Stablecoins at 10: From right place, wrong time, to right place, right time

The following is a guest post from Vincent Chok, CEO of First Digital Group.

On 21st July 2014, we witnessed the launch of the world’s first stablecoin, BitUSD. It was a powerful new concept to enter the market, offering the promise of a stable digital currency that could facilitate transactions without the volatility associated with other cryptocurrencies. Yet four years later, BitUSD lost its one-to-one parity with the US dollar and has been unable to recover since. BitUSD was not alone. The early years were mired by numerous failures as the structures, infrastructure and oversight needed to support stablecoins were not yet mature.

Today, the landscape has changed significantly with robust projects and, not least, with highly anticipated stablecoin regulation in Hong Kong. As stablecoins celebrates their 10th anniversary, it is a time to reflect on its journey thus far and why the environment now paves the way to a successful future, demonstrating that stablecoins are now in the right place, at the right time. 

Examining Previous Failures

Ten years ago, the idea of stablecoins was new and exciting, at a time when the world was still reeling from the effects of the global financial crisis. They were seen as a bridge between the volatile world of cryptocurrencies and the stability of traditional fiat currencies. There was also growing recognition that Web3-enabled digital payment rails could also increase the appeal and accessibility of stablecoins to the underbanked.

However, many early projects failed primarily due to poorly thought-out mechanisms, the lack of robust infrastructure and regulatory oversight. In BitUSD’s case, detailed analysis by BitMEX Research found the stablecoin was collateralised with an obscure, volatile, itself-unbacked asset, BitShares. In the event of a fall in the price of BitShares, a single BitUSD could be used to purchase more BitShares and thereby encourage mass arbitrage similar to traders of traditional asset classes. However, the opposite was not guaranteed, thus creating a structural weakness.

Another notable example is TerraUSD (UST), which maintained its price peg through an arbitrage mechanism involving its sister token, LUNA. While innovative, this mechanism had several flaws.

During normal conditions, the redemption fee was 0.5%, but during the collapse, fees skyrocketed to 60%, making it unprofitable for arbitrageurs to restore the peg. Inaccuracies in the Luna Price Oracle contributed to instability, with discrepancies up to 70% between the Oracle Price and exchange price. The lag between UST redemption and selling LUNA created uncertainty, preventing effective arbitrage. In the end, the collapse of UST was exacerbated by a speculative attack and a bank run-like scenario, where heavy redemptions led to a death spiral for both UST and LUNA.

Other stablecoins, like Acala USD (aUSD), and DEI from Deus Finance, also faced significant issues. Acala USD, for example, was brought down by a technical exploit where hackers were able to mint 1.28 billion aUSD due to a misconfiguration in a liquidity pool. 

DEI was targeted in a hack that exploited vulnerabilities on multiple networks, leading to a $6 million loss. In hindsight, many of these mistakes could have been easily avoided, however as is very often in emerging technologies, trial and error is part of the process to maturity. 

Learning From the Past

Today, the environment for stablecoins has vastly improved. Learning from the mistakes of the past, modern projects reflect more robust models and well-considered mechanisms. For instance, we have seen less non-collateralised, algorithmic stablecoin projects enter the market in favor of fiat and commodity based stablecoins. Unlike algorithmic stablecoins, collateralised stablecoins do not rely on market forces to maintain their stability and are less exposed to fundamental risk. FDUSD, for example, is pegged against the US Dollar, backed with audited cash and high-quality cash equivalent reserves that are custodied in financial institutions.

Modern stablecoins are also built on more secure and scalable blockchain platforms, reducing the risk of technical exploits. Factors include better standards, as well as the fact that the sector’s professionalization has attracted top talent from major technology companies, cybersecurity fields and more. 

Regulatory Certainty

In the early days of stablecoins, the regulatory landscape was characterized by a lack of clear guidelines and standards. This ambiguity posed significant challenges for stablecoin projects, as they navigated a complex web of financial regulations across different jurisdictions. Many early projects operated in a regulatory gray area, which led to issues of compliance and security. However, today, regulatory bodies are successively introducing clearer guidelines that help to mitigate risk, introduce good governance and provide much needed certainty for projects to thrive.

The Hong Kong Monetary Authority is expected to introduce its stablecoin regime in the coming months. The licensing criteria and conditions are expected to include stringent requirements to ensure the stability and integrity of stablecoins under its jurisdiction. The city is known for having developed some of the highest standards in financial regulation and governance through its rise as an international financial hub.

Dubai’s VARA regime also offers an attractive foundation for digital asset companies to build businesses and solutions in the market. Only recently the Central Bank of the United Arab Emirates approved the issuance of regulations for licensing and oversight of stablecoin arrangements. 

The European Commission’s MiCA regulation also includes provisions addressing capital requirements, governance, and consumer protection for stablecoins.

Interoperability and Exchangeability

Regulation will play an important drive since regulated stablecoins will have the same KYC and AML mechanisms as Central Bank Digital Currencies (CBDCs), creating a level playing field. Exchangeability and interoperability between the two will open up the utility of stablecoins to traditional financial services. 

Today, the usage of stablecoins remains largely focused on cross-border payments and remittance scenarios. Proliferation and broadening the scope of its utility must be predicated by greater credibility and trust. Historic issues with well-known stablecoins and heavy exposure to the U.S. market at a time of inherent uncertainty continue to shadow the sector. 

This presents a compelling case for alternatives issued outside the U.S. market and developed with trust-by-design. Characteristics include collateralized, high quality reserves that are audited, unlimited minting and 1:1 redemption. 

Right Place, Right Time

As stablecoins mark their 10th anniversary, it’s clear that they have come a long way. The early failures provided valuable lessons that have shaped the development of more resilient and reliable stablecoins. As the world continues to change, as risk and uncertainties grow, there has never been a stronger desire from people and businesses for greater trust, certainty and consistency.

Therefore, stablecoins are in the right place at the right time. Supported by robust infrastructure, emerging regulatory frameworks, and increased interoperability. These factors position stablecoins to play a transformative role in the financial system, harnessing their inherent programmability to inspire novel business models and increasing accessibility to the financial system for users worldwide.

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