An old saying holds that markets are ruled by either greed or fear. Greed once governed cryptocurrencies. The price of bitcoin, the best known, rose from about $900 in December 2016 to $19,000 and then to over $67,000 in November and now to $35,070. Recently, fear has been in charge. Prices of other cryptocurrencies, which followed bitcoin on the way up, have collapsed too. Economists define a currency as something that can be at once a medium of exchange, a store of value and a unit of account. Lack of adoption and loads of volatility mean that cryptocurrencies satisfy none of those criteria. That does not mean they are going to go away (though scrutiny from regulators concerned about fraud and sharp practice that is rife in the industry may dampen excitement in the future). But as things stand there is little reason to think that cryptocurrencies will remain more than an overcomplicated, untrustworthy casino.

Believers in virtual currencies say that one of their selling points is freedom from government meddling. Cryptocurrencies such as bitcoin promised to upend the financial system and replace conventional money with assets outside the control of governments and banks. Yet a single tweet can cause its value to rise or fall sharply. This volatility makes it an inferior medium of exchange. Instead, bitcoin has now become an asset class. Its future is far from certain. El Salvador has become the first country to adopt bitcoin as legal tender, while other countries are closing the door on it.

Crypto ecosystem

Bitcoin’s resurgence has come just as champions of cryptocurrencies have started to gravitate to another system, Ethereum, whose digital tokens are called “ether”. This has both political and technical causes. Bitcoin’s developers have yet to agree on how to increase the capacity of their network, which can only process seven transactions per second. And Ethereum makes it easier for users to create self-executing “smart contracts”, something of a fad in the world of cryptocurrencies.

Pledges of stability often lead to financial crises. Because banks offer deposits that are redeemable on demand and superficially riskless, but which are backed by longer-term, less liquid, and riskier assets, they are vulnerable to runs. Stablecoins are similar. The fast-moving frontier of financial innovation can seem an intimidating place. Concepts such as decentralisation, distributed ledgers and symmetric encryption can befuddle the outsider. Scholars and regulators may therefore have been relieved to spot parallels between the burgeoning world of stablecoins—digital tokens that are pegged to an existing currency or commodity.

Nepal's case and response

The central bank's approach to handling cryptocurrencies can be labelled as hands-off in its regulations. But alarm has mounted about the speculative fervour. So intense is the demand that Nepalis pay a “Yeti premium” of roughly 25 percent for their bitcoins (not easily arbitraged away because of capital controls). On September 9, 2021, for the second time, the central bank issued a notice saying crypto-currency exchanges were banned and illegal in the country. Their devotees are yet to respond with a petition urging leniency. While it is important to warn and protect citizens against predators, realising that "crypto-derivatives are just as risky as other derivatives" is also equally important. A ban on one type could mean consumers invest directly in other unregulated cryptocurrencies instead.

Governments have an obligation to fight the deception, tax evasion and money laundering that plagues the crypto world. Police seizures of bitcoin and the staggering decline of 6.9 percent in national remittances suggest that they are becoming more zealous. Considering the fact that remittances contribute to around 23.33 percent of the national GDP, a 6.9 percent decline is a concern given that one of the strongest possible uses for blockchain technology is to facilitate cross-border settlements. The harder issue they must grapple with is whether cryptocurrencies threaten the financial system. Were bitcoin to collapse, our crypto “stress test” (like the ones that commercial banks are required to perform for physical currencies) suggests that its holders would lose hundreds of billions of dollars, but the fallout would be manageable.

A swifter approach to the issue has surfaced in a few regional neighbouring countries where some governments appear to soften their stance, saying a ban is just one idea. Other incoming measures are less potent: Investors will have to pay taxes on capital gains and register trading accounts under their real names, allowing mining options limiting only to in-country.

It may be tempting to ban stablecoins, especially if central banks launch their digital currencies—much as private banknotes were replaced with government monopolies on physical cash. Yet it is possible that regulated private-sector stablecoins will eventually bring benefits, such as making cross-border payments easier, or allowing self-executing “smart contracts”. Regulators should allow experiments whose goal is not merely to evade financial rules. But first, they must prevent the repackaging of risks with which the world is all too familiar.

Regulators must act quickly to subject stablecoins to bank-like rules for transparency, liquidity and capital. Those failing to comply should be cut off from the financial system, to stop people from drifting into an unregulated crypto-ecosystem. Policymakers are right to sound the alarm, but if stablecoins continue to grow, the government will need to move faster to contain the risks.

But rather than throttle virtual currencies and the innovations they might spawn, many governments have let them develop, within parameters bypassing the “virtual-currency act”, declaring that they are assets and can be used for payments. The financial services authority could grant licences to limited mining, trading and exchanges, to reduce the risk of fraud. But perhaps one less appreciated lesson from free banking is that, if innovation is not to be smothered, the quality of regulation matters. Crypto might offer a lifeline to some. But it will take more than the world’s most decentralised currency to change one of the world’s most centrally planned economies.