Crypto has been around for quite some time, and it is widely considered as a good instrument for speculators, especially after its huge surge in 2021. But what about the possibility of contagion from the cryptocurrency markets to the broader financial system?
My basic view is that there’s not much, really, but there’s more than there used to be, and it will be a good sign for crypto if there is more contagion. If crypto is more tied up with traditional finance — if more investors own both bonds and crypto, if crypto provides financing for traditional businesses, etc. — then that will be a sign that crypto is important, but it will also increase the risks of crypto.
One popular theory of contagion is about stablecoins. Not algorithmic stablecoins, which try to be worth a dollar without holding any dollars, and which can crash to zero with surprisingly little impact on anything else, but “backed” stablecoins like Tether and USD Coin, which try to be worth a dollar by holding roughly $1 of dollar-denominated financial assets (commercial paper, Treasuries, bank deposits, etc.) for each $1 of stablecoins they issue. If there is a run on one of those stablecoins, then they will need to sell their underlying assets, which, if the coins are big enough, could cause the prices of those assets to go down.
When we discussed this, I wrote that “at a high level you could argue that Tether is one of the more important crypto projects in terms of having an effect on the real economy,” just because it purportedly buys so much commercial paper, meaning that it effectively lends billions of dollars to (presumably non-crypto) companies to fund their operations. On the other hand, lots of people have their doubts about Tether, in part because it bizarrely refuses to disclose much about its holdings, and because there is curiously little evidence about what Tether — which seems to be one of the world’s biggest buyers of commercial paper — actually buys.
In that vein, here is a new paper by Sang Rae Kim at Yale on “How the Cryptocurrency Market is Connected to the Financial Market”:
The cryptocurrency market is connected to the traditional financial market through reserve-backed stablecoins. A one standard deviation ($320 million) increase in the issuance of major stablecoins (Tether and USD Coin) on a given day results in a 10.7% increase in the commercial paper issuance quantity, a 20 basis point decrease in the commercial paper yield, and a 15 basis point decrease in the Treasury yield the following day. This shows that the exponential growth of stablecoins created an excess demand for short-term money-like safe assets such as commercial paper and Treasury. I also explore the fiat cryptocurrency market’s effect on the commercial paper market. A one standard deviation increase in the market capitalization growth of major fiat cryptocurrencies (Bitcoin, Binance Coin, and Ethereum) on a given day results in an 11.9% decrease in the commercial paper issuance quantity, a 20 basis point increase in the commercial paper yield, and a 18 basis point increase in the Treasury yield the following day. This result suggests that investors exchange stablecoins for fiat cryptocurrency when the fiat cryptocurrency market is doing well, lowering the demand for stablecoins and thus commercial paper.
Huh! A correlation between stablecoin issuance and commercial-paper issuance does suggest that, you know, the stablecoins hold commercial paper. Kim also “conduct[ed] an event study that studies the impact of Tether’s shift in their reserve management strategy away from holding commercial paper to holding Treasuries,” finding that “stablecoin issuers’ impact on the commercial paper market was significantly subdued following this strategy shift,” suggesting that the strategy shift was real.
On the other hand a 15 basis point effect on US Treasury yields seems like it might prove too much? Treasuries trade more than half a trillion dollars a day, and I don’t really believe that the demand for Tether has a big effect on the demand for Treasuries. (There may be some correlation: A flight to safety in crypto markets might mean more demand for stablecoins, while a flight to safety in traditional markets might mean more demand for Treasuries.) I guess when demand for stablecoins drives demand for US Treasuries, that’s when you’ll know that crypto has really arrived.