May 2022 marked some of the darkest days in the annals of cryptocurrency. TerraUSD – a type of cryptocurrency known as stablecoin – collapsed, obliterating over US$400 billion in market value and bankrupting many investors. Ironically, its creator, Do Kwon, once quipped that he enjoyed watching 95 per cent of companies entering the crypto market crash and burn, only to suffer the same fate himself. How did a cryptocurrency that was meant to be pegged to the US Dollar and reportedly backed by hard currency fail?

The stablecoin backstory

Invented in 2009, Bitcoin was the world’s first cryptocurrency. Its white paper describes it as “an electronic payment system based on cryptographic proof instead of trust”.

Bitcoin transactions are recorded on a secure blockchain, so there is no need to rely on a middleman. Instead, trust is placed in computer code. Transactions become more efficient as smart contracts could be executed immediately once their programmed/coded conditions are met. This means faster, cheaper and, in theory, more reliable transactions. In theory, anyway.

But cryptocurrencies are speculative and highly volatile, making them unsuitable as a fiat currency substitute. Enter the stablecoin. A type of cryptocurrency that could be collateralised – backed by assets such as money, cryptocurrencies or commodities – or algorithmic, using a set of rules to stabilise its price.

The earliest example of a stablecoin is fiat-based Tether, or USDT. First issued in 2014, it currently has the third largest share of the cryptocurrency market at US$68 billion. Each USDT issued was meant to be backed by US$1. However, contrary to what was promised, each USDT was instead backed by a basket of assets that included cash equivalents, other cryptocurrencies and loans made by Tether. These were obviously more volatile than cash. Additionally, Tether has never audited its reserves. While the idea of a “dollar-for-dollar” backing is attractive, there were clearly issues of accountability.

Enter the Dai stablecoin in 2017. Unlike Tether, Dai is backed by other cryptocurrencies such as ether. However, crypto-backed stablecoins have a drawback: overcollateralisation. To buffer against cryptocurrency’s inherent volatility, users have to tie up extra capital that could otherwise be invested.

Launched in September 2020, TerraUST was different. It was an algorithmic stablecoin which, in theory, had the potential for near perfect capital efficiency. TerraUST operated on a two-coin system, Terra and Luna. Terra was a US Dollar pegged stablecoin while Luna served as the staking and governance asset. If the value of Terra rose above US$1, the equivalent value of Luna would be burnt and more Terra would be minted, making Terra less valuable and bringing it closer to its US$1 peg. Conversely, if the price of Terra fell below US$1, Terra was swapped for Luna and burnt, which in turn made Terra more valuable.

In May 2022, the crypto market experienced a major crash, which knocked Terra off its US$1 peg. Spooked, more and more Terra token holders exited. This forced the Terra-Luna exchange to mint more Luna, also causing the value of Luna to plunge. As prices of both Terra and Luna went into freefall, investors sold off all their holdings on the open market, leading to a “death spiral”. So much for algorithmic stablecoins.

Are Stablecoins “Fools’ Gold”?

Their short history suggests that stablecoins can only achieve true stability when they are fully backed by a stable asset and subject to appropriate regulation.

However taboo it may be to the cryptoverse, regulation is inevitable. Whenever technology develops, regulation always plays a balancing act. It protects consumers while striving not to stifle innovations meant for their benefit. Take, for instance, Big Data. While social media intermediaries generate value from personalised services and targeted advertising, allowing them unfettered discretion to collect information is not an unmitigated good. In 2010, Facebook permitted Cambridge Analytica to amass personal data belonging to over 50 million users without their consent, which was leaked and sold to bad actors who used it to influence electoral processes worldwide. The scandal led to widespread calls for the regulation of consumer data collection and usage. The risk is that innovation, without appropriate regulation, leads to exploitation.

Back to stablecoins. Calls for enhanced regulation have followed the TerraUST fallout but the regulatory regime is still in its infancy. Governments have since urged policymakers to take action, collaborating with financial institutions to develop suitable legislation to minimise risks and maximise benefits associated with stablecoins.

A notable example is the Hong Kong Monetary Authority’s (HKMA) recommendation of an agile regulatory approach that prioritises areas with elevated risk while leaving space for financial innovation.

Back home, the MAS has announced a stablecoin regulatory framework to apply to single-currency stablecoins (SCS) pegged to the Singapore Dollar or any G10 currency, that are issued in Singapore. These include a minimum base capital and liquid assets to reduce the risk of insolvency, and the requirement to redeem the SCS at par. Transparency is another requirement with mandated disclosure on the value stabilising mechanism, rights of holders, and audit results of reserve assets. Only such SCS will be eligible to be recognised and labelled as “MAS-regulated stablecoins”.

But even with robust domestic regulation, there are still problems: various countries may adopt distinct approaches, resulting in inconsistencies and regulatory gaps. This may lead to regulatory arbitrage: the practice of utilising more favourable laws in one jurisdiction to circumvent less favourable regulation elsewhere, especially given the internet’s essential borderless nature.

In this regard, it is encouraging to note that at the recent G20 Summit, Singapore announced its intentions to broaden its network of digital economy agreements with other countries. These aim to establish rules and standards that promote digital economy participation, greater data protection, and safe cross-border payments. Some examples include the UK-Singapore Digital Economy Agreement and the Singapore-Australia Digital Economy Agreement. We can also expect efforts towards a seamless digital trade ecosystem across the region as Singapore collaborates with Indonesia to advance the ASEAN Digital Economy Framework by 2025.

While stablecoins hold potential to shape the future of money, there is still much ground to cover on the regulatory front. At first blush, proponents of cryptocurrency who favour an efficient decentralised system may baulk at regulation, an apparent regression to an inefficient centralised system. However, history has proven that appropriate regulation is not anathema to efficiency. Appropriate regulation works hand in hand with innovation to prevent exploitation and to promote benefits.

Ultimately, for cryptocurrencies to work, they must trade and operate in a trustless system, where code is the organising principle. But there must be trust in the rules of the game – so if you say a token is collateralised, then it really must be truly collateralised.

Perhaps that is the regulatory sweet spot. Let code operate, but have accountability if things go wrong. Trustless operations but trusted rules. Watch this space.