In December 2023, the Hong Kong Monetary Authority officially released the "Consultation Document on Legislative Proposals for Implementing a Regulatory Regime for Stablecoin Issuers in Hong Kong", and launched the "Sandbox" regime for stablecoin issuers in March 2024[1]. The Hong Kong dollar digital stablecoin is on the verge of being launched to the world. At this critical moment in history, it is very necessary for us to deeply explore a crucial question: Can the Hong Kong dollar digital stablecoin become a strong currency on the blockchain? And what should we do?

The traditional "impossible triangle" no longer holds

In the blockchain web 3.0 world, the traditional "impossible triangle" no longer exists. This is a disruptive change and also the starting point for us to consider new problems. The "Mundell-Fleming Trilemma" of the open economy is a famous proposition in international economics. It was independently proposed by the famous economists John Fleming and Robert Mundell in the 1960s; later, American economist Paul Krugman also elaborated on it. [2] According to the content of the "Mundell-Fleming Trilemma", the three vertices of the triangle correspond to three goals, namely: (1) completely independent monetary policy; (2) completely fixed exchange rates; (3) completely free capital flow. The "Mundell-Fleming Trilemma" says that a country can only choose two of the three goals at most, and it is impossible to have all three.

The creation of legal tender, the formulation and transmission of monetary policies, the design and implementation of financial supervision, the parity relationship between interest rates and exchange rates in traditional financial markets, and the pricing and flow of complex financial products are all based on this "impossible triangle". It can be said that the "impossible triangle" is the core "algorithm" for the operation of the world financial system since the Bretton Woods system.

Hong Kong is a real example of the effectiveness of the "impossible triangle". Hong Kong adopts the "linked exchange rate" system under the currency issuing authority. The Hong Kong dollar is pegged to the US dollar, and the fixed exchange rate is 7.8 Hong Kong dollars to 1 US dollar (allowing a 0.64% float, that is, allowing 7.75 to 7.85 Hong Kong dollars to 1 US dollar). At the same time, Hong Kong allows the free flow of capital. Under the framework of the "trilemma", Hong Kong maintains two "vertices" of the "triangle", namely stable exchange rates and fully mobile capital, but loses another "vertices", namely the independence of monetary policy. It took Hong Kong more than 40 years to establish the world credit of the Hong Kong dollar, and the Hong Kong dollar linked exchange rate has become the mainstay of Hong Kong's economic and financial stability.

However, in the world of blockchain web 3.0, there is no such "impossible triangle". After the digital currency is put on the chain, it will participate in the full competition of all digital currencies, and the exchange transactions will be carried out 24*7. The point-to-point exchange on the blockchain can be fast, efficient and barrier-free, and is basically not affected by the degree of capital account openness of the country. Of course, there is also an "impossible triangle" on the blockchain, which was proposed by Vitalik Buterin, the founder of Ethereum, that is, "the blockchain network cannot achieve security, decentralization and scalability at the same time." This blockchain "impossible triangle" will lead to different blockchain structures and algorithms, and is also the common logic for various public chains and applications to compete with each other. Therefore, it will also deeply affect the ecological environment of the Hong Kong dollar digital stablecoin participating in the crypto competition.

On-chain vs. off-chain currency competition

We adjust our perspective to a more microscopic level. Without physical restrictions, the competition of digital currencies will be based on network ecology, application scenarios and incentive mechanisms.

There are many types of stablecoins that have been issued on the chain. The most commonly used one is USDT, which was issued by Tether in 2014. Its current market value is 113 billion US dollars, accounting for about 60% of the stablecoin share. However, Tether does not publish its audit report, and its off-chain reserve assets are not transparent. The market is quite worried about the stability of its currency value and whether it will have an uncertain impact on off-chain traditional finance. The second largest share is USDC, which was listed in May 2018 and has a current market value of 32 billion US dollars. Its parent company CIRCLE FINANCE is a payment company listed on the New York Stock Exchange. The off-chain reserve assets of USDC will be disclosed in the audit report every quarter. The third largest share is DAI, an algorithmic stablecoin issued by MakerDAO (its reserve assets are other digital assets on the chain, such as BTC, ETH, etc.), with a current market value of 5.3 billion. The DAI stablecoin single-collateral Sai system was launched in 2017. DAI is the largest algorithmic digital stablecoin with the largest market value.

