📈 economics

Stablecoin Depegging, Financial Intermediary Balance Sheet Constraints, and Liquidity in the U.S. Traditional Money Market

This paper demonstrates that stablecoin depegging transmits liquidity stress to U.S. traditional money markets by tightening financial intermediaries' balance sheet constraints, causing heterogeneous liquidity deterioration across Treasury bills, commercial paper, and repo markets that is significantly amplified when intermediary capital is under stress.

Original authors: Mo-Lei Chen, Yin-Ting Zhang, Wei-Xing Zhou

Published 2026-07-01

📖 5 min read🧠 Deep dive

CC BY 4.0

Original authors: Mo-Lei Chen, Yin-Ting Zhang, Wei-Xing Zhou

Original paper licensed under CC BY 4.0 (https://creativecommons.org/licenses/by/4.0/). ✨ This is an AI-generated explanation of the paper below. It is not written or endorsed by the authors. For technical accuracy, refer to the original paper. Read full disclaimer

The Big Picture: A Digital Dollar Crisis Spills Over

Imagine the world of cryptocurrency as a giant, chaotic amusement park. Stablecoins are like "park tokens" designed to always be worth exactly $1. They are the bridge between the wild crypto world and the calm, serious world of traditional banking (the "U.S. Money Market").

This paper asks a scary question: What happens if the park tokens suddenly stop being worth $1?

The researchers found that when these digital tokens lose their value (a "de-peg"), it doesn't just hurt crypto investors. It creates a ripple effect that shakes up the traditional banking system, specifically the markets where banks and governments borrow short-term money.

The Cast of Characters

To understand the story, let's meet the players:

The Stablecoin Issuers (The Token Makers): Think of them as a massive warehouse holding $1 bills and government bonds to back up their digital tokens.
The Financial Intermediaries (The Big Banks/Dealers): These are the "plumbing" of the financial system. They are the ones who buy and sell the bonds and cash that the token makers hold. They act as the shock absorbers for the economy.
The Money Markets (The Plumbing): This is where short-term loans happen. The paper looks at three specific pipes:
- Treasury Bills: The safest, most trusted pipes (like gold-plated plumbing).
- Commercial Paper: Unsecured IOUs from companies (like standard PVC pipes).
- Repo Market: Loans backed by collateral (like a pawn shop where you leave your watch to get cash).

The Story: What Happens When the Token Breaks?

1. The Panic (The De-peg)

Imagine a rumor spreads that the park tokens are fake. Everyone rushes to the warehouse to trade their tokens back for real dollars. The token makers have to sell their reserves (bonds and cash) instantly to pay everyone back. This is a "fire sale."

2. The Bottleneck (The Bank's Limit)

Normally, the Big Banks (Intermediaries) would happily buy these bonds to keep the market calm. But here is the catch: Banks have a "backpack" limit.
Due to strict rules (like Basel III), banks can only carry so much weight on their balance sheets. They can't just expand their backpacks infinitely.

When the token makers dump a massive pile of bonds on the banks, the banks' backpacks get full. They can't absorb the shock without breaking their own rules. This creates a "traffic jam" in the financial plumbing.

The Three Different Reactions

The paper found that the three types of money markets reacted very differently to this traffic jam:

The Treasury Market (The Safe Haven):
- Reaction: At first, it actually got better.
- Analogy: When people panic, they run to the safest place first. Investors dumped their risky assets and bought Treasury bonds, making those bonds easier to trade for a day or two.
- The Twist: After that brief calm, the pressure from the banks' full backpacks kicked in, and liquidity started to get tight again.
The Commercial Paper Market (The Unsecured IOUs):
- Reaction: It got worse immediately.
- Analogy: This is like a credit card with no collateral. As soon as the token crisis hit, lenders got scared and stopped lending money to companies. The cost to borrow money spiked instantly on the very first day.
The Repo Market (The Pawn Shop):
- Reaction: It got worse, but with a delay.
- Analogy: This is like a pawn shop. It took a few days for the news to travel through the system. Once the banks realized their "backpacks" were too full to handle the extra collateral, the cost to borrow money here started climbing, peaking a few days after the initial shock.

