A stablecoin collapse could spill into the U.S. bond market and economy, professor warns

The near $1.4 trillion collapse of the crypto market in 2022 didn’t make a dent to traditional assets like stocks or to the real economy.

But one academic has warned that the failure of a major stablecoin could have an impact on the U.S. bond market, marking a potential new area that investors need to keep an eye on as contagion continues to spread across the industry.

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Stablecoins are a type of digital currency that is supposed to be pegged one-to-one with a fiat currency such as the U.S. dollar or the euro. Examples include tether (USDT), USD coin (USDC) and Binance USD (BUSD), which are the three biggest stablecoins.

Those kinds of coins have become the backbone of the crypto economy, allowing people to trade in and out of different cryptocurrencies without needing to convert their money to fiat.

Issuers of those stablecoins say they are backed by real assets such as fiat currency or bonds so that users can redeem their token one-for-one with a real asset.

Tether says that more than 58% of its reserves are held in U.S. Treasury Bills, accounting for around $39.7 billion. Circle, the company behind USDC, has around $12.7 billion worth of Treasurys in its reserve. Paxos, which issues BUSD, said it has around $6 billion of U.S. Treasury bills. All those figures are from the companies’ latest reports which were issued in November.

But while there are no signs of major stablecoins collapsing, Eswar Prasad, an economics professor at Cornell University, said it’s something regulators he’s spoken to are worried about because of the impact it could have on traditional financial markets. That’s because a potential run on a stablecoin — where large swathes of users look to redeem their digital currency for fiat — would mean the issuer has to sell off the assets in their reserve. That could mean dumping large amounts of U.S. Treasurys.

“And I think [the] concern of regulators is if there were to be a loss of confidence in stablecoins … then you could have a wave of redemptions, which will in turn mean that the stablecoin issuers have to redeem their holdings of Treasury securities,” Prasad told CNBC at the Crypto Finance Conference in St. Moritz, Switzerland, this week.

“And a large volume of redemptions even in a fairly liquid market can create turmoil in the underlying securities market. And given how important the Treasury securities market is to the broader financial system in the U.S. … I think regulators are rightly concerned.”

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

The academic warned that if such a run were to occur when bond market sentiment was “very fragile as it is in the U.S. right now,” there could be a “multiplier effect” thanks to large selling pressure on Treasurys.

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

The Federal Reserve hiked interest rates several times in 2022 and is expected to continue to do so this year as it looks to tame rampant inflation. The U.S bond market had its worst year on record in 2022.

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

Last year, a coin called terraUSD collapsed. It was dubbed an algorithmic stablecoin, so called because it maintained its one-to-one peg with the U.S. dollar via an algorithm. It was not backed in full by real assets such as bonds as USDC, BUSD and USDT are. The algorithm failed and terraUSD crashed, sending shock waves across the crypto market.

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

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

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

Tai likened a potential stablecoin blowup 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.