US Federal Reserve Banks Warn of Potential Financial Instability Risks Associated with Stablecoins

On September 26, the Federal Reserve Banks of Boston and New York jointly released an insightful staff report, titled “Runs and Flights to Safety: Are Stablecoins the New Money Market Funds?” The report delves into a thought-provoking comparison between stablecoins like Tether (USDT) and USD Coin (USDC) and traditional money market funds. Within its pages, the report presents some significant findings, which raise important concerns about the potential for instability within the broader financial system due to stablecoins.

One of the standout discoveries highlighted in the report is the striking resemblance in investor behavior between stablecoin runs observed in 2022 and 2023 and the historical runs on money market funds during the turbulent financial years of 2008 and 2020. This observation suggests that stablecoins may share certain characteristics with money market funds, particularly during periods of market stress.

The report’s authors draw a rather sobering conclusion, asserting that stablecoins could introduce instability into the wider financial ecosystem, especially if they continue to expand and establish deeper connections with critical financial markets such as short-term funding markets. The concern lies in the potential for stablecoins to trigger runs, where investors scramble to redeem their holdings, possibly leading to a cascading effect that could result in asset devaluation and turmoil for remaining investors.

One of the pivotal insights from the report is the identification of a crucial threshold for stablecoins. It appears that stablecoins face a “break-the-buck” moment when their value slips below $0.99. This breach prompts a surge in redemptions and the possibility of runs, akin to the critical moment when the net asset value of a money market fund drops below a dollar. In such cases, investors may see their shares, which are typically valued at $1, dip below market price, compelling them to seek safer investment options.

The report also draws attention to international efforts aimed at addressing the potential risks associated with stablecoins. Italy’s central bank, for instance, has taken proactive steps to identify contributing factors and mitigate the risk of stablecoin runs. Citing the collapse of Terra in 2022 as a stark example, the Italian banking authority underscored that stablecoins have, on occasion, proven to be anything but stable.

Furthermore, Italy has advocated for the establishment of an international regulatory body to oversee cryptocurrencies, stablecoins, and related technologies. This call for global cooperation underscores the growing recognition among authorities worldwide that the stability and security of the financial system demand a coordinated effort to manage the evolving landscape of digital assets.

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