Hong Kong believes stablecoin volatility could spill over into traditional finance

Hong Kong believes stablecoin volatility could spill over into traditional finance

The fall of crypto giants this year raised questions about the stability of cryptocurrencies and their impact on fiat ecosystems. The Hong Kong Monetary Authority (HKMA) assessed the situation and found that the volatility of crypto-assets, including asset-backed stablecoins, could potentially spill over into the traditional financial system.

The HKMA assessment of asset-backed stablecoins pointed out the risk of liquidity mismatch, which adversely affected their stability during “fire sale” events. A fire sale event is related to a short-term price swing when investors can buy stablecoins cheaper than their market price – a phenomenon noticed during the Terra (LUNA) crash.

According to Hong Kong’s central bank, the linking of crypto assets has made the crypto ecosystem more vulnerable to systematic shocks. In addition, the increase in crypto exposure from financial institutions may be subject to knock-off effects from sudden developments in cryptocurrency prices:

“The increasing size of asset-backed stablecoins, together with their inherent risks, could make asset-backed stablecoins a potential magnifier of the volatility effect from crypto to traditional financial assets.”

The flowchart shared by the HKMA suggests that fluctuations in the price of asset-backed stablecoins may lead to reserve adjustment of stablecoins. This is mainly driven by the assumption that the demand and supply of stablecoins can trigger volatility in their prices.

Illustration of Tether’s transaction mechanism and spillover channel from crypto to traditional financial assets. Source: HKMA

The study also recalled the crash of Terra USD (UST), an algorithmic stable coin issued by Terraform Labs, which had caused mass redemptions of Tether (USDT). In this light, the HKMA recommended standardizing regular disclosures that can help regulators inspect liquidity conditions and risks.

The second recommendation to regulators is to strengthen the asset-backed stablecoins’ liquidity management via restrictions on the composition of reserve assets.

Related: Could Hong Kong really become China’s proxy in crypto?

The Securities and Futures Commission in Hong Kong advised management companies looking to offer exchange-traded funds (ETFs) to “have a good record of regulatory compliance”, among other requirements.

The SFC circular came as part of a policy update by the Hong Kong government, which announced its readiness to engage with global crypto exchanges on regulatory issues.