The downfall of cryptocurrency giants this year has reignited questions about the stability of cryptocurrencies and their impact on the fiat ecosystem. The Hong Kong Monetary Authority (HKMA) has assessed the situation and found that instability in crypto assets, including asset-backed stablecoins, could spill over into the traditional financial system.

Monetary Authority Evaluate Research on asset-backed stablecoins points to the risk of a liquidity mismatch, negatively impacting their stability during “fire-sale” events. The sell-off event is associated with momentary price swings when investors can buy stablecoins at a discount to the market price — a phenomenon noted during the Terra (LUNA) crash.

According to Hong Kong’s central bank, the interconnectedness of crypto assets makes the crypto ecosystem more vulnerable to systemic shocks. Furthermore, the increased exposure of financial institutions to cryptocurrencies may be affected by the shock effect of sudden developments in cryptocurrency prices:

“The growing size of asset-backed stablecoins, combined with their inherent risks, could make asset-backed stablecoins a potential amplifying factor for volatility spillovers from cryptocurrencies to traditional financial assets.”

The flow chart shared by the HKMA suggests that fluctuations in the price of asset-backed stablecoins could lead to stablecoin adjustment provisions. This is largely due to the assumption that the demand and supply of stablecoins triggers fluctuations in their prices.

An illustration of Tether’s transaction mechanics and spillover channels from cryptocurrencies to traditional financial assets.Source: HKMA

The research also reviewed the collapse of Terra USD (UST), an algorithmic stablecoin issued by Terraform Labs, which led to a massive redemption of Tether (USDT). With this in mind, the MAS proposes to standardize regular disclosures to help regulators check liquidity conditions and risks.

The second recommendation to regulators is to strengthen liquidity management for asset-backed stablecoins by limiting the composition of reserve assets.

related: Could Hong Kong Really Be China’s Proxy in Crypto?

Hong Kong’s Securities and Futures Commission recommends that managers seeking to offer exchange-traded fund (ETF) products “have a good track record of regulatory compliance,” among other requirements.

The SFC announcement is part of a policy update from the Hong Kong government, which announced its readiness to engage with global cryptocurrency exchanges on regulatory issues.