Figure: Some digital stablecoins circulating on the chain

In the web 3 world on the chain, the "FIT21" bill that has been voted by the U.S. House of Representatives defines Bitcoin as a digital commodity, but there is no clear definition for other digital currencies, so the regulatory agency and applicable rules for digital stablecoins have not yet been clarified. Digital stablecoins are a type of digital currency and a medium for connecting on-chain and off-chain. Currently, the U.S. Treasury bonds held in the off-chain reserve assets corresponding to USDT and USDC have accounted for about 10% of the total size of U.S. Treasury bonds, which is one of the reasons why the United States publicly embraces Crypro. If Crypto is subject to reasonable supervision in the future, Crypto will form a positive cycle with the off-chain dollar repatriation mechanism, further consolidating the international status of the dollar.

Now, let’s turn our attention back to the off-chain world. In the off-chain world of paper money, how do we define international currency? According to the definition of international currency by Kenen (1983) and Krugman (1984), similar to the functions of local currency, international currency also has three functions of currency: medium of exchange, unit of account, and store of value. For different users, it can be further divided into six functions: (1) As a medium of exchange, it means trade settlement and financial transactions for the private sector, and a tool currency for foreign exchange intervention for the government (public) sector. (2) As an account unit, it represents the unit of account for trade and finance in the private sector, while for the government (public) sector, it plays the role of an “anchor” currency pegged to the local currency. (3) As a store of value, it is used as an investment asset and foreign exchange savings in the private sector, while for the government (public) sector it is a foreign exchange reserve. Each of these six functions can be associated with other functions to a certain extent (Cohen, 1971) [3]. There were five currencies included in the International Monetary Fund's SDR currency basket that year, namely the US dollar, euro, renminbi, yen and pound sterling. According to the results of the IMF's 2022 valuation review, the US dollar accounted for 43.38% of the SDR and the renminbi accounted for 12.28%.

Table Attributes of international currencies[4]

Functions of Money

Government (Public) Sector

Private sector

Store of Value

foreign exchange reserves

Foreign exchange savings

Medium of Exchange

Currency of foreign exchange intervention tool

Trade settlement and financial transactions

sales unit

Anchor currency pegged to the local currency

Unit of account for trade and finance

Table: Composition and weight of the SDR basket after the 2022 valuation review

currency

SDR weight in 2002 (%)

US Dollar

43.38

Euro

29.31

Chinese Renminbi

12.28

Japanese Yen

7.59

Pound Sterling

7.44

Data source: International Monetary Fund

Let's go back to the question we asked at the beginning: Can the digital Hong Kong dollar stablecoin become a strong currency on the chain? A possible design of the digital Hong Kong dollar stablecoin is: the digital Hong Kong dollar stablecoin and the Hong Kong dollar banknote are exchanged at a 1:1 ratio. Since the Hong Kong dollar implements a linked exchange rate system with the US dollar, the on-chain digital Hong Kong dollar stablecoin maintains a 7.8:1 anchor relationship with the off-chain US dollar. Of course, other possible designs also include the Hong Kong dollar digital stablecoin being pegged to a basket of currencies including the US dollar and the RMB, but this approach requires solving the arbitrage problem of on-chain and off-chain assets, because Hong Kong dollar cash is anchored to the US dollar. If the digital Hong Kong dollar stablecoin is not anchored to the US dollar, then there will be price differences and arbitrage problems between the Hong Kong dollars on and off the chain.

Hong Kong has always been the most important window for China to communicate with the outside world. It is the largest offshore RMB center, and has built a bridge for China's huge high-quality assets to connect with the world. Capital from all over the world flows to Hong Kong, converting local currencies into Hong Kong dollars to obtain high returns from Chinese assets. This is the Hong Kong narrative of China's 40 years of reform and opening up, and it is also the biggest advantage of Hong Kong. However, in the world of blockchain, since the classic "impossible triangle" no longer exists, there is no control of capital flows between currencies, and there is no "center" to intervene in the performance of exchange rates. We must raise the following four questions: 1) If mainland capital cannot legally and compliantly exchange Hong Kong dollar digital stablecoins, what are the advantages of Hong Kong dollar digital stablecoins? 2) If mainland capital allows legal and compliant free exchange of Hong Kong dollar digital stablecoins, how to control capital outflows from the mainland, after all, this will lead to more serious financial instability; 3) The 1:1 exchange of digital Hong Kong dollar stablecoins and Hong Kong dollars actually implies an additional condition, that is, the absolute stability of Hong Kong's linked exchange rate. Is it necessary to effectively hedge this additional condition at the beginning of the design of the stablecoin system? 4) How does the digital Hong Kong dollar stablecoin compete with other stablecoins, such as USDT, USDC, etc.

