BIS Report Establishes Links Between Stablecoin and FX Markets

Many words have been expended about the growing inter-connection between digital assets and FX markets, and there is little doubt that the two worlds will continue to intertwine from a market structure perspective, however a new paper from the Bank for International Settlements (BIS) claims to find direct links between FX market behaviour and activity in stablecoin markets.

The report, Stablecoin Flows and Spillovers to FX Markets, was authored by Iñaka Aldasoro from the BIS, alongside Paula Beltrán and Federico Grinberg from the IMF, looks at how the parallel, crypto-based, FX ecosystem is connected to traditional FX markets, and develops a model to explain how stablecoin demand in one country, can spill over to exchange rats and dollar funding globally.

The stablecoin industry is dominated by the US dollar, with other major currencies only just starting to see the green shoots of their own projects, and the paper observes that 70% of fiat-to-stablecoin conversions originate from non-US dollar markets. This has given rise to the parallel market identified by the authors, who use data from 64 exchanges around four stablecoins (USDT, USDC, DAI and BUSD) against 27 currencies, across a four-year span, to feed their model.

They find a gap between the cost of acquiring dollars via stablecoins and via the spot FX market (parity deviations) that sees a 1% exogenous increase in net stablecoin inflows raising parity deviations by 40 basis points. It also depreciates the local currency, and widens the dollar premium in synthetic funding markets (covered interest parity – or CIP – deviations).

The authors’ model of constrained arbitrage rationalises these findings and provides structural foundations for the identification strategy. The paper finds that counterfactual simulations show that halving cross-market frictions would attenuate CIP spillovers by roughly 50% and cut exchange rate effects by nearly one-third.

“A dynamic extension that closely matches the empirical impulse responses shows that spillovers grow disproportionately when intermediaries suffer losses, as depleted capital reduces their capacity to absorb further shocks,” the paper states. “Our results establish stablecoins as an emerging segment of global currency markets with direct implications for financial stability.”

As is often the case with the BIS, the paper is very focused upon potential lessons for policy makers, hence more importance is placed upon the impact of FX swap and funding markets. That said, it also argues that an improved regulatory environment, as well as improved on-ramp infrastructure, would have a positive effect and ease the threat of destabilisation in FX markets.

Equally, however, the authors note that tightening of arbitrageur constraints across all dollar funding venues could amplify cross-market transmission. There is also the question of the sheer pace of stablecoin market growth. “As demand elasticity rises with market maturation, the same flow shocks generate larger price responses, suggesting that spillover risks may increase as the market develops,” the authors warn.

Currently, the authors estimate the spillover ratio at approximately 0.15, although in emerging markets especially, this can rise dramatically, thus impacting FX swaps market users that do not interact in the crypto markets.

This link highlights two policy directions, the authors argue. First, they note that prudential requirements on stablecoin intermediaries, such as capital buffers, reserve liquidity mandates, and limits on concentrated currency exposures, would shrink the spillover channel at its source by reducing cross-market frictions and preserving risk-bearing capacity.

The paper also argues that policymakers responsible for currency stability, particularly in emerging markets, could consider incorporating stablecoin market monitoring into their macroprudential surveillance, since the transmission mechanism runs through balance sheets that also serve traditional FX swap markets. “Monitoring the evolution of the spillover ratio as stablecoin markets grow would provide an early warning indicator of Increasing interconnectedness,” they conclude.