DeFi-ying the Fed? Monetary Policy Transmission to Stablecoin Rates

Abstract

Does the Federal Reserve’s monetary policy transmit to stablecoins pegged to the US dollar? Large stablecoin issuers do not pay interest, but investors can lend stablecoins in Decentralized Finance (DeFi) lending protocols, where interest rates are governed by predetermined interest rate rules enforced by smart contracts. This leads to markedly different interest rates between conventional short-term rates and stablecoins’ interest rates. We first document that the recent Federal Reserve’s interest rate hiking cycle coincided with falling stablecoin interest rates until July 2022, after which the correlation became positive. To make sense of the observed dynamics, we develop a simple model of DeFi lending and bring it to the data. The model successfully reproduces the observed shift in monetary policy transmission to stablecoin rates.