The Real Culprit: "Marginal Cost" vs. "Broken Backpack"

The researchers wanted to know why the banks stopped lending. Did they lose all their money (capital)?

The Finding: No. The banks didn't lose a huge amount of their own money. Their "backpacks" were still intact.
The Real Reason: It became too expensive for them to carry more weight.
- Analogy: Imagine you are a delivery driver. You haven't lost your truck (capital), but suddenly the road is full of potholes and the tolls have skyrocketed (marginal cost). You are still able to drive, but you are too tired and it costs too much to take on one more package.
- The "shadow price" (the hidden cost) of expanding their balance sheet went up, so they stopped buying the bonds the token makers were selling.

The "Stress Test" Factor

The paper also looked at what happens when the banks are already tired.

If the banks are healthy (Loose Capital): They can absorb the shock. The money markets barely notice the de-pegging.
If the banks are stressed (Tight Capital): The shock is amplified. The "traffic jam" becomes a gridlock. The same token crisis causes a massive liquidity crisis in the traditional markets.

The Bottom Line

This paper proves that the crypto world and the traditional banking world are now deeply connected. If a stablecoin breaks, it doesn't just hurt crypto investors; it jams the pipes of the U.S. economy.

The danger isn't that banks will go bankrupt immediately; the danger is that the cost of doing business for banks goes up so high that they stop providing liquidity, causing short-term borrowing costs to spike for everyone else. This risk gets much worse if the banks are already under financial pressure.

Technical Summary: Stablecoin Depegging, Financial Intermediary Balance Sheet Constraints, and Liquidity in the U.S. Traditional Money Market

Problem Statement
As the global stablecoin market has expanded to over $300 billion by the end of 2025, its integration with the U.S. traditional money market has deepened, with issuers holding approximately 70–80% of reserves in U.S. Treasury securities and reverse repurchase agreements (RRPs). While stablecoins function as intermediaries for crypto-asset transactions, they lack a lender of last resort and are vulnerable to runs. The paper investigates the transmission mechanism of stablecoin depegging events to traditional money market liquidity. Specifically, it addresses the gap in existing literature regarding how depegging shocks propagate through financial intermediary balance sheet constraints. The central question is whether the forced liquidation of reserve assets by stablecoin issuers during a depegging event triggers liquidity stress in traditional markets (Treasury bills, commercial paper, and repos) and how this transmission is conditioned by the capital health of financial intermediaries.

Methodology
The paper employs a two-pronged approach combining a theoretical analytical framework with empirical estimation using Local Projections (Jordà, 2005).

Analytical Framework:
- The authors develop a model extending the liquidity spiral framework of Brunnermeier and Pedersen (2009) to include stablecoins.
- The model posits that financial intermediaries (e.g., primary dealers) face a funding constraint where net worth ( $W_t$ ) must cover margin requirements for both crypto ( $c$ ) and traditional ( $T$ ) assets.
- Two transmission channels are identified:
  - Margin Channel: Depegging increases information sensitivity, raising margin requirements on crypto assets ( $m_{c,t}$ ).
  - Liquidation Channel: Issuers liquidate reserves, forcing intermediaries to absorb selling pressure in traditional markets, increasing their positions ( $x_{T,t}$ ).
- These forces tighten the intermediary's balance sheet, raising the shadow cost of capital ( $\phi_t$ ). The model predicts that even without a material decline in capital stock ( $W_t$ ), a rise in the marginal cost of expanding balance sheet capacity ( $\phi_t$ ) widens liquidity spreads in traditional markets.
Empirical Strategy:
- Data: Daily data from January 1, 2022, to January 1, 2025, covering major stablecoins (USDT, USDC, DAI) and U.S. money market segments.
- Shock Identification: A three-regime Markov regime-switching model (Hamilton, 1989) is used to endogenously identify depegging states. A composite depegging shock variable ( $DepegShock_t$ ) is constructed, weighted by market capitalization and the smoothed probability of being in a depegging regime.
- Estimation: The baseline regression uses local projections to estimate impulse responses of liquidity spreads at horizons $h=0$ to $h=3$ :
  $y_{t+h} - y_{t-1} = \alpha_h + \beta_h DepegShock_t + \sum \phi_{h,\ell} DepegShock_{t-\ell} + \dots + \varepsilon_{t+h}$
- Controls: The model controls for broad crypto market movements (Bitcoin returns), Treasury volatility (MOVE index), equity volatility (VIX), fiscal liquidity (TGA balance), and global dollar liquidity.
- State-Dependent Analysis: The paper estimates heterogeneous effects based on intermediary capital constraints (using primary dealer capital ratios) and monetary policy cycles (tightening vs. non-tightening).

