Faculty of law blogs / UNIVERSITY OF OXFORD

Don’t Let Crypto Hype Deter Tough Stablecoins Regs


David Evans
Chairman, Global Economics Group


Time to read

3 Minutes

Despite all the hype, cryptocurrencies are a small part of the financial system. At the peak value in October 2021 the market cap of crypto was about $2.7 trillion. The total value of physical money (M0) was about $40 trillion that year and the broader money supply (M3) was about $90 trillion. And crypto is largely confined to its own ecosystem. When the prices of cryptocurrencies plunged, a large stablecoin issuer collapsed in early May 2022, and crypto investors started pulling funds in classic runs, nothing much happened to the traditional financial system.

The confined crypto world became a case study, however, in what can go wrong without banking-type supervision.. Now there is increased interest in regulating stablecoins in case they get so big and intertwined with our financial system that they do pose systemic risk to the economy. That leads to the age-old question of how to balance the benefits from regulation against the cost of suppressing innovation. The standard decision-theoretic framework shows that we need to assess expected benefits and costs from different options. In practice prior experience informs probabilities and expectations. When we really don’t know there’s a premium to keep options.

Given all we do know about crypto my recent paper argues for stringent financial regulation. Stablecoins should be backed with cash and short-term instruments, supervised by an independent trustee, and held in a regulated bank. I also recommend further to ensure that stablecoins are not used to support unsafe apps that themselves pose systemic risk or financial shenanigans as many crypto apps now do.

The past demonstrates that public blockchain cryptocurrencies are highly volatile over short and long periods of time—an annual average of 16 times the dollar between 2012 and 2021. The main blockchains have no algorithmic or human-based mechanisms for ensuring stability because of conscious design decision their founders made. After 13 years the promise of crypto being a general-purpose payment method, which was fanciful given the inherent volatility, is unfulfilled and largely abandoned by crypto investors.  No ‘killer app’ for public blockchains has emerged with widescale adoption. There are apps such as remittances and lending but there is no evidence that they are widely used.

The present is frankly disturbing. Speculation is the predominant use case for cryptocurrencies. The crypto exchanges make money from volatility, which increases the volume of trades, and from speculation that drives prices up. The large ones invest in feeding hype, for example with celebrity-studded ads hawking ‘the vision’, or the fear of missing out like the guy who didn’t believe the light bulb would amount to anything. Today, we also have hard evidence that lax regulations of stablecoins, combined with the inherent volatility of the native cryptocurrencies have resulted in the classic systemic financial risks from runs and contagion within the crypto ecosystem.

The future vision is distant, uncertain, and vague. Supposedly, the blockchain will be the basis for web3 (often described as a decentralized internet based on blockchain) or financial nirvana (often described as lacking intermediaries and promoting financial equality). All this despite the fact that crypto has evolved into a highly concentrated industry with a bevy of billionaires. The latest promises beg the question why the future, the next big thing, which crypto enthusiasts have promised for the last 13 years, isn’t yet visible.

Regulators considering where to strike the balance between innovation and regulation for crypto are working with a far different set of knowledge in which to form expectations of benefits, costs, and risks compared to what regulators had for mobile money, such as M-PESA in Kenya or more recently for FinTechs, particularly in the UK. Mobile money schemes and FinTechs came to regulators with clean hands. They could pose problems, but there wasn’t any evidence that they had or would. They were also nascent, so it was possible to put in guardrails to limit risk while regulators collected data from actual use.

Regulators cannot discount the possibility that overly onerous crypto regulations could prevent the realization of valuable innovations. Crypto is a vast heavily funded enterprise that could lead to disruptive socially valuable innovation including smart contracts. But when it comes to stablecoins, regulators should err on the side of caution. The risks posed are too high and immediate while the likelihood of valuable innovation too uncertain and remote.  

They should go beyond requiring bank regulations to ensure the safety and soundness of deposits. Stablecoins underpin an increasing number of unregulated crypto apps that could pose substantial financial risks themselves. When crypto prices collapsed, many investors lost the stablecoins they had deposited in crypto apps, such as Celsius, in return for high interest rate. Directly regulating these apps may be difficult given the ability of crypto apps to locate in places—or nowhere at all in theory—where there is little regulation or operate as decentralized autonomous organizations for which there is no one to regulate.

Regulators should limit the use of stablecoins in unsafe applications to staunch their spread. They could approve stablecoins only for use with approved applications. Regulators themselves could approve applications or rely on approval by other reputable regulators. As an alternative, regulators could require the stablecoin issuer to enable the use of its stablecoins only for apps that the issue has approved following  an application review process to weed out unsafe apps. t.  In either case, the stablecoin issuer should be subject to penalties, including a possible halt in activities, if it fails to exercise care to  prevent its stablecoins from being used with unsafe applications.

David S. Evans is the Chairman of the Global Economics Group.


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