How a crypto crash could spread to Treasury bonds and other fixed-income securities

The study’s findings are surprising, since there was no obvious contagion in early May from the collapse of TerraUSD USTUSD, -25.60% /LUNA LUNAUSD, -10.71 to the fixed-income market generally. This led many who had been worried about possible contagion to breathe a sigh of relief.

We shouldn’t be breathing easier, according to the new study. The TerraUSD-LUNA debacle tells us nothing about the impact of a sudden decline in bitcoin BTCUSD, -2.44% or other large cryptocurrency, Kim told me in an interview.

To understand what the study found, it’s helpful to distinguish between the different kinds of cryptocurrencies:

• Fiat cryptocurrencies. This category includes the thousands of blockchain-based coins that are not backed by any collateral. Bitcoin, ethereum ETHUSD, -4.06%, binance coin XTZS, -8.05%, shiba inu SHIBUSD, -1.59, and dogecoin DOGEUSD, +6.09% are among the better-known fiat cryptocurrencies. Their prices fluctuate with supply and demand.
• Stablecoins. These are cryptocurrencies designed to maintain a constant value, such as $1 U.S. dollar. Crucially, there are two different types of stablecoins:
• Algorithmic stablecoins. These stablecoins maintain their value according to an algorithmic relationship to other cryptocurrencies. 
• Collateralized stablecoins. These stablecoins maintain their value by being backed by non-crypto assets, such as commercial paper and U.S. Treasury securities.

The channel that contagion would follow from, for example, a bitcoin crash to the financial markets generally would be via collateralized stablecoins, Kim told me. Three-quarters of the time when investors buy or sell a fiat cryptocurrency, a stablecoin is on the other side of the transaction. And Tether and USD Coin USDCUSD, together account for more than 80% of the total market capitalization of all stablecoins.

Specifically, the causal chain would operate as follows:

1. Bitcoin and other large cryptocurrencies would fall in price as investors sell.
2. The market cap of collateralized stable coins would increase as investors park the proceeds of their sales.
3. The managers of the collateralized stablecoins would need to purchase the necessary collateral to back their increased market cap — most prominently, commercial paper and U.S. Treasury securities.
4. This would cause the price of that collateral to increase and their yields to fall.

This causal chain isn’t just hypothetical. Kim closely analyzed daily changes in the market caps of cryptocurrencies, collateralized stablecoins, the commercial paper market, and commercial paper and Treasury yields, and found that they are correlated to each to a statistically significant extent.

To illustrate the magnitude of the contagion, Kim estimated what could happen to commercial paper and Treasury yields if the three largest fiat cryptocurrencies suffered a one-day decline in the 5% to 10% range. That’s big, but hardly rare. If cryptocurrency holders were to panic, which by no means is out of the question, these fiat cryptocurrencies could experience a much bigger one-day decline.

Nevertheless, Kim estimates that a 5% to 10% daily decline in the largest cryptocurrencies would cause commercial paper yields the next day to fall 20 basis points and Treasury yields by 17 basis points — with their prices falling by a corresponding extent. Those are big changes for a single day, and we should all sit up and take notice.

Why no contagion from TerraUSD/LUNA?

Kim’s analysis therefore helps us understand why there was no contagion from the collapse of TerraUSD and LUNA: Since no financial market assets were being used to collateralize these algorithmic stablecoins, their collapse had little impact beyond those investing in them.

This isn’t Monday morning quarterbacking to point this out. In his research, which Kim completed before the TerraUSD/LUNA fiasco, he found no statistically significant correlation between changes in market cap of algorithmic stablecoins and the yields on commercial paper and U.S. Treasurys.

The bottom line? The financial markets’ muted reaction to the collapse of TerraUSD and LUNA provides false comfort. Like it or not, we’re all vulnerable to a crypto crash.

Mark Hulbert is a regular contributor to MarketWatch. His Hulbert Ratings tracks investment newsletters that pay a flat fee to be audited. He can be reached at markhulbertratings.com

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