Since their introduction 10 years ago, stablecoins, or the world’s ‘digital dollars,’ have skyrocketed in popularity, offering an alternative to the volatility of cryptocurrencies. The concept was, and still is, fairly straightforward. By pegging their price to an external asset, stablecoins are designed to maintain a stable value, making them more suitable for everyday transactions, such as payments or overseas remittances, or even larger trade settlements.
That said, not all stablecoins are created equally. Broadly speaking, there are collateralized stablecoins backed by underlying assets such as fiat or cryptocurrencies or equivalent. Others are non-collateralized, such as algorithmic stablecoins, which rely on smart contracts and programmed algorithms that adjust their supply based on changes in demand. When demand rises, the algorithm mints new tokens to maintain stability, and vice versa when demand decreases.
Over the years, there has been criticism that algorithmic stablecoins are risky. They are prone to fundamental weaknesses and lack underlying assets to serve as a safety net. For this reason, regulators such as the Hong Kong Monetary Authority do not accept stablecoins structured in this manner under their stablecoin regime.
It’s trust that makes or breaks stablecoins
In many ways, whether a stablecoin is collateralized or not is not the key issue. The fundamental issue is whether users trust that the underlying fundamentals are sustainable. If users do not trust that the collateral is sufficient or the pegging mechanism is robust, they may opt not to use the stablecoin altogether. Traditional stablecoins, being pegged to external assets such as fiat currency or other liquid instruments, generally provide more direct assurance that the stablecoin can be redeemed for its equivalent value. Other factors such as regulatory compliance, historical stability and the simplicity of its mechanism also lend a higher level of confidence in the ability of these stablecoins to maintain their peg.
Algorithmic stablecoins are based on a much more dynamic method of regulation without the reliance on underlying assets. These types of stablecoins appeal to users who value decentralization, as they offer an independent mechanism from conventional collateral. Of course, algorithmic stablecoins are not without risk. Maintaining investor confidence in a stablecoin hinges on maintaining a stable peg, and in the absence of physical reserves, this job falls on the algorithm entirely. Unexpected market events can lead to what’s known as a ‘death spiral’.
Take Terraform Labs’ UST and LUNA, for example, which was based on a dual-based token system. In theory, 1 UST could be redeemed for $1 worth of LUNA and vice versa. The basic rule of the protocol is that users burn LUNA to mint UST and burn UST to mint LUNA. However, in the case of UST and LUNA, the ‘mint-and-burn’ mechanism demonstrated how overdependence on complex algorithms could lead to hyperinflation of the token, causing its peg to destabilize.
It’s a chicken-and-egg-challenge…
Similar to how fractional reserve banking requires a certain degree of sophistication compared to full reserve banking, so does the development of algorithmic stablecoins. For example, this involves assembling a team of skilled individuals with expertise in finance, technology, and economics. Additionally, a strong market data infrastructure is essential to provide reliable and comprehensive data that informs and strengthens the resilience of the algorithms. Advanced technology, such as AI, plays a crucial role in stress-testing and refining these stablecoins. Moreover, robust testing and development are necessary to ensure that algorithmic stablecoins are not only tested within known parameters but also against unpredictable market behaviours.
Of course, this is easier said than done. Quite simply, the industry is not yet at the stage where it can design sophisticated, scalable, properly stress-tested algorithmic stablecoins that investors can properly trust. Continued development and testing are essential to making algorithmic stablecoins reliable and trusted financial instruments. For this to happen, we need to attract investment, the right talent and build the right infrastructure.
That starts with the chicken (aka. collateralized stablecoins)
For stablecoins to be fully embraced as mainstream financial products, building investor and user confidence is key. This, I believe, starts with fiat-backed stablecoins.
Due to their underlying collateral structure, fiat-backed stablecoins are often considered the most reliable type of stablecoin. Take FDUSD, for example. It is backed on a 1:1 basis against high-quality cash and cash equivalent reserves. This ensures holders can redeem their FDUSD tokens for their equivalent value in USD. This feature provides safety and inherent trust to the stablecoin reserves. Particularly when investors are concerned with potential volatility, it is easier to trust the stability mechanism when tangible assets such as fiat currencies are involved. This, in turn, helps to encourage its more mainstream and everyday usage.
Another essential factor in building trust in stablecoins is regulatory compliance and oversight. As more regulatory frameworks across markets such as Europe, Singapore, and Hong Kong emerge, regulatory clarity will help reduce risk for market participants, boosting their mainstream appeal.
Finally, outside of the design is the diverse utility of fiat-backed stablecoins. For one, stablecoins provide a modern way to conduct fast global money transfers, acting as a new base layer for payments to enable money to move securely and be settled in an instant. Stablecoins have also found their use as a store of value in countries with volatile currencies, helping users preserve their purchasing power, even in the event of inflation or economic uncertainty. This is why it is likely the U.S dollar-backed stablecoins will continue to dominate the market landscape due to the greenback’s symbiosis with global trade. Although we’ve seen a trend towards multi-currency settlement and other alternatives such as CBDCs, for now, USD will continue to be seen as a stable currency that users prefer.
Only once we have mastered fiat-backed stablecoins, earned trust, and encouraged application development can we attract the investment, right talent, and resources needed to further the infrastructure for stablecoins. From there, we can then begin to explore more exotic mechanisms in the algorithmic and non-collateralized realm.
DISCLAIMER
This publication is general in nature and is not intended to constitute any professional advice or an offer or solicitation to buy or sell any financial or investment products. You should seek separate professional advice before taking any action in relation to the matters dealt with in this publication. Please note our custody services of the reserves are provided by First Digital Trust Limited.
