the United States and Europe, China’s digital currency internationalization efforts may encounter systemic compliance barriers.

China should therefore actively participate in standard-setting processes led by institutions such as the BIS, FSB, and IMF, while leveraging the early advantages of the digital RMB in cross-border payments and central bank digital currency bridge initiatives.

Given the fragmentation of global stablecoin regulation and the resulting regulatory arbitrage, China could gain strategic initiative in the emerging “digital financial order” by helping shape early international stablecoin governance standards and compliant sandbox frameworks.

In conclusion, stablecoins have emerged as critical infrastructure for value transmission in the digital era. Their essential nature lies in the refined replication and accelerated evolution of traditional shadow banking within blockchain space.

For China, managing stablecoin risks is not only a matter of financial stability but also a matter of monetary sovereignty in the digital age. The differentiated regulatory strategy of “strictly blocking the back door while opening the front door” represents an inevitable choice for safeguarding financial security and strengthening China’s international voice in the global transformation toward digital finance.

This article was originally published on the Chief Economist Circle WeChat public account.

References

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Authors

Liu Feng

Chief Economist, International Institute of Green Finance (IIGF), Central University of Finance and Economics; Council Member, China Chief Economists Forum.

Tang Xiya

Doctor of Economic Law and Postdoctoral Researcher in Applied Economics; currently with the Legal and Compliance Department of China Galaxy Securities.