Cystatin M/E is a member of a superfamily of evolutionarily-related cysteine protease inhibitors that provide regulatory and protective functions against uncontrolled proteolysis by cysteine proteases. Although most cystatins are ubiquitously expressed, high levels of cystatin M/E expression are mainly restricted to the epithelia of the skin (epidermis, hair follicles, sebaceous glands, and sweat glands) and to a few extracutaneous tissues. The identification of its physiological targets and the localization of these proteases in skin have suggested a regulatory role for cystatin M/E in epidermal differentiation. In vitro biochemical approaches as well as the use of in vivo mouse models have revealed that cystatin M/E is a key molecule in a biochemical pathway that controls skin barrier formation by the regulation of both crosslinking and desquamation of the stratum corneum. Cystatin M/E directly controls the activity of cathepsin V, cathepsin L, and legumain, thereby regulating the processing of transglutaminases. Misregulation of this pathway by unrestrained protease activity, as seen in cystatin M/E-deficient mice, leads to abnormal stratum corneum and hair follicle formation, as well as to severe disturbance of skin barrier function. Here, we review the current knowledge on cystatin M/E in skin barrier formation and its potential role as a tumor suppressor gene.