GENIUS Act Loophole Explained: Step By Step Guide

The **GENIUS Act of 2025** is a proposed US federal framework designed to regulate stablecoins, specifically aiming to prevent them from functioning as interest-bearing savings accounts. The core controversy, known as the “GENIUS Act Loophole,” is the regulatory gap that allows third-party crypto exchanges and distribution partners to pay rewards or yield on stablecoin balances, even though the stablecoin *issuer* is legally banned from doing so.

• Distinguish between issuer and platform rewards
• Assess platform counterparty risk
• Verify yield funding sources

This debate matters profoundly because it determines the future utility of stablecoins. If digital dollars can easily offer high returns, they become direct competitors to traditional bank savings accounts, potentially shifting billions of dollars out of the banking system. For you, the user, this regulatory fight dictates whether stablecoins remain purely payment tools—fast, cheap ways to move money—or evolve into a new venue for earning passive income on your liquid funds.

What Is the GENIUS Act and Why Was It Created?

When lawmakers began drafting federal rules for stablecoins, their primary goal was to ensure financial stability and consumer protection. They recognized that stablecoins—digital tokens pegged 1:1 to a fiat currency, like the US dollar—could become a critical part of the global payment infrastructure.

However, Congress wanted to draw a clear line between a stablecoin and a traditional bank deposit. The GENIUS Act was intended to provide strict standards for reserves (ensuring the stablecoin is always backed 1:1) and consumer protection, but it also included a critical restriction.

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The Core Intent: Payments, Not Savings

The central pillar of the GENIUS Act is the prohibition on yield. The law explicitly prohibits stablecoin **issuers**—the companies that mint the tokens and hold the reserves—from paying interest or yield to holders simply for holding the token.

Dr. P’s Analogy: Think of a stablecoin like a digital $1 bill. The GENIUS Act says the US Mint (the issuer) cannot pay you interest just for keeping that dollar in your wallet. Lawmakers wanted stablecoins to be used for buying and selling, not for sitting and collecting interest, which is the traditional role of a bank savings account.

Banks strongly supported this restriction. Their argument was straightforward: if stablecoins could pay yield directly, they would become an alternative to insured savings accounts. This could encourage depositors to move funds out of traditional banks, potentially destabilizing the local lending market.

The GENIUS Act, therefore, was designed to keep stablecoins focused on their function as efficient **payment instruments** and settlement tools.

Understanding the Stablecoin Yield Loophole

The controversy arises not from the stablecoin issuers themselves, who generally comply with the ban on paying yield, but from the third-party platforms that distribute and hold those stablecoins.

Community banks argue that the law only restricts the issuer, leaving a gaping hole that distribution partners—such as crypto exchanges, wallets, and affiliated platforms—can exploit to offer rewards to customers.

The Mechanics of the Workaround

From the customer’s perspective, the outcome is the same: they deposit stablecoins and earn a return. However, the source of the payment is structurally different, which is the key to the loophole. The process generally works like this:

1. A user deposits stablecoins onto a crypto exchange or platform.
2. The stablecoin **issuer** (e.g., Circle or Tether) does not pay any interest on the underlying token.
3. The **platform** (the exchange or distributor) uses its own funds, platform revenues, or affiliate structures to pay a reward to the customer.

This structural separation means the platform is incentivizing the customer to hold the stablecoin balance with them, effectively working around the spirit of the GENIUS Act. Banks argue that because distribution partners can effectively work around the restriction, the act becomes less effective in practice.

The rewards offered by these platforms can be funded in several ways:

• Platform Revenues: Using trading fees or other service charges to subsidize the rewards.
• Marketing Subsidies: Treating the yield as a marketing expense to attract and retain users.
• Affiliate Structures: Revenue-sharing arrangements tied to the stablecoin issuance and distribution network.

Regardless of the funding source, the result is that the customer is earning returns simply by holding stablecoins, which is precisely what the GENIUS Act intended to prevent.

Why Community Banks Are Sounding the Alarm

While large, multinational banks have diverse funding sources and easy access to wholesale funding markets, smaller **community banks** are fundamentally dependent on stable, local retail deposits. This is why the loophole debate is particularly urgent for them.

The Local Lending Impact

Community banks rely on local deposits to fund local lending. When you deposit money into a community bank, that money is used to issue mortgages, small business loans, and farm loans within that specific geographic area. This relationship is the engine of local credit.

Dr. P’s Analogy: Imagine a community bank’s deposits are the water in the town reservoir. That water is used to irrigate local farms and supply homes (loans). If a new, attractive stablecoin pool opens up nearby and offers a better rate, the water (deposits) flows out of the reservoir. The bank then has less water to supply the town, meaning fewer loans and higher costs for local businesses and households.

If stablecoins, through third-party rewards, become an attractive alternative for holding liquid funds, deposits could flow out of community institutions and into the crypto ecosystem. This outflow could directly reduce the capacity of community banks to lend to small businesses, students, and homebuyers, raising the overall cost of credit in local markets.

The Banking Policy Institute (BPI) has warned Congress that incentivizing a shift from traditional deposits and money market funds to stablecoins undermines the spirit of the ban on issuer-paid yield and could have a measurable negative impact on credit availability.

