Why Cryptocurrencies’ Recent Swoon Holds Limited Impacts for Stocks

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This year may feel like one blow after another. Russia’s brutal war in Ukraine and China’s lockdowns extending supply chain havoc have ramped inflation higher and longer than we initially expected. This has central banks attempting to rein it in more aggressively, roiling sentiment. While this has affected markets broadly, it dramatically hit one asset last week: stablecoins, cryptocurrencies designed to maintain fixed values against currencies like the dollar. One collapsed spectacularly, sparking broader fallout in the crypto world—and seemingly putting other stablecoins on the brink. This spurred fears of a crypto-Lehman moment, with broader market ramifications. While possible, and we are watching for contagion effects, it doesn’t seem likely to us.

The headling-grabbing collapsed stablecoin was TerraUSD (UST), which claimed a one-to-one exchange rate with the dollar. But unlike most stablecoins, it didn’t hold any cash equivalents or traditional securities to back it. Instead, UST was backed—or, to use its lingo, “algorithmically stabilized”—by a sister token named Luna, which was free-floating. As Luna got caught up in the broader crypto selloff, it sparked a flight from UST, culminating in huge sales on May 7 that caused liquidity to vanish.^[i] The peg broke, and both Terra and Luna collapsed.

This scenario essentially fulfills long-running warnings—including from regulators—that stablecoins are inherently unstable. To anyone familiar with currency pegs and money market funds (MMFs), the potential paradox likely looked familiar. To credibly fix the value of a currency unit or MMF share to $1, for example, the underlying assets backing them should at least equal what the pegged currency or MMF in question claims. If they aren’t fully reserved or even over-collateralized, then a pegged-currency or MMF holder may not be able to redeem them and get the amount promised back, rendering them subject to a quasi-bank run. This makes them vulnerable to volatility in their underlying reserve assets. There is a long history of pegs breaking amid such pressure—it isn’t new to stablecoins.

Hence, as we wrote when we discussed stablecoins previously:

“... currency pegs are made to be broken. Neither they nor money market funds have proven particularly adept at maintaining a fixed value during times of high stress—when you may want them to most—and those are in regulated areas. In our view, it isn’t impossible that doubts about their claimed stability could lead to a crypto-version of a bank run (without a crypto-central bank as lender of last resort), resulting in a not-so-stable price crash.”

That is almost exactly what happened to UST. Other stablecoins—and their backing arrangements—are now under the microscope. Time will tell if UST was just a one-off or the tip of the stablecoin iceberg. That said, we don’t see many noteworthy implications for markets broadly. Although the crypto downturn has coincided with stocks’, we don’t think A has caused B. Rather, they both have gotten hit simultaneously with negative sentiment. We wouldn’t read anything more into it. There is very little fundamentally linking them.

Now, that doesn’t mean there is no transmission mechanism from the cryptorealm—as we have also explored before, public companies’ acquisition of cryptocurrencies on their balance sheets could impact some stocks. Many have taken severe hits over the last week. But outside of a few like Coinbase and Microstrategy, firms’ crypto exposure tends to be pretty small and limited to things like brokerage services or relatively meager crypto holdings compared to their core businesses and balance sheets. Most firms have steered clear of crypto overall. Corporate stablecoin exposure is tinier still.

So as headlines blare, keep perspective. Since cryptocurrencies’ peak last November, they have shed around $1 trillion in market capitalization.^[ii] That may sound big, but economic activity, like GDP, is an annual flow. That $1 trillion figure is cumulative. How much of that translates into lost economic activity? According to industry reports, crypto M&A and fundraising was $89.3 billion in 2021.^[iii] If that all goes to zero, which we presume it won’t, the impact on $103.9 trillion global GDP the IMF estimates in 2022 would be a rounding error.^[iv]

Only a small fraction of business is conducted through cryptocurrency. The likelihood of a run that spreads to other more mainstream markets or the global economy is exceedingly low. The global financial system and major banking institutions don’t have any great exposure, much less substantial leverage tied to cryptocurrencies or stablecoins. Crypto-asset derivatives trading on regulated exchanges amount to only around $50 billion—a tiny sliver against the trillions in financial contracts that trade daily.^[v] Far more crypto-asset transactions take place on unregulated exchanges, but because they are unregulated, linkages with financial institutions are limited—they simply aren’t set up for it, not least because of legal and compliance restrictions. Although traditional banks and brokerages have dabbled with cryptocurrencies and their underlying blockchain technology, with some fielding research experiments and undertaking tests and trials, wholesale adoption is far from widespread. Popular and practical use cases beyond speculation have yet to emerge, one reason sentiment swings can have such a large effect on crypto assets.

So what is driving the crypto-downturn today? In our view, it is sentiment—the same factor that has underpinned broader market weakness to start the year, only amped higher by crypto’s speculative nature and technical factors involving stablecoins. But we don’t see much here that suggests it is a worrisome sign volatility will continue or worsen.