How should governments regulate stablecoins and cryptocurrency?

Since the inception of bitcoin in 2009 interest in cryptocurrencies has soared - but a sudden and painful crash has triggered calls for tougher regulation.

In early May, cryptocurrencies terraUSD and luna lost 99 per cent in value in just two days. This triggered a wider loss of confidence in crypto markets, which went on to shed some $41 billion.

This sudden and painful crash after a two-year boom has stoked fears that catastrophe in cryptocurrency markets could have implications for the real economy. Even true believers are prepared to say there’s a problem – there are no safety nets for investors. This has led to desperate investors to cry for help – and for regulation.

What should governments do? The recent turmoil has spurred the US and UK and others around the world to consider how to create laws and guidelines to make cryptocurrencies safer for investors. Opponents of regulation say it runs counter to the free, decentralised ethos of digital currencies. But understanding the risks – and how they could be mitigated – is critical. In our research and in presentations to UK lawmakers, we’ve identified some of the risks posed by stablecoins – these are cryptocurrencies that are pegged to an external asset, typically the US dollar.

Stablecoins are a means of having a version of the dollar on blockchain, and in 2020 volumes in circulation rose by 500 per cent. Investors use these blockchain-based coins as a gateway to buy and sell on cryptocurrency markets. For every $1 million of stablecoins in the market, for instance, the issuer holds real assets worth $1 million. As long as a stablecoin’s asset remains steady, so will its value.

What risks do stablecoins and cryptocurrency pose?

System risks - Some analysts warn that the industry is sizeable enough to damage economies if mismanaged – we identify these as systemic risks, which are difficult to regulate.

Boom and bust cycles in cryptocurrencies can spill over into the wider economy if investors take hefty losses.

Investors use stablecoins to take positions in digital currencies – this exposure in a currency pegged to a real world asset can also pose a risk to the real economy. A crash in bitcoin, for instance, will affect investors’ balance sheets, with losses leading them to scale down lending elsewhere that will have knock-on effects.

Custodial risks - Centralised stablecoins such as tether or USDC, both pegged to the dollar, face what we call custodial risk. Private issuers of stablecoins in unregulated markets are not accountable – and there is a risk they could even abscond with funds.

Run risks - This is a risk familiar in conventional banking. If panic sets in, cryptocurrency investors will try to redeem their stablecoins for dollars, which could in turn trigger a 'run' on stablecoins. There’s a risk here that redemptions could then exceed the stablecoin issuer’s reserves.

Payment risks - If the value of stablecoins falls, this can potentially trigger companies and consumers with holdings of the digital currencies to go bust and default on payments.

No market likes uncertainty, and some level of stability is welcome. But authorities should maintain a light touch as over-regulation would stifle the innovative nature of digital currencies.

Well-judged controls could reap the benefits of the technology but minimise excessive speculation and subsequent spillover to the real economy. In an ideal world, a regulatory framework could be easily adopted by the banking sector to allow cryptocurrency markets to run smoothly.

What policies could be used to regulate markets?

Authorities must now come up with effective regulation to minimise the systemic, custodial, run and payment risk of stablecoins.

To guard against a run on a digital currency governments could demand that issuers of stablecoins hold specified and transparent levels of capital. They could require scheduled audits to ensure that an issuer has sufficient collateral.

Leading stablecoins such as tether and USDC are backed 100 per cent by the equivalent in dollar assets, but their balance sheets are opaque. They are backed by liquid dollar reserves and treasury bills, but also less liquid commercial debt. Could authorities reduce instability by demanding tighter controls on collateral and more transparency?

Another option for regulators is deposit guarantee insurance. This would come into play in times of bank-like runs, when a central bank could provide liquidity to help issuers meet demands on their reserves.

Macroprudential regulation is an approach that aims to limit the costs and fall-out of financial instability at a system-wide level and could be applied to minimise the systemic risks of cryptocurrency – it could include capping the level of individual investment in cryptocurrencies for instance. Another option would be to increase the capital requirements, such as liquid reserves, held by stablecoins.

What does the future hold for cryptocurrencies?

Optimists believe the recent shakeout of crypto markets will ultimately improve choice for investors, and digital currencies will remain firmly part of the landscape. Whether nations embrace cryptocurrencies, stablecoins or central bank digital currencies depends on the maturity of the economy and payments markets.

Last year El Salvador, followed this year by the Central African Republic, became the first two countries in the world to adopt bitcoin as legal tender, although the move has stoked concern and scepticism.

Stablecoins – provided they are fully collaterised – offer a less volatile solution to bitcoin and are an alternative to sovereign currencies, particularly when there is high inflation. They could also improve financial inclusion by providing an alternative method to save and consume without the need to hold a bank account, for instance.

For developed economies such as the US and Europe, arguments for light touch regulation are strong and the benefits of digital currencies – not least the ability to bypass the staid banking system – are still appealing.

But after the latest crash, the ball is now firmly in the court of the authorities.

Further reading:

Eichengreen, B., and Viswanath-Natraj, G. (2022) "Stablecoins and central bank digital currencies : policy and regulatory challenges", Asian Economic Papers, 21, 1, 29-46.

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 Empirical Finance on the MSc Finance and MSc Finance and Economics.

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