The lesson of the FTX disaster and the blowup of the stablecoin Luna is that regulation is needed to prevent runs on deposits and misuse of customer funds.
The lesson of the FTX disaster and the blowup of the stablecoin Luna is that regulation is needed to prevent runs on deposits and misuse of customer funds.
I f there’s a lesson to be learned from the blowup of the algorithmic stablecoin Luna and the implosion of cryptocurrency exchange FTX, it is that we need to regulate stablecoins and crypto firms like banks.
Why? Crypto firms and stablecoins alike are susceptible to runs and misuse of customer funds without it. Simple regulation — rules governing customer deposits in crypto firms such as FTX and mandating the full backing of stablecoins — akin to deposit insurance can help bring stability to a sector that desperately needs it.
The trading arm of FTX, Alameda Research, allegedly borrowed FTX customer deposits to cover its losses. Most of that customer money likely is lost and won’t be returned. If FTX had been a traditional bank that had somehow gone insolvent, its customer deposits would still have been insured up to $250,000 by the FDIC, and many of its customers wouldn’t be in such dire straits now.
Two of this year’s economics Nobelists, Doug Diamond and Phil Dybvig, created a highly influential model of bank runs that shows how introducing deposit insurance can help prevent deposit runs and create financial stability.
The old-school bank runs of the panic of 1929, the runs on prime money-market mutual funds in 2008 and 2020, the crashing of algorithmic stablecoin Luna this year, and the dash of customers taking deposits out of FTX all followed a similar pattern: Solvency concerns triggered waves of customers to withdraw their money simultaneously, and there wasn’t enough money available on deposit to cover those withdrawals.
The beauty of deposit insurance is that it ensures customers will be able to withdraw their deposits whenever they like, curtailing the incentives that create runs in the first place. In other words, deposit insurance is a backstop that, just by virtue of being in place, rarely ever needs to be used.
Incentivizing depositors to move toward the “good equilibrium” of no runs and away from the “bad equilibrium” of runs is what this framework is all about, and it could help solve many financial-stability problems we face today. The simple idea is that banks, crypto firms, stablecoins, and money-market mutual funds pay some small premium in exchange for a government-established deposit-insurance scheme that safeguards all involved against disaster.
In a 2021 piece, I argued that we need such a scheme to prevent runs on prime money-market mutual funds, which have occurred during each of our last two major financial crises (the global financial crisis of autumn 2008 and the Covid-19 crisis of spring 2020). Unfortunately, regulators have since opted for a mechanism of “swing pricing,” which I think is an insufficient means of dealing with the problem of runs. (The SEC is now also proposing that all open-end mutual funds adopt “swing pricing,” which will likely create further unnecessary complexity and costs for asset managers.)
To be sure, more financial regulation is not always a good thing. Establishing fees and gates for prime money-market funds, as regulators did after the 2008 crisis, arguably made such funds even more susceptible to runs when the next crisis hit in 2020. But cryptocurrency and stablecoins need to be backstopped in some way to alleviate the risk of runs.