Digital Stablecoin Yield Farming

The competition of stablecoins on the chain is achieved through the wealth effect. Various smart contracts on the chain will provide users with generous participation rewards. Investors can obtain high points rewards and airdrop opportunities by depositing stablecoins and providing liquidity for stablecoin pools, which makes the fixed income of stablecoins on the chain very high (more than 20% is very common). This principle is similar to the taxi coupons of Didi Dache at the beginning of its establishment and the coupons of Luckin Coffee, which are high subsidies mainly issued to increase popularity.

Here we can give an example of risk-free yield farming: Recently, the risk-free arbitrage of stablecoins USDT and USDC on the SUI public chain has been very popular. At that time, Facebook's Libra team evolved into the Meta system of blockchain, and then some personnel formed a new R&D team to develop the current SUI public chain. The Scallop smart contract on the SUI chain provides lending services for stablecoins USDT and USDC, which also forms an ultra-high return risk-free arbitrage opportunity. Users can pledge USDT on the Scallop smart contract (the pledge rate is 85%), and then borrow USDC (the borrowing cost is 21.13%, the reward return is 28.32%, and the yield is 7.19%). Furthermore, we use the USDT borrowed in the previous step for a second pledge, and then borrow USDC; this process can be repeated until the amount that can be pledged approaches zero. After adding up the income of each layer of arbitrage, the annualized income is as high as about 40%. (June data). Yield farming of smart contracts like Scallop will greatly promote the use of digital stablecoins USDT and USDC, forming a positive spiral of smart contract protocols and digital stablecoins.

Figure: Investment income in Scallop protocol on June 22

Back to the Hong Kong dollar digital stablecoin, it will soon participate in the competition of the stablecoin track after it is put on the chain. In addition to the macro requirements mentioned above, the Hong Kong dollar digital stablecoin also needs to provide investors with yield farming opportunities. The advantage of Hong Kong's web 3.0 ecosystem is the huge Chinese customer base and development team. The success of the Hong Kong dollar digital stablecoin requires powerful and rich blockchain applications, public chains, second-layer network applications, smart contracts, Defi, Depin, etc. These infrastructures and applications are preferably in the Chinese environment, or at least provide Chinese users with a more comfortable and friendly experience. The construction of this ecosystem will involve two aspects of problems: (1) Regulatory issues. Hong Kong must give a clear answer to the world, that is, how open will Hong Kong be to embrace crypto? (2) Technology issues, that is, how will Hong Kong attract web 3.0 developers, programmers, encryption experts, etc. from all over the world. This will be a process of harmonious balance between regulation and innovation, and this process is not easy.

Finally, we raise a more important question, which is also a 1 and 0 question, that is, the Hong Kong dollar digital stablecoin "must" become an internationally strong digital currency, only! In the past few decades, Hong Kong's core competitiveness has been reflected in three aspects: financial center, re-export trade and shopping paradise. These three together have created the fundamentals of Hong Kong's economy and the basic foundation of the Hong Kong dollar linked exchange rate. Web 3.0 is undoubtedly a technological revolution. Hong Kong must stand at the forefront of the blockchain wave. This is a competition for survival and a 1 and 0 choice.

[1] Sandbox is an emerging regulatory term in the field of fintech. The original meaning of "sandbox" is the place where children play with sand, allowing people to play and unleash their creativity in a limited and safe environment. In the field of fintech, "sandbox" mainly refers to regulators allowing financial institutions to test and collect data and user opinions in a risk-controlled and small-scale environment before launching new services and products, thereby speeding up the launch of related products and services and ensuring that the services and products meet regulatory requirements.

[2] Robert Mundell proposed the view of supporting the fixed exchange rate system after studying the international economic situation in the 1950s. In the 1960s, Mundell and John Fleming proposed the Mundell-Fleming model to analyze the IS-LM model under an open economy, which can be regarded as a classic analysis of the use of monetary policy under a fixed exchange rate system. In 1999, American economist Paul Krugman drew a triangle based on the above principle. He called it the "eternal triangle", which clearly demonstrated the internal principle of the "Mundell triangle".

[4] This table was originally drawn up by Cohen (1971) and modified by Kenen (1983) and Frankel (1992).