The market for stablecoins – a type of crypto asset – has quickly expanded in recent years and become more intertwined with the traditional financial system. What does that mean for financial stability?

Kenechukwu Anadu, who co-leads a group focused on bank, non-bank, and financial stability risks, spoke with Six Hundred Atlantic about the potential impacts of stablecoins on the broader financial system. He discusses how stablecoins are different from other crypto assets, like Bitcoin, and just how fast they’ve grown. He also talks about his research into how stablecoin investors behave after a shock.

AMANDA BLANCO:

Hello, and thank you for joining us on this episode of Six Hundred Atlantic. I'm your host, Amanda Blanco, and today we're speaking with Ken Anadu. He is a vice president in Supervision, Regulation & Credit at the Boston Fed. Ken recently co-led a virtual conference with Marco Cipriani at the New York Fed on stablecoins and financial stability. And the question they're asking is, “How could stablecoins potentially impact the stability of the larger financial system?” Now, that's a big question, especially as stablecoins become increasingly popular. So, welcome, Ken, and thanks for joining us today.

KEN ANADU:

Thank you very much for having me on the show, Amanda.

AMANDA BLANCO:

Ken, let's start with the basics here. So, what do we mean when we talk about crypto assets?

KEN ANADU:

That's a wonderful question, Amanda. Before I delve into that, let me just note that the views I provide today are mine and, of course, not representative of the Federal Reserve Bank of Boston or the Federal Reserve system.

So, what's a crypto asset? Quite simply, a crypto asset is a digital asset that is created and transacted on the blockchain. And one can think about the blockchain as a shared digital ledger where transactions are recorded. The most popular crypto asset now is Bitcoin, which accounts for I think a little over 50% of the crypto asset space. Now, Bitcoins have been around for quite some time, but they're becoming increasingly popular. I think there's a variety of reasons for that, one of which is there are some like that you can transact in Bitcoins or other crypto assets without an intermediary, and there might be others that are buying crypto assets in part because they expect the price to increase in the future.

AMANDA BLANCO:

So, what exactly is a stablecoin and how is that different from other crypto assets like Bitcoin?

KEN ANADU:

A stablecoin is a type of crypto asset that seeks to maintain a stable price, usually $1. So unlike Bitcoins, which I just talked about, whose price is volatile, a stablecoin seeks to reduce that price volatility.

The most popular type of stablecoins seek to maintain a stable price by backing each of the tokens issued with reserves. Let me talk a little bit about how that works. So, a stablecoin issuer issues one token, and an investor buys the token, so obviously the stablecoin issuer gets $1. Then the stablecoin issuer uses that $1 to buy usually traditional financial assets, such as commercial paper or U.S. treasuries, to back that token that is issued. Now, the reverse happens if the investor wants their money back. So, they give the token to the stablecoin issuer, and they have to return the money.

AMANDA BLANCO:

And why would someone want a crypto asset that, unlike Bitcoin or other currencies that may be more volatile, why would they want something that's more stable?

KEN ANADU:

I think currently stablecoins are used primarily as a means to transact in other non-stablecoin crypto assets. So you can imagine, just hypothetically, an investor might be worried about the price of Bitcoin, for example, and they could sell Bitcoins and invest the proceeds into a stablecoin. And then down the line, if they think the price of Bitcoin is at the point where they might want to purchase it, then they sell the stablecoins and buy Bitcoins. So currently it's not used widely as a cash management vehicle but often used as a mechanism for trading other crypto assets.

AMANDA BLANCO:

I think that's really helpful, Ken, and I was also just kind of wondering why do researchers, including those at the Fed, why is this something researchers are looking into or that the Fed cares about? And how could stablecoins potentially impact the stability of the larger financial system?

KEN ANADU:

In the welcoming remarks for the conference that you alluded to, that Boston and New York organized, President Susan Collins, our Bank president, noted that one can think about stablecoins as a form of private money. And, of course, I agree with that. And history has shown that private money are susceptible to runs. And what I mean by that, you can think about just traditional bank runs. So, given that, it's important for us to understand what's driving the growth of stablecoins, how are they connected to the traditional financial system, and how could stresses in stablecoins impact the broader financial system and the real economy?

AMANDA BLANCO:

And how does that relate to why you decided to organize the recent conference with the New York Fed?

KEN ANADU:

So, we looked at the growth of stablecoins over the past couple of years, and one thing we realized is that since 2019, stablecoins' size has increased from less than $5 billion to about $160 billion.

AMANDA BLANCO:

Wow.

KEN ANADU:

So, if my math is correct, which is always dangerous, that's about 31 or 30 times, which is astronomical growth. So, my colleagues and I decided, let's write a paper on stablecoins just to try and understand what are they, what's driving this growth, and how could stresses at stablecoins impact the broader financial system? In doing this, we realized that there's a small but rising literature on stablecoins, which spans the gamut from past collapses of stablecoins, to how stablecoins transact and operate, and indeed to similarities and differences between stablecoins and other traditional financial products. Given this, we thought it would be useful to convene those researchers, regulators, and policymakers together just to better understand how this growth in stablecoins could impact the broader financial system and the real economy.

