The cryptocurrency market has quickly expanded in recent years, potentially posing stability risks to the larger financial system. As the market continues to grow, a new working paper by Federal Reserve System researchers investigates how investors in a form of cryptocurrency known as stablecoins react to “shocks” – unexpected events in the crypto market.

It’s critical to know that now, before the stablecoin market becomes large enough to have broader impacts on financial stability, said Christina Wang, a paper co-author and a senior economist and policy advisor in the Boston Fed’s Research Department.

“We definitely want to understand these dynamics as well as we can before … (stablecoins) gain even more scale, to help build a solid foundation for any regulatory considerations,” she said.

The working paper, “Runs and Flights to Safety: Are Stablecoins the New Money Market Funds?”, was written by researchers at the Federal Reserve Banks of Boston and New York and UMass Amherst. It compares stablecoin investor behavior during recent periods of stress to how money market fund investors reacted during the 2008 financial crisis and the 2020 onset of COVID-19.

If a stablecoin is the subject of an investor run, it can be rapidly liquidated, said Mattia Landoni, a senior economist in the Boston Fed’s Supervision, Regulation & Credit department.

“Very large pools of assets being liquidated very quickly is one of the things that financial stability regulators are always concerned about,” he said.

The researchers found that stablecoin investors react similarly to money market fund investors, as they tend to “run” from riskier stablecoins following negative shocks and move toward stablecoins they perceive as “safer.” But what’s considered safe depends on what type of shock it is.

What are stablecoins and money market mutual funds?

The value of many popular cryptocurrencies including Bitcoin is highly volatile. But stablecoins aim to keep a stable price – usually pegged to the U.S. dollar, the authors write. 

Some stablecoins are backed by financial assets that have little credit or liquidity risks, such as bank deposits and U.S. Treasuries. Theoretically, that means they are not prone to sharp fluctuations in price. The authors say that asset-backed stablecoins issued by U.S. based entities are generally considered less risky than non-U.S.-based, or “offshore,” asset-backed stablecoins. That’s because offshore stablecoins are often partially backed by riskier assets, such as commercial paper, precious metals, and sometimes other cryptocurrencies.

Most money market mutual funds also seek to maintain a stable price. But unlike cryptocurrencies, these mutual funds are registered with the U.S. Securities and Exchange Commission and are typically sponsored by large banks or “fund families” under one investment company, the paper says.

Co-author Antoine Malfroy-Camine, a senior risk analyst at the Boston Fed, said stablecoins and money market funds may seem different, “but we see that they experience very similar investor run and flight-to-safety dynamics during periods of stress in their respective markets.”

Findings: Investors flee from “riskier” stablecoins after negative shocks

The researchers used CoinGecko, a website that aggregates cryptocurrency data, to gather daily price information on 12 stablecoins from Jan. 1, 2021, to March 15, 2023. During this period, stablecoin Terra collapsed, and there was also a run on stablecoin USDC.

Using the daily data, they calculated the circulation of each of the 12 stablecoins, and they estimated the changes in the circulating supply of each coin, or their “flows.” They found that investors tend to move away from stablecoins they perceive as riskier following negative shocks and flow toward “safer” ones. This pattern is consistent with investor behavior in money market funds following the 2008 financial crisis and the start of the COVID-19 pandemic in 2020, the researchers say.

They also found that what makes a stablecoin “safer” depends on the type of shock. For example, when Silicon Valley Bank failed in March 2023, investors rushed to move their funds out of USDC, a U.S.-based stablecoin that held part of its cash at the bank. The researchers found that outflows from USDC likely went to two offshore stablecoins, even though they are generally considered to be “riskier.” But given the specific nature of this shock, including the fact it was sparked by a U.S. bank, it made sense for investors to shift toward offshore stablecoins, Wang said.

How far must the value of a stablecoin fall for investors to run?

The researchers found that investor shifts towards safety tend to occur between stablecoins in the same blockchain, as they do within money market fund “families,” or investment platforms. Wang said keeping transactions in the same blockchain is similar to moving assets between funds within the same bank or investment company, which tends to be faster and less costly than transferring them to other platforms.

“For investors who really want to move their money, speed is of paramount importance,” she said.

The researchers also determined that when a stablecoin pegged at $1 drops to 99 cents, it hits its “depegging threshold”– the value it needs to hit to spark investor runs.

“In money market funds, specific (depegging) thresholds have roots in regulation, whereas the threshold for stablecoins was unclear,” Wang said. “So, this was a useful exercise.”

Read the full paper on bostonfed.org.