Terra, Tether & the Vulnerability to Runs.

Macro Perspectives

We talked yesterday about the crypto currency bubble. Bitcoin has more than halved, which is not unusual for its history…the bigger issue is the stablecoin universe.

Again, this is a couple of hundred billion dollars that were traded for private digital currencies, with the promise of remaining pegged to a currency (like the dollar) or asset (like gold). These pegs have broken.

A once $15 billion stablecoin called Terra now trades for 42 cents on the dollar. The biggest stablecoin is Tether ("tethered" to the U.S. dollar) - it too has broken the peg, trading as low as 95 cents on the dollar.

Interestingly, on Monday (May 9) the Fed released its annual report on Financial Stability. That same day, Terra broke the peg. On Tuesday, Janet Yellen (the Treasury Secretary) testified before the Senate Banking Committee…Tether broke the peg on Tuesday.

In the Fed report, among the vulnerabilities to the financial system that were cited:  "the vulnerability to runs" in the "rapidly growing stablecoin sector."

Guess what that triggered? Runs on stablecoins (i.e. mass simultaneous investor withdrawals/redemptions).

So, is this a threat to the financial system? Will there be contagion?

In the case of Tether, it doesn't hold its $80+ billion of liabilities in U.S. dollars in a bank. In fact, below is the breakdown of how the Tether liabilities ("reserves") are invested, based on their end of year 2021 independent accounting report.

They have about $40 billion of investments (including commercial paper, money market funds, secured loans and other digital currencies). This is like a shadow bank. It seems very likely that the company will have a difficult time recovering principal from these investments to return to Tether holders - if they see mass Tether redemptions.

The bigger problem is what a mass exodus of Tether's investments (all of that commercial paper, money market funds, etc.) might mean to the financial system.

It was a run on a money market fund back in 2008 that set off more similar runs across the money market universe, requiring the Fed to step in - they halted redemptions, and guaranteed the principal of money market funds. This risk seems to be what is adding significant weight on markets.

With all of the above in mind:

• The Japanese yen tends to behave like a safe haven in times of global uncertainty and economic/financial stress. Yesterday it was up 1%.

• Treasuries have bounced sharply the past three days (THE place for global capital flight when risk is elevated).

• The dollar made new 20-year highs today (the other hiding place for global capital in "risk-off" environments).

As we've discussed, when the Fed announced it's quantitative tightening plans, history tells us that unforeseen consequences will follow (something will break in the financial system). This may be it, in the making.

The good news: History also tells us that the Fed will respond (in such a case). With backstops, guarantees, more QE.  Whatever it takes. The easiest, first step for the Fed to take, to curtail any flare up in the financial system, might be to signal to markets that they will hold off on QT - take a wait and see approach.     

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