What forex markets can teach us about unstable stablecoins

Almost all financial markets have been under pressure in recent months. However, crypto assets have had a particular tough time in 2022. The best-known cryptocurrency, Bitcoin, is down around 40% year-to-date and nearly 60% from its peak.

Acute crypto volatility is nothing new, but the interesting action recently has been in so-called stablecoins. These are designed to have a relative value that is fixed to underlying reference assets (normally, but not always, the US dollar). As we saw last week though, these assets can prove anything by stable.

TerraUSD, the third-largest stablecoin by market cap until a week ago, slumped to the point where it is now essentially worthless. Tether and USDCoin, the two largest stablecoins, wobbled but have so far held firm.

Lessons from forex markets

There are useful parallels here with the more pedestrian world of foreign exchange. Attempts to fix the value of one currency to another are as old as the hills.

Stablecoins can be divided into three broad categories:

• Fiat-collateralised stablecoins: these are asset-backed with dollar cash or near-cash equivalents
• Crypto-collateralised stablecoins: rather than fiat currencies, these coins are collateralised with other cryptocurrencies. Given the volatile track record of these assets, they are typically overcollateralised
• Algorithmic stablecoins: while these coins may also be backed by collateral, their value is primarily controlled by an algorithm that controls supply of the coin

TerraUSD is one example of an algorithmic stablecoin, while Tether and USDCoin are both fiat-collateralised. Just as stablecoins differ in design, fixed exchange rate regimes also come in a number of forms:

• Legislative approaches: Some countries or regions have legal mandates that require the central bank to match any local currency issued with foreign assets. Hong Kong is one example.
• Reactive approaches: Other countries maintain currency stability through regular intervention. One example is the Saudi Riyal, which is effectively supported by oil revenues

Some of those pegs are incredibly stable: the Hong Kong dollar and Saudi Riyal have been pegged to the US dollar since the 1980s, and the Danish kroner has been pegged to the Euro since the 1990s. But currency pegs also sometimes fail, as happened in Lebanon last year, with the currency losing more than 90% of its value as a result of the financial crisis in the country. Closer to home, the British pound’s peg to the German Deutschemark collapsed on Black Wednesday in 1992.

The lesson from currency crises is that acute confidence shocks can be self-reinforcing and a credible and transparent institutional framework is the best way to guard against speculative attack.

Those were also the messages from the US Federal Reserve’s Financial Stability Report published at the beginning of May: “stablecoins remain prone to runs” as they are “backed by assets that may lose value or become illiquid during stress… these vulnerabilities may be exacerbated by a lack of transparency”.

Spillover effects?

Should we care about this latest bout of cypto volatility? We are looking for signs of spillover in the commercial paper (CP) market, given that asset-backed stablecoins are backed by something in the region of $100 billion of short-dated assets issues by companies and governments.

It is not exactly reassuring when those associated with asset-backed stablecoins decline to give many details of the composition of their holdings because of not wanting to reveal their “secret sauce”.

So far, we’ve seen some stress in CP markets, but nothing that looks out of kilter with the broader softening in the credit markets that has taken corporate bond spreads to their widest levels since early 2020.

The stress in stablecoins, and cryptocurrencies more broadly, looks to be a symptom of the broader tightening in financial conditions rather than an additional cause. The asset class is probably not yet big enough to be an accelerant of stress, but the argument that such assets can provide a port in a storm has been found wanting in recent months.

All data are sourced from Bloomberg as at 19 May, unless otherwise stated.