The financial (in)stability risk of stablecoins

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The financial stability risks of stablecoins

The financial stability risks of stablecoinsAmong the more interesting and potentially impactful developments of explosive growth in cryptocurrency markets has been the advent and broadening acceptance of stablecoins. As we have noted in prior work, these tokens form the backbone of offshore trading activity, representing the bulk of turnover in most pairs. Though the market has diversified a bit and has occasionally tilted slightly more towards fiat USD under stress, as a general matter this remains very much the case. The associated inflows have helped the stablecoin market to grow rapidly—though it has slowed some recently, the largest such tokens are now well above $100bn in total market value (Exhibit 1). With that growth, regulatory focus on this market has likely shifted from consumer protection to financial stability, including a recent meeting of the Presidential Working Group and recent comments from Boston Federal Reserve President Rosengren.

Stablecoins are also critical in the sense that they serve as the primary interaction point between the crypto-native and traditional financial systems through their reserve funds. As we discussed in detail a couple of months ago, recent public disclosure from Tether (USDT), the largest stablecoin issuer, reveals that roughly three-quarters of the fiat currency assets used to back the tokens in circulation were invested in cash and equivalents, the bulk of which is commercial paper as of March 2021. Questions around the precise nature of these holdings remain, including the precise definition of “commercial paper”, whether it is domestic or offshore, potential FX exposure, and others. Other stablecoin issuers have not made comparably detailed disclosures, but if their reserves are similarly allocated, the overall exposure of short-term unsecured funding markets to stablecoins could be substantial. At the moment, stablecoin funding appears…very stable. The total float of USDT and USDC shows little evidence of meaningful redemptions. That is particularly remarkable in the context of secondary market price action—the four largest such tokens are ‘breaking the buck’ with regularity (at least in the secondary market; Exhibit 2). In fact, their median intraday realized volatility (let alone more extreme days) is well in excess of even the most disorderly trading in pegged fiat currencies like HKD, SAR, AED and DKK (Exhibit 3). As some have speculated, this likely reflect shigh convenience yield with stablecoins offering market access (e.g., offshore and decentralized exchanges), faster and lower costs for cross-border and inter-exchange transfers, and other features that mitigate this level of price volatility. Further, the vast majority of turnover in stablecoin pairs is versus cryptocurrencies, for which this component of volatility would be a much smaller driver of returns in fiat currency units (Exhibit 3, again).

This functional exchangeability depends on sufficiently deep and liquid markets in stablecoin/fiat pairs—especially versus the U.S. dollar. Intraday price action suggests that secondary market liquidity provision is insufficiently elastic to meet emand, and not just under stress, leading to the frequent discounts described above. This is perhaps not surprising given the wide dynamic range of daily trading volume for USDT/USD, for example, which can vary by several factors even after adjusting for the growth of tokens outstanding (Exhibit 4). There are also operational risks associated with the concentration of this activity on a handful of exchanges, anyone of which can represent almost half the turnover on the heaviest days (and frequently 30-40%; Exhibit 5). There is furthermore some pro-cyclicality with traditional markets, particularly risky assets. As volatility increases, so does the correlation between equity and BTC returns (Exhibit 6). Because stablecoin/fiat turnover tends to spike when cryptocurrency markets in general come under pressure, this in turn suggests the demands on secondary stablecoin/fiat liquidity will increase during periods of increased risk aversion across markets—precisely the time when depth tends to decline across all asset classes. It is also worth noting that more idiosyncratic events such as a hash rate shock or heavy-handed regulatory intervention by central governments can generate similar liquidity events. Were a spike in demand to be met with low secondary market depth in these pairs and potentially an operational event on a key exchange, one could imagine a scenario in which that liquidity demand migrates from exchanges to the issuers themselves.

While there is not much direct linkage between events in crypto currency markets and the traditional financial system, reserves backing stablecoins may have some overlap. As noted previously, disclosures from Tether indicate significant holdings of commercial paper (i.e., 50% of their reserves portfolio or roughly $30bn), presumably denominated in USD. Assuming no significant changes to these allocations, the rapid growth of USDT would suggest that they could become one of the largest holders of USCP–if indeed that’s what is included in the disclosed holdings. Furthermore, while other stablecoin issuers have not made the same detailed disclosures, assuming their reserves are similarly allocated, the overall exposure of stablecoins to USCP could be comparable to that of U.S. prime MMFs. But by no means are stablecoin issuers a dominant player in the USCP market (Exhibit 7). Indeed, while prime funds are easy to identify as active market participants, stablecoin related activity is difficult to spot.

It is worth noting that beyond the high-level disclosure of their reserves portfolio, very little is known about the nature of USDT’s CP position, including issuer names or domiciles, tenors, credit rating or if the position is managed in-house or by a third party manager. These details might matter to secondary markets if reserves need to beconverted into cash.

