Market Observations


Market Observations Article
May 2022

Authors & Contributors

Has the recent collapse of the stablecoin UST and its crypto token twin LUNA seriously set back the rapidly expanding world of cryptocurrencies? Media moralizing notwithstanding, we believe that the Luna lapse represents a bug, not a feature, of stablecoins related to the organizing principle of its support mechanism. The steady value of one unit of UST to the US dollar was to be maintained by algorithmically purchasing (or selling) it when the price was below (or above) par with the matched dollar proceeds (or obligations) of the opposite transaction in the varying-value crypto token LUNA. However, relying on a varying-value token to support a stablecoin is akin to attempting to defend a fixed exchange rate with reserves made up entirely of the local-currency-denominated sovereign debt. At a time of stress, a run on the parity of the defended obligation triggers a run on the reserve asset. The price can only be reliably supported with a stock of assets valued outside the defense perimeter, which is why traditional reserve managers obsess about holding liquid hard currencies. Likewise, we believe investors should scrutinize the asset holdings of issuers of stablecoins more than the coding of their algorithms.

That said, the episode cast a considerable shadow, as investors withdrew from the asset class, lowering the market value of crypto tokens and the firms that hold and trade them, and we should draw as many lessons as possible. We offer three.

First, the price dynamics throughout the crypto complex show that contagion can be powerful, and they work through four main mechanisms.

1.       Forced Selling: The UST managers appear to have sold more varying-value tokens than LUNA, apparently Bitcoin, in defense of UST, depressing its price.

2.       Cross Hedging: Speculators wanting to capitalize on the price spiral of UST and LUNA took similar positions in other stablecoins and tokens, moving their prices even though they were bystanders to the original drama.

3.       Common Holders: Following standard risk management procedures, those suffering losses from UST and LUNA cut exposures to the other assets in their portfolios across the board, depressing values generally. For those investors using leverage, the need to post additional margin reinforced this mechanism. We believe the original wealth loss was probably significant enough to spill over to other, more traditional, asset classes.

4.      Common Reputations: Reputation damage to the UST/LUNA business model influenced investors’ perception of (and risk aversion toward) other stablecoins. This was probably worsened by information asymmetries that are rife in the market. Uninformed market participants took a signal from price declines in UST/LUNA driven by better informed participants fleeing from somewhere and fled themselves— from everywhere.

Related to that last aspect of contagion, the second lesson came when Tether (USDT) temporarily broke the buck, trading as low as 95 cents on the dollar, after large outflows when the standing of stablecoins slipped in investors’ esteem. If reserves are not liquid (and the opacity of Tether’s balance sheet does not help), then a run cannot be beaten back immediately. This experience has probably fed investors misgivings about stablecoins, lowering the hurdle for subsequent runs.

The third lesson is that progress toward a more stable financial system sometimes follows a bumpy road. After the drama of the past week, the private sector probably views the crypto complex more warily, which lowers values and adds to the volatility of prices therein. This is not obviously detrimental to financial stability. More importantly and of more lasting import, the crypto crash has likely energized official scrutiny of the sector. Here, again, this may be good for financial stability because official sluggishness, especially in the US and related to the fragmented and overlapping set-up of regulation, has been an impediment to progress. The Federal Reserve (Fed), for example, only issued a consultative document on central bank digital currency for public comment this January. Established firms take careful consideration when entering a market segment that could subsequentially made more hostile by regulation. The result is a proliferation of smaller and start-up participants encamped in the crypto landscape. It appears crypto is now a bigger bogy on the regulatory radar, perhaps ultimately bringing more order and opportunity when some flight controllers get on the job.



All investments involve risk, including the possible loss of principal. Certain investments have specific or unique risks. No investment strategy or risk management technique can guarantee returns or eliminate risk in any market environment. Past performance is no indication of future performance.

This material has been provided for informational purposes only and should not be construed as investment advice or a recommendation of any particular investment product, strategy, investment manager or account arrangement, and should not serve as a primary basis for investment decisions. Prospective investors should consult a legal, tax or financial professional in order to determine whether any investment product, strategy or service is appropriate for their particular circumstances. This document may not be used for the purpose of an offer or solicitation in any jurisdiction or in any circumstances in which such offer or solicitation is unlawful or not authorized. Views expressed are those of the author stated and do not reflect views of other managers or the firm overall. Views are current as of the date of this publication and subject to change. This information may contain projections or other forward-looking statements regarding future events, targets or expectations, and is only current as of the date indicated. There is no assurance that such events or expectations will be achieved, and actual results may be significantly different from that shown here. The information is based on current market conditions, which will fluctuate and may be superseded by subsequent market events or for other reasons. References to specific securities, asset classes and financial markets are for illustrative purposes only and are not intended to be, and should not be, interpreted as recommendations. Some information contained herein has been obtained from third party sources that are believed to be reliable, but the information has not been independently verified. No part of this material may be reproduced in any form, or referred to in any other publication, without express written permission.

Indices referred to herein are used for comparative and informational purposes only and have been selected because they are generally considered to be representative of certain markets. Comparisons to indices as benchmarks have limitations because indices have volatility and other material characteristics that may differ from the portfolio, investment or hedge to which they are compared. The providers of the indices referred to herein are not affiliated with Mellon Investments Corporation (MIC), do not endorse, sponsor, sell or promote the investment strategies or products mentioned herein and they make no representation regarding the advisability of investing in the products and strategies described herein.

Recent market risks include pandemic risks related to COVID-19. The effects of COVID-19 have contributed to increased volatility in global markets and will likely affect certain countries, companies, industries and market sectors more dramatically than others.

BNY Mellon Investment Management is one of the world’s leading investment management organizations encompassing BNY Mellon’s affiliated investment management firms and global distribution companies. BNY Mellon is the corporate brand of The Bank of New York Mellon Corporation and may also be used as a generic term to reference the Corporation as a whole or its various subsidiaries generally.

Mellon Investments Corporation (MIC) is a registered investment adviser and subsidiary of The Bank of New York Mellon Corporation (BNY Mellon). MIC is composed of two divisions: Mellon, which specializes in index management, and Dreyfus, which specializes in cash management and short duration strategies. Dreyfus is also a division of BNY Mellon Investment Adviser, Inc. (BNYMIA), a registered investment adviser.

Personnel of certain of our BNY Mellon affiliates may act as: (i) registered representatives of BNY Mellon Securities Corporation (in its capacity as a registered broker-dealer) to offer securities and certain bank-maintained collective investment funds, (ii) officers of The Bank of New York Mellon (a New York chartered bank) to offer bank-maintained collective investment funds, and (iii) Associated Persons of BNY Mellon Securities Corporation (in its capacity as a registered investment adviser) to offer separately managed accounts managed by BNY Mellon Investment Management firms.