Long reads

How should stablecoins and digital currencies be regulated by the government?

Ganesh Viswanath-Natraj

Ganesh Viswanath-Natraj

Assistant Professor, Gillmore Centre, Warwick

Ever since Bitcoin's emergence in 2009, interest in cryptocurrencies has skyrocketed. However, an abrupt and painful crash has sparked calls for more stringent regulatory measures.

In May 2022, cryptocurrencies TerraUSD and Luna plummeted in value by 99% within just two days, causing a broader loss of confidence in the crypto markets and leading to a staggering loss of $41 billion.

This sudden crash, following a two-year boom, has raised concerns that a cryptocurrency market catastrophe could have consequences on the real economy. Even staunch believers in cryptocurrencies acknowledge the problem – the absence of safety nets for investors. This has prompted desperate investors to call for assistance and demand regulatory intervention.

So, what should governments do in response? Recent turmoil has compelled the US, UK, and other nations worldwide to consider the creation of laws and guidelines aimed at making cryptocurrencies safer for investors.

Those opposing regulation argue that regulations would contradict the free and decentralised ethos of digital currencies. However, recognising the risks and finding ways to mitigate them is crucial.

Stablecoins act as a digital version of the dollar on the blockchain, with circulation volumes skyrocketing by 500% in 2020. Investors use these blockchain-based coins as a bridge to engage in buying and selling within cryptocurrency markets. For each $1 million of stablecoins in the market, the issuer holds real assets worth $1 million. As long as the underlying asset remains stable, so does the stablecoin's value.

The risks of stablecoins and cryptocurrency

 1. Systemic Risks

First, there are systemic risks, a concern raised by analysts who see the industry's vast size as potentially disruptive to mainstream financial markets and the real economy. Stablecoins used in crypto derivative markets can increase risk exposures of financial intermediaries. Because stablecoin issuers hold traditional assets, a run on stablecoins can lead to systemic risks to the financial sector and financial intermediation, for example when they are forced to engage in fire sales of commercial paper and other assets.

 2. Custodial risks

Centralised stablecoins like Tether or USDC, which are pegged to the dollar, encounter custodial risk. In unregulated markets, the lack of oversight for private issuers of stablecoins increases the potential for these issuers to abscond with funds. If the stablecoins are no longer backed by reserve assets, this disrupts the convertibility of stablecoins into dollars.

 3. Run risks

This risk is familiar in traditional banking. If there is a concern that the stablecoin issuer does not have sufficient reserves backing the value of the currency, investors may rush to exchange their stablecoins for dollars, potentially initiating a 'run' on stablecoins. A devaluation of the currency can arise when reserves or backing are less than 100% of the value of issuance or less than perfectly liquid.

 4. Payment risks

Payment risk derives from the role of stablecoins as a medium of exchange. If a firm has receivables denominated in stablecoins, its cash flows are subject to fluctuations in the stablecoin value. A devaluation can lead to a decline in the value of firm receivables and cause financial distress.

What policies could be employed to regulate stablecoins?

A regulatory framework can facilitate the smooth operation of cryptocurrency markets and mitigate the systemic, custodial, run, and payment risks associated with stablecoins.

It's crucial for authorities to strike a balance and avoid excessive regulation, which could stifle the inherent innovation of digital currencies. Prudent and well-considered controls have the potential to harness the advantages of this technology while curbing undue speculation and its subsequent impact on the real economy.

To safeguard against potential runs on digital currencies, governments might mandate stablecoin issuers to maintain specified and transparent levels of capital. This could include the implementation of scheduled audits to ensure adequate collateral.

Prominent stablecoin Tether is backed by equivalent dollar assets, yet the opacity of their balance sheet raises concerns. While they possess liquid dollar reserves and treasury bills, they also hold less money-like assets like corporate bonds and risky cryptocurrencies like Bitcoin. Could regulatory bodies reduce instability by enforcing stricter controls on collateral and enhancing transparency?

Another avenue for regulators to consider is the introduction of deposit guarantee insurance. This mechanism would come into play during bank-like runs, wherein central banks could provide liquidity to assist issuers in meeting demands on their reserves.

Macroprudential regulation, aimed at curtailing the costs and repercussions of financial instability at a systemic level, offers a potential strategy to minimise the systemic risks posed by cryptocurrencies. This approach could encompass measures like capping individual cryptocurrency investments or elevating the capital requirements, including liquid reserves, held by the stablecoin issuer.

The future of stablecoins

Stablecoins, when fully collateralised, present a comparatively stable alternative to Bitcoin. 

The extent to which nations embrace stablecoins hinges on the maturity of their economies and payment markets.

In emerging markets, stablecoins can serve as a substitute for sovereign currencies of countries with high inflation and macroeconomic instability. Additionally, they hold the potential to enhance financial inclusion by providing an alternative means of saving and spending without necessitating a traditional bank account.

In the case of developed economies like the US and Europe, the rationale for maintaining a lightly regulated stance is more appealing. The advantages of digital currencies, including the ability to circumvent the traditional banking system, continue to exert a strong pull.

The responsibility now lies with the authorities to navigate the path forward.

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