Why Do Stablecoins Depeg?
Crypto Basics

Why Do Stablecoins Depeg?

Created 1yr ago, last updated 1yr ago

Recent market volatility has caused stablecoins to deviate from its peg — here's a look at why.

Why Do Stablecoins Depeg?

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Stablecoins represent a type of cryptocurrency that aims to retain a consistent value in proportion to an asset, such as fiat currencies or gold. They have gained widespread usage in the DeFi space, and as a substitute for the volatility associated with Bitcoin and other cryptocurrencies. Nevertheless, these coins may not always possess the stability they profess to exhibit.

Check out the list of stablecoins!

Several factors can cause stablecoins to lose their peg, meaning that they trade at a different price than their reference asset. For instance, one USDC, a stablecoin backed by US dollar cash reserves and short-dated treasuries, should always be worth one dollar. But if there is not enough demand or supply for USDC in the market, or if someone tries to manipulate its price, it could trade at a discount or a premium.

Depegging can undermine the trust and utility of stablecoins, which are supposed to offer fast, cheap and global transactions without sacrificing price stability and predictability. It can also hurt their profitability for both users and stablecoin issuers.

This article will examine 3 main reasons why stablecoins depeg, and how it affects their performance and adoption. It will also provide some examples from recent news on when stablecoins have depegged and how (and if) they have recovered.

Lack of Market Liquidity

Stablecoins that claim to keep a fixed value relative to an asset like fiat money or gold, need enough market liquidity to maintain their peg. Market liquidity means how easily an asset can be traded without affecting its price. If there are too few buyers and sellers in the market, the value can diverge from its peg.

That happened on March 11, 2023, when USDC, a stablecoin backed by US dollars and treasuries, and issued by Circle, plunged to $0.88. The reason was the collapse of two major banks that served crypto firms: Silicon Valley Bank (SVB) and Silvergate Bank (SI).

Circle held $3.3 billion of USDC’s cash reserves on SVB, and over the weekend that SVB collapsed, it was uncertain how much would be recovered. This spooked the market and caused widespread selling of USDC. Meanwhile, Circle could not offer redemptions as banks were closed on the weekend. The sudden fall in demand for USDC outstripped its supply in the market, causing its price to drop below its peg.

Market Manipulation

Market manipulation is another reason why stablecoins can depeg. Market manipulation means any activity that deliberately influences or distorts the price of an asset for personal benefit or advantage. Stablecoins can be subject to market manipulation, just like other cryptocurrencies.

For example, in 2017, Tether (USDT), a stablecoin issued by Tether Limited and backed by US dollars held in reserve accounts, was accused of manipulating Bitcoin prices by issuing more USDT than it had reserves for. A study by researchers at the University of Texas at Austin found that Tether was used to buy Bitcoin at key moments when it was declining, creating artificial demand and inflating its price.

The study also suggested that Tether was not fully backed by US dollars as claimed, but rather by loans from Bitfinex, a crypto exchange affiliated with Tether Limited. This raised doubts about Tether’s solvency and credibility, and sparked legal investigations by regulators and law enforcement agencies.

Flaws in the Design

A third reason why stablecoins can depeg is flaws in the design of the stablecoin mechanism. Stablecoin mechanism refers to how a stablecoin maintains its peg through various methods such as collateralization, algorithmic adjustment, or governance. Stablecoin mechanisms can fail to account for external factors or risks that affect its stability or security.

For instance, amidst a market drawdown in May 2022, a bank run on algorithmic stablecoin, TerraUSD (UST) and LUNA, once the top 10 most valuable cryptocurrency, saw the peg of UST broken from $1. Due to its design, $1 of UST could be claimed for $1 of LUNA. However, as investors scrambled to exit, it accelerated the downfall of both UST and LUNA, causing a spiral effect and finally, the implosion of the LUNA ecosystem. Over $60 billion in value was wiped out, and UST now trades at cents to the dollar.
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