Can Cryptos Avoid Collapse Through Regulation?

Stablecoins is having major implications from the standpoint of digital asset markets, particularly it's highlighting the risks of losses to many investors, particularly unsophisticated investors who didn't necessarily understand the products that they were investing in. At the beginning of the year, we highlighted a number of the big themes for finance, regulation, and technology coming across the year. And one of those that we highlighted was very much around risks in the context of digital assets, cryptocurrencies and stablecoins in particular. And another that we highlighted is the idea of geopolitical risks and in particular questions around interest rate rises and inflationary pressures. And all of these things so far have come together in 2022 and had a major impact on financial services and markets. And one of the most visible areas is in the context of cryptocurrencies and stablecoins. In the past month, we've seen the collapse of one of the most popular stablecoins, an interaction between two instruments called Luna and Terra, what is called an algorithmic stablecoin that is designed to maintain stability and value between the digital token and the US dollar via an algorithmic issuing, collapsing, and rebalancing between the two coins. As co-authors and I have highlighted in previous work on stablecoins, algorithmic stablecoins bring with them a range of risks, particularly in the context of crises. And the collapse of Luna and Terra together, as one of the most popular algorithmic stablecoins, is having major implications from the standpoint of digital asset markets. Particularly, it's highlighting the risks of losses to many investors, particularly unsophisticated investors who didn't necessarily understand the products that they were investing in. But it's also highlighting some of the risks from the standpoint of regulators. And if we think about this, one aspect is pushing forward that trend towards bringing digital assets into the financial regulatory system. The second is driving forward regulation in particular of stablecoins. And if we look at stablecoins, we can see a number of different models. One model at one end of the spectrum is actually what you would call a synthetic CBDC, a synthetic central bank digital currency. And in this structure, you have an issuer or consortium which issues a coin which is backed directly by assets such as government bonds from the underlying fiat currency issuing government and also by liquidity from the central bank. That's at one end of the spectrum. And this is almost equivalent to a directly issued central bank digital currency. At the other end of the spectrum, you have tokens which claim a link in value to a fiat currency like the dollar, but without any clear backing. They could be algorithmic or there could be lack of clarity around what is backing that valuation. And these are most at risk. And in between, we have a variety of options. One side is something that is in really many ways close to what we would think of as a money market mutual fund. In other words, you have an issuer of a coin which owns a portfolio of a variety of different securities. They could be very safe securities like highly liquid government bonds and notes like a money market mutual fund, or they could be more speculative securities like a mutual fund. And from my standpoint, this sort of mutual fund money market type mutual fund stable coin should be regulated in the same way as money market funds and securities funds. Second, you have what are effectively banks. In other words, you have an issuer which issues a token that is linked in value to the dollar that is backed by the full credit of the issuer that could be backed by essentially the deposits, the owners of that individual currency, which makes it like deposits. In other words, that quasi bank could be issuing a certain amount of currency in relation to the amount of deposits that it has. That would then subject it to banking regulation, the need for a banking license. And in my view, that business model should be regulated along those lines. Your final business model is where you have essentially a very restricted type of one-to-one backing in assets, where you have gold, physical currencies, highly liquid government bonds in a one-to-one backing to the coin that is issued. This looks a lot like a currency board of the sort that we have in Hong Kong. And that, once again, requires a different form of regulatory framework. But going forward, from the standpoint of stable coins, the key is that investors, purchasers, users understand what sort of coin it is that they're getting. And from a regulatory standpoint, that you have appropriate regulatory frameworks in place to make sure that the sort of coin that investors think they are buying is regulated accordingly, and that all parties are aware of the risks. And I think, as we go forward, this is central to the way that we approach the regulation of stable coins, which play a very important role in linking the traditional financial system, fiat currencies, to blockchain environments, which depend on the ability to have a monetary instrument which is robust and usable. Going forward, there are also opportunities to build these regulatory and supervisory systems directly into the systems for the individual tokens themselves. This is what we would call embedded supervision mechanisms to allow supervisors to monitor, or even embedded regulation, where the requirements for the assets backing the coin, the disclosure of the information are embedded directly into the technology, so that the technology itself is embedding the regulatory requirements that are necessary from the standpoint of protecting investors, protecting financial stability, and encouraging markets to grow.