How and why do stablecoins depeg?

A stablecoin is a type of cryptocurrency designed to have a stable value for a specific asset or basket of assets, usually fiat currencies such as US dollars, euros, and Japanese yen.

Stablecoins are designed to provide a “stable” store of value and medium of exchange compared to traditional cryptocurrencies such as Bitcoin (BTC) and Ether (ETH), which are highly volatile. .

Fiat currencies, cryptocurrencies, and commodities such as gold and silver are examples of assets used to collateralize or “back” stablecoins. Tether (USDT), USD Coin (USDC), and Dai (DAI) are examples of USD-pegged stablecoins.

Stablecoins can also be algorithmically stabilized through smart contracts and other mechanisms that automatically adjust the stablecoin supply to maintain a peg to the underlying asset.

Despite their potential benefits, stablecoins are not without risks. The most significant risk for stablecoins is the potential for broken pegs and loss of value relative to the underlying asset.

Depegging is when the value of a stablecoin deviates significantly from its pegged value. This can occur for a number of reasons, including market conditions, liquidity issues, and regulatory changes.

USDC is a fully reserved collateralized stablecoin. This means that all USD coins are backed by real cash and short-term government bonds. Nevertheless, USDC issuer Circle announced on March 10 that USDC was detached from the U.S. dollar, and about $3.3 billion of his USDC reserve of $40 billion is now announced it was lodging at a defunct Silicon Valley bank. The bank, his 16th largest bank in the US, collapsed on his March 10th, making him one of the largest bank failures in US history. Given USDC’s collateral influence, other stablecoins have similarly de-pegged from the US dollar.

Related: USDC lifts peg as Circle confirms $3.3 billion stuck in Silicon Valley banks

MakerDAO, a protocol based on the Ethereum blockchain, will launch DAI, an algorithmic stablecoin designed to maintain an exact 1:1 ratio to the US dollar. However, the DAI also fell off the peg amid the Silicon Valley Bank collapse, largely due to the contagion effect of the USDC de-pegging. Over 50% of the reserves backing DAI are held in USDC.

Tether issues USDT, and all USDT tokens are equivalent to their corresponding fiat currency at a 1:1 ratio and are fully backed by Tether’s reserves. However, USDT also experienced a de-pegging in 2018, raising concerns about the overall stability mechanism of stablecoins.

Importance of stablecoin pegs

The importance of a stablecoin peg is to provide a stable and predictable value for an underlying asset or basket of assets (usually fiat currencies such as the US dollar). Stablecoins are a desirable alternative for various use cases such as cryptocurrency trading, payments, and remittances due to their stability and predictability.

Stablecoin pegs allow traders to enter and exit positions independent of price fluctuations in cryptocurrencies such as BTC and ETH. This is important for institutional investors and companies that rely on a reliable store of value and medium of exchange to conduct their business.

A stablecoin peg can also make cross-border transactions more accessible. This is especially true in countries with unstable currencies and limited access to traditional financial services. Compared to traditional methods such as wire transfers and money transfer services, stablecoins can provide a more effective and affordable way to make payments and transfer value across borders.

Stablecoin pegs can also increase financial inclusion, especially for people and businesses without access to traditional financial services. Stablecoins can be used for payments and digital asset transactions without the need for a bank account or credit card. This is essential in developing countries and emerging markets.

Why Depeg Stablecoins?

Stablecoins can be de-pegged due to a combination of microeconomic and macroeconomic factors. Micro factors include changes in market conditions, such as sudden increases or decreases in stablecoin demand, liquidity issues, and changes in underlying assets. Macro variables include changes in overall economic conditions, such as inflation and rising interest rates.

For example, a stablecoin’s price may temporarily exceed its pegged value if demand spikes due to increased trading activity in the cryptocurrency. Still, if insufficient liquidity meets rising demand, the price of the stablecoin could fall below its fixed value.

On the macroeconomic side, high inflation could reduce the purchasing power of the underlying assets that underpin the stablecoin, leading to a depeg event. Similarly, adjustments in interest rates and other macroeconomic indicators can affect demand for stablecoins.

Regulatory changes and legal issues can also cause stablecoin depeg. For example, if a government bans the use of stablecoins, the demand for stablecoins will decrease and their value will decline. Depeg events can also be caused by technical issues such as smart contract bugs, hacking attacks, and network congestion. For example, a flawed smart contract could result in an improper calculation of the value of a stablecoin, resulting in significant deviations from the peg.

How are stablecoins depegged?

De-pegging of a stablecoin typically occurs in several steps, but this may vary depending on the specific stablecoin and the circumstances leading to the de-pegging event. Below are some of the common characteristics of unpegged events.

Stablecoin value deviates from peg

As mentioned earlier, many factors can cause stablecoin depeg, including market turmoil, technical issues, lack of liquidity, and regulatory issues. The value of a stablecoin can change dramatically compared to a pegged asset or basket of assets.

Traders and investors react to unpegging events

Whether they think the stablecoin’s value will eventually return to the peg or continue to move off the peg, traders and investors will likely buy the stablecoin when it leaves the peg dramatically. You may respond by buying or selling.

Creates arbitrage opportunities

Arbitrage opportunities could materialize once the value of the stablecoin moves off the peg. For example, a trader can sell a stablecoin and buy the underlying asset for a profit if the stablecoin is worth more than its peg.

Stablecoin issuers take action

If the value of a stablecoin continues to fall off its peg, the issuer of the stablecoin may take steps to rectify the problem. This may require changes in stablecoin supply, collateral rates, and other actions to increase trust in stablecoins.

stable coin value

As traders and investors adjust their positions and stablecoin issuers respond to unpegging events, the value of the stablecoin could stabilize. If the stablecoin issuer succeeds in regaining public trust, the value of the stablecoin may return to its peg.

Risks and challenges associated with unpegging stablecoins

Depegging stablecoins can pose some risks and difficulties for investors, traders, and the larger cryptocurrency ecosystem.

  • Market Volatility: When a stablecoin is de-pegged, the market can experience significant turmoil as traders and investors change their holdings in response to the de-pegging event. This can lead to market uncertainty and increase the potential for losses.
  • Reputational risk: Depegging a stablecoin puts the reputation of the issuer and the larger cryptocurrency ecosystem at risk. This can make it difficult for stablecoin issuers to attract new users and investors and reduce the total value of the market.
  • Liquidity Risk: If a stablecoin is de-pegged due to a large sale of the stablecoin by traders or investors, liquidity issues may arise. As a result, the value of the stablecoin may decline, making it difficult for traders and investors to liquidate their holdings.
  • Counterparty Risk: Traders and investors may be exposed to the risk of default by the issuer of the stablecoin or other parties participating in the operation of the stablecoin due to depeg events.
  • Regulatory Risk: The de-pegging of stablecoins can also pose regulatory issues. Governments and authorities may impose restrictions on stablecoins if they believe the assets threaten the stability of the wider financial system.

RELATED: Circle’s USDC Instability Causes Domino Effect on DAI, USDD Stablecoins

Given the above risks, investors and traders alike should keep an eye on the performance of the stablecoins in their portfolios. Investigate stablecoin issuers and their collateral, and be on the lookout for signs of depegging or other issues that may affect the value of your stablecoin. We may also consider diversifying our holdings using various stablecoins and other assets. This reduces the chances of incurring losses in a stablecoin unpegging event.