AMANDA BLANCO:

And can we say a little bit more about that paper you co-authored? You found parallels between investor behavior in stablecoins and traditional money market funds when they're hit by an unexpected event or a sudden shock. Can we talk a little bit about why this is important?

KEN ANADU:

Absolutely. And you're right. So, in our paper, first of all, taking a step back, in our paper, what we did was try to examine how investors in stablecoins react to broad-based shocks in the crypto industry and also to idiosyncratic shocks. That's shocks that are specific to stablecoins. One of the things that we found is that during periods of stress, investors in stablecoins that are perceived as more risky tend to pull their money out, and those stablecoins that are perceived as less risky tend to receive the money. So, that's what we call a flight to quality or flight to safety, for obvious reasons. And one of the interesting things about this finding is that these flight to safety dynamics are quite similar to what we've observed in certain traditional financial markets or financial products, such as money market funds.

And so why is this important? It's important because if we go back to money market funds and those runs, the runs from 2020 had implications to the short-term funding markets. So, you can imagine what would happen if that market shuts down unexpectedly. You could have severe stresses in that market, which is what we saw in 2020 until the official sector stepped in to create emergency lending programs. So, given that, we want to be attuned to what's happening in stablecoins, given their similarity between stablecoins and money market funds.

AMANDA BLANCO:

So, as we're talking about different types of stablecoins, I mean, given the name, you'd think they'd all be stable. So, what makes one coin more or less risky than the other? What factors play into that?

KEN ANADU:

That's a wonderful question, Amanda. Let me say two things. The first is when I described stablecoins, I said they attempt to maintain a stable price. Of course, we've seen some stablecoins collapse, so that clearly suggests that that is not always the case. And the second thing that I want to point out is that there are different types of stablecoins. There are some stablecoins that are not backed by anything at all. They're called algorithmic stablecoins, and they seek to maintain a stable price by a supply-demand matching algorithm.

And then on the other end of that spectrum are stablecoins that are collateralized or backed by primarily Treasury securities. So, in our work, we found that that difference matters. So, depending on the riskiness of the collateral, if at all, those that tended to have riskier or no collateral experience larger outflows, all else equal, than those that tended to have relatively less risky collateral.

AMANDA BLANCO:

Thank you for helping us understand that. Now, just thinking about your paper and the different topics that were discussed at the conference, what do you think the public really needs to better understand about stablecoins, and this space, and crypto assets?

KEN ANADU:

So, the three things that I will say is that first, as I've said before, is that the stablecoin industry is growing, and it's seen tremendous growth since 2019. The second is that the stablecoin industry is becoming increasingly interconnected with traditional financial markets. And then the third thing that I will flag is that, and this relates to the collapse of the then third-largest stablecoin in 2022, one of the papers from the conference found that investors in that stablecoin that were smaller and less sophisticated experienced larger losses than investors that were larger and more sophisticated. So, in my mind, this obviously raises questions about investor fairness, investor protection in this space.

AMANDA BLANCO:

And as we're looking towards the future of stablecoins and crypto assets in general, we hear so much about this industry really expanding. What do you think people should be aware of more broadly? Are risks overblown? Are there risks that are being taken too lightly?

KEN ANADU:

Yeah, that's a hard question. I generally try not to speculate or forecast. That's always dangerous. But what I will say is that in its most recent financial stability report, the Federal Reserve talked about stablecoins and two points were made. One was that stablecoins are runnable, which is something I said earlier. And then the second is that their size is quite small now, certainly relative to the traditional financial system or financial assets. So, in my mind, when I think about the relatively small size now, I think it dampens the degree to which serious issues at stablecoins right now will impact the broader financial system.

Another point to make, which I think is important, is that currently stablecoins, as I mentioned earlier, are used primarily as some means to transact in other crypto assets, so they're not used broadly as cash management vehicles. But having said that, they're growing. They're becoming more interconnected to the traditional financial system. So, we that think about financial stability need to be attuned to what could happen if this industry grows even larger and becomes even more intertwined with the traditional financial system. Could shocks in that world, in a world where they're much larger, could shocks have severe repercussions for the financial system? That's something that we are charged with trying to understand, and that's why we continue to monitor this space.

AMANDA BLANCO:

Well, thank you, Ken. The rise of cryptocurrency and its implications can certainly be a bit of a mystery, so it's really helpful for us to make sense of where things are. And I think it'll certainly be interesting to see how stablecoins continue to develop. So, thanks so much for taking the time to talk with us.

KEN ANADU:

Thank you so much, Amanda. I really enjoyed doing this. It was a lot of fun.

AMANDA BLANCO:

You can find more information on everything we discussed today on our website. Check out bostonfed.org/sixhundredatlantic, where you can listen to interviews, as well as our podcast seasons. You can also subscribe to our email list to stay up to date on new episodes. And don’t forget to rate, review, share, and subscribe to Six Hundred Atlantic on your favorite podcast app. I’m Amanda Blanco signing off on another episode of Six Hundred Atlantic. Thanks for listening.