Stablecoins’ untethering may prompt regulation: Fitch

The failure of two prominent stablecoins to maintain their pegs to the U.S. dollar highlights the risk of the crypto sector and may intensify calls for regulation, says Fitch Ratings.

In a new report, the rating agency said that recent trouble in a couple of major stablecoins — Terra and Tether — which both lost their currency pegs, exposed the risks faced by investors.

Both episodes, “highlight the fragile nature of private stablecoins, and will accelerate calls for regulation,” Fitch said.

To date, so-called algorithmic stablecoins (such as Terra) have faced particular regulatory skepticism, Fitch noted, given the challenges they face in maintaining their value.

Recently, Terra’s algorithmic peg failed as, “the backing entity’s crypto reserve was not sufficiently large to serve as a source of stability when [Terra’s] algorithmic peg mechanism came under speculative pressure,” Fitch explained, adding that the failure of Terra’s peg, “sent shocks through the decentralised finance (defi) sector…”

Indeed, in the wake of that event, a more conventionally-pegged stablecoin, Tether, also saw its value deviate from its U.S. dollar peg.

“There could be significant negative repercussions for cryptocurrencies and digital finance if investors lose confidence in stablecoins,” Fitch said.

“Bouts of volatility will probably continue as the crypto sector digests the repercussions of the failure of the [Terra] peg, and as U.S. policy rate increases and equity volatility pressure high-beta assets,” it noted.

As for the effects on traditional financial markets, at this point, the links between crypto markets and regulated financial markets “remain weak” Fitch said — which limits the risk of crypto volatility spreading to the mainstream markets and causing financial instability.

“However, many regulated financial entities have increased their exposure to cryptocurrencies, defi and other forms of digital finance in recent months, and some Fitch-rated issuers could be affected if crypto market volatility becomes severe,” it noted. “There is also a risk of an impact on the real economy, for example through negative wealth effects if crypto asset values fall steeply.”

James Langton

James is a senior reporter for Advisor.ca and its sister publication, Investment Executive. He has been reporting on regulation, securities law, industry news and more since 1994.