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The writer is a professor of economics at London Business School
The EU has led the way in setting a regulatory framework for crypto. Yet the risks that its Markets in Crypto-Assets Regulation (Mica) sought to contain are now materialising.
One source is the desire of some member states to be crypto hubs, so national regulators may be permissive in their authorisations in the name of financial innovation. Another is at the EU level, a reluctance to admit that Mica may be incomplete, at least in regard to stablecoins.
A stablecoin’s value is pegged to a fiat currency, predominantly at $1. The peg is supposed to be supported by liquid reserves. But such pegs are always subject to runs by holders seeking to convert holdings back into dollars, whatever the backing. Both the main stablecoins, tether and USDC, have briefly fallen below their $1 pegs in the past.
A key issue now concerns the business model of global firms issuing the same stablecoin both inside and outside the EU. These stablecoins are deemed fully fungible, meaning tokens issued in one jurisdiction are interchangeable with those issued in another. This model allows some to circumvent Mica’s safeguards, enabling regulatory arbitrage and creating the risk of a run on a stablecoin that could be contagious across stablecoins and the financial institutions involved with them.
Mica is clear on the rules for a stablecoin issued by several issuers all within the EU. Under a unified regulatory framework, the issuers must maintain a single reserve, a unified custody policy, and make clear all issuers of the same stablecoin are jointly liable for any redemptions.
But the regulation is silent when it comes to a global firm issuing the same fungible stablecoin both from an EU-regulated entity and from a third-country entity as Circle has done. In this case, the reserves backing the stablecoin are split across jurisdictions, each with its own requirements, enforced by local regulators tasked with safeguarding the interests of their own jurisdiction. Stablecoin regulations remain unaligned on requirements regarding prohibitions on interest, redemption and eligible reserve assets.
If a deterioration in confidence led to a run, investors could seek to redeem their fungible stablecoins in the EU, where Mica requires immediate and cost-free redemption at par. And reserves held in the US might not be available to meet redemptions in the EU — we saw in 2008 and 2020 that national authorities may in effect ringfence liquidity in their jurisdictions.
EU supervisors and EU-regulated entities would be responsible for liabilities taken on by third-country issuers. This is like allowing depositors in a bank outside the bloc to redeem their deposits held in the third country through its EU subsidiary. This would mean the European supervisors of an EU subsidiary of a large global banking group would be responsible for the solvency and liquidity of the entire group.
In a significant run on a multi-country stablecoin, the reserves located in the EU might be quickly depleted. It is difficult to estimate the full amount of stablecoins in circulation in the EU and accurately calibrate the reserves that the EU issuer should hold. A run could transmit shocks throughout the EU banking sector.
Mica gives national authorities general supervisory powers to implement mitigation measures. But if there is divergence, firms will look for jurisdictions with the most favourable treatment.
Some argue the multi-issuance model should remain unrestricted, as stablecoins’ value lies in enabling seamless cross-border transactions. But allowing the model without strict safeguards exposes all member states to risks given that authorisation in one country means approval across the bloc due to Mica “passporting” rules.
If this model were to proliferate, the EU could face a scenario where public intervention might ultimately be necessary to protect stablecoin holders. We saw this with some money market funds in 2008 and 2020.
Members of the European parliament and the European Central Bank have voiced strong reservations about allowing fungibility between EU and non-EU stablecoin issuers. Mica should explicitly regulate these risks and the European Commission and parliament should quickly conduct a formal review. Meanwhile, macro-prudential authorities should analyse the systemic threats posed by this model.
Stablecoins may represent financial innovation, but the risks they pose are not novel. Economists have studied similar dynamics in traditional finance for decades. The EU should learn from history and avoid repeating it.