How stablecoins will impact foreign exchange markets

Stablecoins are likely to play an increasingly important role in currency markets and digital transactions.

They are already gaining traction. As of July 2024, the total market value of stablecoins has surpassed $160 billion USD.

Stablecoins are cryptocurrencies that maintain a peg to traditional fiat currencies like the US dollar or Euro. The most prominent examples by market capitalization are Tether (USDT) and USD Coin (USDC), both of which uphold a 1:1 parity with the US dollar.

These stablecoins provide a more stable alternative to volatile cryptocurrencies like Bitcoin, serving as a bridge between fiat currencies and digital assets.

However, they are not without risks. For instance, the collapse of Silicon Valley Bank in 2023 forced Circle’s USD Coin to lose its dollar peg, trading at 87 cents rather than $1.

And in 2022, the crypto prices collapsed when stablecoin Terra fell below have its pegged value, triggering a broader crypto market collapse.

Such incidents have intensified calls for stricter regulation of stablecoin issuers, ensuring they maintain safe, liquid assets and can process redemptions at par value.

One response to these concerns is the Markets in Crypto Assets (MiCA) regulation, implemented by the EU’s European Securities and Markets Authority in June 2024.

Can blockchain-based stablecoins add value to traditional markets?

While managing stablecoin risks is a key policy focus, it remains an open question whether these blockchain currencies can truly add value to traditional markets.

For instance, central banks are exploring Central Bank Digital Currencies on blockchain platforms, such as the BIS Innovation Hub’s Project Mariana, which aims to determine if blockchain currency markets can provide a more efficient and cost-effective solution for cross-border payments and foreign exchange trading.

In collaboration with Angelo Ranaldo from the University of Basel and Junxuan Wang from the University of Cambridge, we conducted the first systematic study of blockchain currencies —stablecoins pegged to traditional currencies and traded on decentralized exchanges — to assess the viability of blockchain for foreign exchange trading.

Our research focused on trade and price data for Circle’s Euro stablecoin (EURC) and its US dollar counterpart (USDC) from the Uniswap V3 exchange.

This exchange, which uses Automated Market Maker (AMM) technology for pricing, offered a unique environment to test the market efficiency of blockchain markets and their potential to replace traditional financial market infrastructure.

Given that EURC is pegged to the Euro and USDC to the US dollar, trading in the EURC/USDC market should closely track developments in the traditional EUR/USD market.

Indeed, we found that the blockchain market operates efficiently, with EURC/USDC prices staying within 20 basis points — or 0.2 percentage points — of traditional EUR/USD market prices. Furthermore, blockchain prices responded to macroeconomic information, such as interest rate announcements from the US Federal Reserve.

What frictions influence blockchain-based stablecoins?

However, there are notable frictions. One is the ‘gas fees’—the fees required to authenticate transactions on blockchain markets—which can become expensive.

A second is the volatility of the Ethereum blockchain market, which can lead to losses for investors. Both of these factors increase trading costs and reduce market efficiency, limiting the potential for blockchain-based markets to compete with traditional markets at scale.

Another key aspect of our research was to explore whether the blockchain market operates in isolation or if it trades on a common information set.

We discovered that movements in the blockchain currency market can predict traditional FX rates. Specifically, a one million change in order flow—a measure of net buying pressure for EURC—was associated with a 3.96 per cent increase in the Reuters EUR/USD return.

Our findings show that not all traders have equal access to information on traditional FX rates, similar to traditional financial markets where information asymmetry is prevalent.

Those with more information can influence prices and leverage arbitrage opportunities—buying on one market and selling at a higher price on another.

How stabelcoin traders affect FX rates

We identified three groups of traders: 'sophisticated' traders, 'primary dealers,' and ‘liquidity providers’.

Sophisticated traders represented by the top ten trading wallets, account for up to 50 per cent of aggregate trading volume. They are informed by their greater access to the traditional banking system and enhanced capacity for arbitrage trades.

Primary dealers with access to minting and redeeming stablecoins, share these informational advantages.

In contrast, liquidity providers have little impact on prices and are essentially uninformed hedgers disconnected from traditional market information.

Our findings have significant implications for the evolution of blockchain-based markets and their potential to transform traditional financial trading.

While blockchain trading offers the possibility of global financial inclusion and accessibility, our key takeaway is that investors in the blockchain market trade on fundamental information from traditional currency markets.

Blockchain markets do not act in isolation—they contribute to the price discovery process, where buyers and sellers determine the appropriate price for a currency or commodity.

Blockchain-based currency: regulatory risks vs efficiency opportunities

Importantly, we identified asymmetric information among different groups of traders, indicating that the welfare of trading in these markets largely depends on whether one is a large or small investor.

As these markets evolve and grow larger, concerns arise regarding their ability to maintain efficiency.

The EURC/USDC market is still in its infancy and represents only a fraction of the trading volume in traditional foreign exchange markets.

Blockchain-based frictions, such as gas fees and other inefficiencies, may pose challenges in achieving competitive gains over traditional foreign exchange platforms.

In summary, our research is a crucial first step in understanding the potential of stablecoins in financial markets.

Our findings offer a balanced perspective, emphasising that while stablecoins pose regulatory risks, they also present opportunities to address inefficiencies and redesign traditional financial markets.

This article was originally published by Finextra as part of a series of articles by experts from The Gillmore Centre for Financial Technology.

Further reading:

Can stablecoins take on the US card giants?

Regulatory transition could be 'impossible' for some stablecoins

How do we keep stablecoins stable?

How are interest rates set on DeFi platforms?

Ganesh Viswanath Natraj is Assistant Professor of Finance at Warwick Business School and a member of the Gillmore Centre for Financial Technology. He teaches Financial Markets on BSc Accounting & Finance and Fintech: Digital Currencies and Decentralised Finance on the MSc Finance and MSc Business and Finance.

Learn more about blockchain and digital technologies on the four-day Executive Education course Leading Digital Transformation at WBS London at The Shard.

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