By: Steve Sosnick, Chief Strategist at Interactive Brokers

Yesterday was another in a series of rocky days for risk assets, with major US indices falling by more than 3%, and with more speculative names showing more dramatic drops. Cryptos and related stocks fared the worst, as the UST stablecoin “broke the buck”. Stablecoins are a key link between cryptocurrencies and fiat money. Until or unless cryptos can be widely used for goods and services, stablecoins are a necessary intermediary between the virtual and real worlds. I’ll leave it to others to explain the mechanics of this event, but it’s the crypto equivalent of a money market fund trading below $1.Those of us who traded during financial crises are keenly aware of how destabilizing it was when money markets broke the buck, which is what made many traders very wary when UST plunged yesterday.

Stablecoins are an inherent point of risk in the crypto world. They claim to either be backed 100% by stable assets, like Tether, or have a mechanism for maintaining the peg, like UST. Yesterday was the first real-world test of the latter methodology, and it doesn’t appear to be a ringing success. The bigger, more worrisome problem would occur if there was a wave of crypto selling that pressured Tether. Even if they are fully collateralized with assets like short-term Treasuries and commercial paper – and we have no choice but to take their word for it because Tether has yet to be audited – those assets can be prone to illiquidity during panicky times. That was a problem for money market funds during the global financial crisis. The normally stable bids for commercial paper faded amidst a wave of sustained selling, and some funds were forced to mark money market positions below $1.If Tether were forced to liquidate its positions quickly it could spill into normally staid money markets.

The events of 2008 caught the Fed’s attention. They addressed the money market illiquidity in real-time, and Dodd-Frank legislation addressed it in a broader sense. Cryptos aren’t regulated, so the Fed has no real ability (or desire?) to intervene in a stablecoin crisis. They could shore up traditional money markets if contagion arose, but crypto investors would be on their own. Some of them clearly recognized that risk, which led to yesterday’s dip, but It doesn’t appear that there has been contagion into other, larger stablecoins so far – let alone the broader economy. As a result, we have seen bitcoin, other cryptocurrencies, and even stocks responding positively since last night. But the larger risk still looms. If cryptocurrencies experience a crash, odds are its ramifications will be felt in traditional markets too.

Changing topics somewhat, I would like to remind readers of a useful mathematical trick. I have started to see articles and Twitter posts glumly pointing out how much a given asset class will need to rise after its recent fall to get back to its old highs or its levels at the start of the year. For example, the Nasdaq 100 is down about 25% year-to-date, so it will need to rise 33% to get back to that level. It is important to keep that type of statistic in mind, considering how unusual it is for any asset – let alone a major index – to rise by a third in a short period of time. 

Here is an easy way to keep these levels straight. If we have reduced the price of an asset by 1/x, it needs to add 1/(x-1) to its current price to get back to breakeven. In the example above, NDX lost ¼ (25%) of its value this year, so it needs to add 1/3 (33%) of its current value to get back to that starting point. The following table both demonstrates that phenomenon and offers a convenient reminder of the up moves required after a downdraft. Keep them in mind if you feel like chasing a bounce.

(Click on image to enlarge)