The Crypto Industry’s Counterarguments

Crypto advocacy groups, including the Blockchain Association and the Crypto Council for Innovation, have pushed back strongly against the banks’ claims, arguing that Congress intentionally drew a clear line and that closing the loophole would stifle innovation.

The industry’s core position is that stablecoins are fundamentally different from bank deposits and should not be regulated as substitutes for them.

Key Arguments Against Closing the Loophole

The crypto industry presents several counterarguments to the banks’ concerns:

• Stablecoins Are Payment Tools, Not Deposits: Stablecoins are primarily used for fast settlement and payment, often outside of traditional banking hours (transaction volumes frequently spike on weekends and holidays). They argue that forcing stablecoins to mimic bank economics suppresses competition.
• No FDIC Insurance: Unlike bank deposits, stablecoin balances held on platforms are generally not insured by the Federal Deposit Insurance Corporation (FDIC). This lack of insurance means they carry a different risk profile and should not be treated identically to insured savings accounts.
• Stablecoins Do Not Fund Loans Like Banks: Industry groups argue that comparing stablecoins to deposit-funded lending is a category error. Stablecoin reserves are often held in short-term US Treasury bills, making them indirect participants in government debt markets, not traditional bank lending systems.
• Banning Third-Party Rewards Stifles Innovation: Treating every incentive program as a prohibited activity could reduce consumer choice and limit experimentation in the rapidly evolving payments sector. Platforms need the ability to offer incentives to attract users to new payment rails.

The industry maintains that Congress’s intent was to ban the *issuer* from paying yield based on the reserves, not to ban every platform from offering lawful rewards funded through their own business models.

Policy Options: How Congress Might Close the Gap

The debate over the GENIUS Act Loophole presents policymakers with several distinct paths forward. How Congress resolves this issue will shape whether stablecoins remain payments-first tools or potentially evolve into more bank-like stores of value.

Three Potential Regulatory Paths

Based on the public arguments presented by both the banking and crypto sectors, Congress has three main options:

1. Affiliate and Partner Prohibition (The Banks’ Preferred Option)

This option involves extending the GENIUS Act’s yield ban beyond the stablecoin issuer to include all affiliates, distribution partners, and intermediaries that deliver yield in practice. This would effectively close the loophole entirely, ensuring that no entity in the stablecoin ecosystem can offer balance-based rewards.

2. Disclosure and Consumer Protection Approach

This middle-ground approach would allow rewards to continue but impose strict requirements on transparency and marketing. Crypto firms would be required to provide clear disclosures, including:

• Who is paying the rewards (the platform, not the issuer).
• What risks are involved (e.g., lack of FDIC insurance).
• That the rewards are not bank-like interest.

Regulators could also impose stricter marketing rules to prevent rewards from being presented as equivalent to traditional bank savings interest.

3. A Narrow Safe Harbor (Activity-Based Incentives)

This option would permit certain types of incentives while limiting others. For example, the law could allow rewards tied to specific usage or activity (e.g., a small reward for completing a certain number of transactions) while explicitly limiting incentives tied purely to the size of the stablecoin balance held (which closely resembles interest).

The outcome of this legislative battle will define the competitive landscape between traditional finance and decentralized finance (DeFi) for years to come.

Safety Check: Regulatory Uncertainty and Your Stablecoins

As a user, you are likely wondering how this regulatory uncertainty affects your digital assets. While the GENIUS Act focuses on the entities issuing and distributing stablecoins, the regulatory environment directly impacts the risk and reward associated with holding them.

Understanding the Risks of Yield-Bearing Stablecoins

If you are earning yield on a stablecoin balance through a third-party platform, it is crucial to understand the risks involved, especially in light of the ongoing regulatory debate.

1. Platform Risk (Counterparty Risk)

The yield you receive is paid by the platform, not the stablecoin issuer. If that platform faces financial difficulties, operational failure, or is subject to regulatory action, the rewards could stop immediately, and your principal balance could be at risk, especially if the platform is not regulated as a qualified custodian.

2. Regulatory Clawbacks

If Congress decides to adopt the strict prohibition model (Option 1), platforms may be forced to immediately cease all yield-bearing activities. This could lead to sudden changes in terms of service or the forced liquidation of certain reward programs.

3. Lack of Deposit Insurance

It bears repeating: stablecoins are not bank deposits. They are not protected by the FDIC. If the platform holding your stablecoins fails, there is no federal guarantee that you will recover your funds, regardless of the yield they were paying.

Dr. P’s Tip: Always verify the source of your yield. If a platform is offering a high yield on a stablecoin, understand that this return is likely funded by the platform’s business activities, not by the stablecoin issuer’s reserves. High yield often means higher risk, especially when the underlying regulatory framework is still being debated in Congress.

The Difference Between Issuer and Platform

When assessing the safety of your stablecoins, always distinguish between the two key players:

• The Issuer: The company responsible for ensuring the stablecoin is backed 1:1 (e.g., holding $1 in reserves for every 1 stablecoin issued). The GENIUS Act focuses heavily on regulating this entity.
• The Platform/Exchange: The service where you hold and trade the stablecoin. This entity is the one currently exploiting the loophole by paying rewards. Their financial health is separate from the issuer’s reserves.

Until Congress provides a final resolution to the GENIUS Act Loophole, users should treat any yield earned on stablecoins as a high-risk incentive, subject to rapid change based on legislative action.