Key Results
The empirical analysis reveals significant heterogeneity in liquidity responses across three money market segments:

Heterogeneous Market Responses:
- 3-Month Treasury Bills: Liquidity initially improves (spreads narrow) immediately following a shock ( $h=0, 1$ ), consistent with a "flight-to-safety" effect. However, this reverses at $h=2$ as spreads widen, suggesting a lagged balance sheet crowding-out effect.
- Commercial Paper (CP): Liquidity deteriorates immediately ( $h=0$ ), with a 1% depegging shock causing a 38.35 basis point (bp) jump in spreads. This reflects the market's sensitivity to credit risk reassessment. The effect reverses quickly by $h=2$ .
- Repo Market: Liquidity deterioration follows a delayed peak pattern. Spreads widen significantly at $h=2$ and $h=3$ (peaking at 4.76 bp), consistent with the time required for collateral valuation channels to transmit stress.
Transmission Mechanism (Balance Sheet Constraints):
- Marginal Cost vs. Capital Stock: The transmission is driven primarily by the marginal cost constraint ( $\phi_t$ ), not the capital stock constraint ( $W_t$ ).
- Empirical results show that the shadow price of capital ( $\phi_t$ , proxied by CIP deviations) rises significantly and immediately upon depegging, peaking at $h=5$ .
- Conversely, the primary dealer capital ratio ( $W_t$ ) shows no statistically significant decline during the shock window. This indicates that liquidity deterioration is caused by the increased cost of absorbing positions, not by a material erosion of intermediary capital.
State-Dependent Amplification:
- Intermediary Capital: When intermediary capital is tight, liquidity deterioration is significantly amplified across all three markets. Under loose capital conditions, the Treasury market shows persistent liquidity improvement, and CP market deterioration is muted.
- Monetary Policy: The transmission effects are stronger during monetary tightening cycles. In non-tightening (easing) cycles, the direction of liquidity effects in Treasury and CP markets can reverse (e.g., from deterioration to improvement).

Significance and Contributions
The paper makes three primary contributions to the literature:

Theoretical Integration: It develops an analytical framework that explicitly incorporates stablecoins into the intermediary asset pricing model, characterizing how depegging shocks transmit to traditional markets via balance sheet constraints rather than just through direct asset reallocation.
Empirical Evidence of Heterogeneity: It provides the first empirical evidence of the dynamic, heterogeneous responses of U.S. Treasury, commercial paper, and repo markets to stablecoin depegging, documenting distinct timing patterns (immediate vs. delayed) and directions (improvement vs. deterioration).
Mechanism Identification: It isolates the marginal cost of balance sheet expansion as the critical transmission channel. The findings demonstrate that stablecoin depegging can impair market liquidity even without a material decline in intermediary capital stocks, provided that capital constraints are binding.

Policy Implications
The authors derive three specific implications for macroprudential regulation:

Reserve Regulation: Regulation should move beyond simple 100% reserve coverage to include tiered monitoring of reserve asset liquidity and requirements for issuers to maintain liquidity buffers to mitigate supply-side pressure during redemptions.
Intermediary Risk Exposure: Regulatory frameworks must account for the indirect risk exposure of financial intermediaries acting as market makers for stablecoin reserves. Stress testing should incorporate these cross-market redemption pressures.
Unsecured Funding Markets: Regulators should monitor the immediate impact of depegging on unsecured funding markets (commercial paper), as sudden liquidity tightening in this sector can transmit to real-economy financing conditions.

The paper concludes that while stablecoin depegging does not yet pose a direct threat to the capital stock of primary dealers, it has established a risk coupling mechanism where crypto-asset shocks can amplify liquidity stress in traditional money markets, particularly when the financial system is already under capital or monetary tightening constraints.