Volatility Spillover of Tether on Traditional Finance

April 20, 2023

How could the volatility of crypto assets, specifically asset-backed stablecoins spillover to the traditional financial system?

Recent study shows:

Tether becomes a stronger volatility transmitter against money market instruments when it shifts from small to large reserve adjustment, with the net volatility spillover rising noticeably from
positive 4.6% to positive 19.7%.

Large reserve adjustment by Tether could change Bitcoin from a net volatility receiver to a net transmitter against money market instruments, with the net volatility spillover changing from negative 6.5% to positive 5.2%.

For the US Treasury and equity, no noticeable increase in the net spillover from small to large reserve adjustment is found.

We are worried that in extreme circumstances, failures of stablecoins could result in large-scale redemptions and fire-sales of their reserve assets, potentially posing material impacts on the traditional financial system such as the money market.

What can we do to reduce the risks of such events happening amid the FTX and Alameda fallout?

Below are the solutions:

  • Standardized and regular disclosures on reserve assets holdings.
  • Improvements on stablecoin liquidity management by imposing restrictions on the composition of reserve assets and requiring well-defined redemption rights.