While USCP can and does trade in secondary markets, primary market flows dominate, and traditional investors are biased to hold these short-term obligations to maturity. Secondary markets in USCP and CD can prove fickle in the face of large liquidity events, similar to those faced by US prime MMFs in March 2020. At that time dealers faced heavy demand to provide liquidity across multiple asset classes (including money markets) with limited balance sheets. Ultimately, the intervention of Federal Reserve via targeted programs was needed to normalize markets.

If a stablecoin reserve liquidity event did occur, it seems unlikely the Fed would intervene in the interest of an unregulated off-shore entity, unless it perceived that the liquidation was a systemic risk to the US financial markets or the economy more broadly. Any reserve liquidation via secondary markets would face an uncertain level of market demand. The threat of a forced sale by a large CP holder could possibly bleed into CP markets if participants thought liquidations could overwhelm secondary market depth, and ultimately impact the primary markets suchthat banks and non-banks would be challenged to fund in CP. The result could be broadly higher CP yields and wider FRA-OIS.

Absent the Fed, the magnitude of the liquidation and its impact on the short-term funding markets largely depends on the willingness of the market to provide liquidity. The latter is usually influenced by the credit of the CP issuer, term and price. In a liquidity event isolated to stablecoin issuers, it’s not impossible that other CP buyers might step in to take advantage of the dislocations in the market for credits where they are active, similar to the events of 2016 when MMF reforms were implemented. Of course, there are times when liquidity events are more widespread and access to liquidity cannot be found. In 2007, a group of prime-like funds (“cash plus” or “enhanced cash”) that held illiquid securitized debt, found themselves unable to sufficiently liquidate positions and instead distributed pro-rata shares of their portfolios in lieu of cash. In this case, many fund shareholders wound up holding the securities (predominantly securitized products with multi-year maturities) until maturity. In the extreme where liquidity is needed but unavailable, a stressed cryptocurrency manager could conceivably seek a similar remedy, depending on its rights undergoverning law.

In any case, without more transparency into USDT’s reserve portfolio, the extent of risks USDT and others pose to the US money markets and the broader financial markets is unclear. But as a general matter these considerations highlight the financial stability concern presented by a large and growing crop of stablecoins.

It is worth noting that the liquidity transformation offered by stablecoins is nothing new and can certainly be done in a way that mitigates these risks. Banks of course have used demand deposits to fund illiquid loan portfolios for centuries, and more recently, money market funds and other shadow banking entities collected by the Federal Reserve Bank of New York suggest primary dealer inventories of CP rarely exceeded $10-15bn over the past five years, but peaked out around $27bn during the most acute phase of the COVID market shock. Banks are generally subject to a higher level of scrutiny and disclosure owing to the fact that their liabilities are used as a medium of exchange as well as a store of value. In other words, their activity leads to the creation and destruction of the credit money that dominates the overall money supply. That makes banks de facto systemically important—hence the introduction of federal deposit insurance in 1934. This leaves stablecoins in something of a conceptual middle ground between deposits and money market fund shares: utilized for some selective forms of payment (for now, at least) but mostly a more liquid claim on a pool of securities (ideally short term and high quality). Without federal insurance, that means there is an argument for their reserve holdings to be subject to more stringent requirements than 2a-7 funds. But regardless of where regulators ultimately fall in their treatment of this new asset class, presumably they will impose liquidity and asset quality requirements as well as a combination of regular, standardized and more extensive disclosure. Though their decentralized nature does not necessarily allow for these to be imposed directly, in principle they can be implemented through the domestic commercial banking system, which is currently acting either custodian orcorrespondent to these issuers.

What does that mean for markets? It seems plausible that the stablecoin market would survive the types of regulations described above. Since most of the larger tokens do not earn interest, it is unlikely they are viewed primarily as an investment vehicle rather than simply a more efficient and crypto-native global settlement system for U.S. dollars and other major currencies. One important impact of greater oversight would presumably be more ease accessing the domestic commercial banking system. That presumes, however, that large banks would be willing to hold the substantial and likely growing non-operational deposits associated with reserve funds. Unless and until the Fed has a much smaller balance sheet and/or there are substantial changes to bank regulations, that seems unlikely. Even so, non-bank endusers may increasingly see stablecoins as a viable alternative to bank deposits or money market fund shares, although most mainstream institutional liquidity managers face constraints that will preclude stablecoin ownershipin the near future. The most likely result would be a new entrant to the already crowded market for short-term investments—a new entrant that is modest in size for now, but with the demonstrated potential to grow.

Regulate them out of existence. Crypto is sub-prime currency backed by sub-prime stablecoins, backed by sub-prime commercial paper, backed by sub-prime fiat currency, backed by god only knows which government.

This is leverage upon leverage upon leverage upon leverage upon leverage based upon nothing more than blockchain voodoo then hilariously repackaged as sound money.

In short, crypto is an empty synthetic currency CDO and it is going to end in complete disaster.

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