As cryptocurrencies are based on fundamentally new technologies enabling decentralized trading, the general perception is that the crypto market is independent of central banks. The crypto market has even been perceived as an island isolated from the traditional financial market. However, if an invisible wall once blocked the transmission of risk between the crypto and traditional financial markets, it seems to be crumbling. In March 2020, Bitcoin fell about 25 % during the turmoil in stock markets precipitated by the outbreak of the COVID-19 pandemic.1 On June 21, 2021, the overall crypto market fell soon after the U.S. Federal Reserve Board announced plans to increase interest rates.2 The recent co-movement of the crypto market with the traditional financial market and its responsiveness to U.S. monetary policy contradict the view that cryptocurrencies are non-dollarized and the finding that the crypto market is isolated from the non-crypto market. Given these observations, and investors are facing a critical question: What is causing the recent breach of the risk-blocking wall between the crypto and non-crypto markets?

So In this paper, we are going to be considering one potential explanation for the emerging link between the crypto and non-crypto markets: the growing importance of stablecoins. Distinguished by their stable prices, stablecoins constitute a unique category of cryptocurrency, in contrast to traditional cryptocurrencies known for their extreme price fluctuations. On the one hand, stablecoins are pegged to traditional assets, such as fiat currencies and commodities, primarily the U.S. dollar, establishing a connection with the non-crypto market. On the other hand, the price stability of stablecoins has positioned them as the primary transaction medium in cryptocurrency trading and an indispensable collateral for decentralized finance (DeFi) within the crypto ecosystems. The circulating supply of stablecoins has surged from under $5 billion in 2019 to over $133 billion in 2022 and their transaction volumes have surpassed those of all other cryptocurrencies, including Bitcoin. Consequently, stablecoins have been dubbed “digital fiat” in the crypto markett. In summary, by anchoring to non-crypto assets and serving a pivotal role in the crypto market, stablecoins possess the capacity to bridge the gap between these two markets.

To formally establish the role of stablecoins as risk transmitters, we employ a theoretical framework to explore the risk spillover dynamics between the crypto and non-crypto markets. Our work extends Li and Mayer's (2022) by incorporating market clearance conditions into their partial equilibrium model to describe how risk can spontaneously spread among various financial markets. We assume that the crypto and non-crypto markets do not share any fundamental risk factors or any common investors, thus shutting down the risk transmission channels through institutional investors in the crypto market (Huang et al., 2022) and indirect cryptocurrency investments in the traditional financial market such as cryptocurrency ETFs and crypto-related stocks (Hackethal et al., 2022). In this way, the only possible risk transmission channel between cryptocurrencies and the U.S. dollars is the stablecoin. In our framework, the stablecoin platform could transfer the risks across these two markets by adjusting either the supplies of tokens or dollar reserves.The platform aims to maintain a nominal dollar peg, but this is done under stochastic inflows and outflows. These fluctuations in demand for stablecoins (due to shifting market conditions) result in changes to the token supply and the platform's reserve adequacy. As a result, the stablecoin's price becomes sensitive to both dollar-side and crypto-side shock. Secondly, thie volatility is transmitted across markets through strategic responses by economic agents. The platform adjusts its reserve levels by minting new stablecoins or redeeming existing ones, which directly impacts the dollar market by either increasing or decreasing the available reserves. Simultaneously, token users rebalance their portfolios between stablecoins and crypto assets in response to changes in their utility, which is influenced by fluctuations in the stablecoin's real value (purchasing power) and token supplies. This leads to shifts in crypto demand and prices, propagating risk from the stablecoin market into the crypto market. Thus, the stablecoin acts as an endogenous conduit that links otherwise segmented markets: the platform links the dollar and stablecoin markets, while token users link the stablecoin and crypto markets. Risk flows indirectly through this two-way transmission chain, where shocks in either market (dollar or crypto) influence the other market via platform interventions and user behavior. Although we assume no shared fundamentals or overlapping investors between the crypto and non-crypto sectors, the stablecoin market facilitates contagion through its unique role in this transmission process.