Stablecoins Could be Source of Financial Instability

In a recently published report by the United States Federal Reserve (Fed), titled “Runs and Flights to Safety: Are Stablecoins the New Money Market Funds?” the New York Fed draws comparisons between stablecoins and traditional money market funds. Money market funds typically refer to short-term, high-quality debt securities and cash equivalents, used by investors as liquid options for parking cash.

The report, released on September 25, claims that stablecoins may impact the broader financial system during times of market volatility. By analysing behaviour of investors in the stablecoin runs of 2022-2023 and comparing this to money market fund runs during the 2008 financial crisis and the 2020 Covid Pandemic, the Fed researchers found similar patterns. In all studied cases investors rushed to safety, from riskier to safer assets.

The Fed report highlights the collapse of the Terra stablecoin in 2022 and the failure of Silicon Valley Bank in 2023, along with the latter’s links to USDC, one of the most prominent stablecoins. After Terra Luna enjoyed stellar adoption, it lost 95% of its market capitalisation following the depegging event.

Break-the-Buck Threshold

The Fed suggests that when the price of a stablecoin declines to 99 cents, representing a 100-basis point drop from its $1 peg, investor redemptions notably increase, resembling the phenomenon observed in money market funds where the Net Asset Value (NAV) falls below $1, known as “breaking the buck.”

Fed Issued Guidelines

On August 8, the Fed issued a supervisory letter regarding state banks that are members of the United States Federal Reserve system and are dealing with stablecoins. Under the new directive, the banks were cautioned to obtain a written nonobjection from the Fed before interacting with stablecoins and crypto in general. The Fed stated:

“Based on the agencies’ current understanding and experience to date, the agencies believe that issuing or holding as principal crypto-assets (referring generally to any digital asset implemented using cryptographic techniques) that are issued, stored, or transferred on an open, public, and/or decentralized network, or similar system is highly likely to be inconsistent with safe and sound banking practices.”

Stablecoin Market to reach US $2.8Tn

Crypto research firm Bernstein Autonomous predicts the stablecoin market to reach US$2.8 trillion ($4.38 trillion) by 2028. Bernstein sees layer-2 chains such as Arbitrum, Optimism, Base and Polygon and layer-1 Solana delivering reduced transaction costs paired with scalability. Given that regulation is moving forward, they expect mainstream consumer demand to drive adoption. In a post, Gautam Chhugani from Bernstein wrote:

The Fed report concluded by stating that if stablecoins continue their expansion and further integrate with critical financial markets like short-term funding markets, they have the potential to pose a risk of financial instability to the wider financial system.