The Crumbling Wall between Crypto and Non-crypto Markets: Risk Transmission through Stablecoins

Abstract

The crypto and non-crypto markets used to be separate from each other. However, we argue that risks are now being transmitted across the two markets via stablecoins, which are pegged to dollars and hold a crucial role in crypto trading. We employ a theoretical framework to demonstrate that the risks originating from the dollar market are shifted to cryptocurrencies through changes in stablecoins’ token supply, and risks originating from cryptocurrencies could be shifted to the dollar market by adjustments in stablecoins’ dollar reserves. Moreover, the risk transmission could be asymmetric, when stablecoins have ample reserves to effectively absorb all initial shock from the crypto market but are unable to hedge against the shocks from the dollar market. Employing copula-based CoVaR approaches, we provide empirical evidence consistent with the model predictions.

Keywords: cryptocurrencies, stablecoins, risk spillover, risk transmission

JEL Classification: G12, G20,G01