A stablecoin collapse could spill over into the US bond market: Academic

The nearly $1.4 trillion collapse of the crypto market in 2022 has not made a dent for traditional assets like stocks or for the real economy.

But an academic has warned that the failure of a major stablecoin could have an impact on the US bond market, marking a potentially new area that investors should keep an eye on as contagion continues to spread across the sector.

Stablecoins are a type of digital currency that is supposed to be pegged one-to-one to a fiat currency such as the US dollar or the Euro. Examples are tether (USDT), USD coin (USDC) and Binance USD (BUSD), the three largest stablecoins.

These kinds of coins have become the backbone of the crypto economy, allowing people to trade in and out of various cryptocurrencies without having to convert their money into fiat.

Issuers of those stablecoins say they are backed by real assets such as fiat currency or bonds, allowing users to exchange their token one-for-one for a real asset.

Tether says more than 58% of its reserves are held in US Treasury Bills worth about $39.7 billion. Circle, the company behind USDC, has approximately $12.7 billion in government bonds in reserve. Paxos, which issues BUSD, said it has about $6 billion in US Treasury bills. All of these numbers come from the companies’ latest reports released in November.

But while there are no signs of major stablecoins collapsing, Eswar Prasad, an economics professor at Cornell University, said it is something regulators he has spoken to are concerned about because of the impact it could have on traditional financial markets. That’s because a possible run on a stablecoin – where large groups of users want to exchange their digital currency for fiat – would mean the issuer would have to sell the assets in its reserve. That could mean dumping large amounts of US Treasuries.

“And I think [the] the concern from regulators is that if confidence in stablecoins were to disappear… you could get a wave of redemptions, which in turn will mean the stablecoin issuers have to buy back their holdings of treasury bills,” Prasad told CNBC at the Crypto Finance Conference in St. Moritz, Switzerland, this week.

“And a large number of redemptions, even in a fairly liquid market, can cause turmoil in the underlying securities market. And given the importance of the Treasury market to the broader US financial system…I think regulators are right to be concerned. “

Prasad advises regulators around the world on policies related to cryptocurrencies.

The academic warned that if such a run happened when bond market sentiment is “very fragile as it is in the US right now,” there could be a “multiplier effect” thanks to major selling pressure on government bonds.

“If you have a big wave of redemptions, that can really hurt liquidity in that market,” Prasad said.

The Federal Reserve raised interest rates several times in 2022 and is expected to continue doing so this year to contain rampant inflation. The US bond market had its worst year ever in 2022.

Stablecoins account for about $145 billion worth of the $881 billion the entire cryptocurrency market is worth, so they are significant. And there have already been failures.

Last year, a coin called terraUSD collapsed. It was called an algorithmic stablecoin, so named because it maintained its one-to-one peg to the US dollar through an algorithm. It was not fully backed by real assets such as bonds such as USDC, BUSD and USDT. The algorithm failed and terraUSD crashed sending shock waves across the crypto market.

The US Federal Reserve also warned in a May 2022 report that “stablecoins remain prone to runs, and many bond and bank loan mutual funds remain vulnerable to redemption risks.”

Bill Tai, a well-known venture capitalist and veteran of the crypto industry, said he doesn’t think there will be a collapse of any of the major stablecoins, but said research into this type of cryptocurrency “has increased for a reason”.

“I think just like in our traditional finance industry, where people were caught off guard by hidden contagion within the subprime market during the great financial crisis, there could be a few pockets of leverage on some of the assets that claim to support stablecoin,” Tai told CNBC in an interview on Thursday.

Tai compared a potential stablecoin blowout to a surprise event like the subprime mortgage crisis, which began in 2007. Lenders offered mortgages to borrowers with poor credit, leading to defaults and contributing to the financial crisis. It came as somewhat of a surprise.

“And if one of those (stablecoins) goes down, there will be another downdraft,” Tai added.