Stablecoin Depeg
The biggest and most basic danger connected to stablecoins is de-pegging risk. Stablecoins tethered to the US dollar could fall.
Dollar-pegged stablecoins may briefly trade at £0.99 or £1.01. However, it can potentially depreciate below £0.70 or less over time. A stablecoin loses its peg if value dips below £0.85 or rises to £1.10.
Depeg definition
When a stablecoin, a cryptocurrency intended to keep a steady value and usually pegged to a fiat currency like the US dollar, loses its fixed exchange rate, it’s referred to a financial and cryptocurrency depeg. This indicates that the price of the stablecoin either rises above or falls below its planned value.
The Dangers of De-Pegging
Stability is the fundamental idea behind stablecoins. They fail in their primary function when they de-peg, which has several serious repercussions:
- Financial Losses: As the value of their holdings declines, holders of the de-pegged stablecoin experience immediate financial losses. Those who use stablecoins for trade, lending, or as collateral may be particularly affected by this.
- Trust Loss: A de-pegging incident damages confidence in the stablecoin’s issuer, the stablecoin in question, and possibly the entire cryptocurrency market. Due to this loss of faith, users may “bank run” to redeem stablecoins, worsening the de-pegging.
- Systemic Risk: A major stablecoin de peg might threaten the cryptocurrency market. This may affect other cryptocurrencies, Decentralized Finance (DeFi) protocols, and exchanges that employ that stablecoin for trading pairs and liquidity.
- Financial regulators are advised to de-peg, which may increase stablecoin legislation and supervision.
- Contagion: If one stablecoin fails, it may affect others and the cryptocurrency market.
Hazards for De-Pegging by Stablecoin Type
What causes de-pegging depends on the stablecoin’s pegging mechanism:
Fiat-backed stablecoins like USDT, USDC, and BUSD:
- Real-world assets (such fiat money, short-term treasuries, or commercial paper) kept in reserves are said to back these stablecoins 1:1.
- The main risk is having insufficient or low-quality reserves. The issuer may not be able to respect redemption requests during a “run” if they do not have sufficient reserves to support all stablecoins in circulation, or if the reserves are held in risky or illiquid assets. In the past, short-term de-pegging anxieties have been sparked by worries over the reserve composition of Tether (USDT).
- Absence of Transparency/Audits: Trust may be damaged and panic selling may result if the issuer is opaque about its reserve holdings or fails to conduct frequent, credible audits.
- Regulatory measures/Bank Failures: De-pegging may be triggered by legal measures taken against the issuer or problems with the conventional banks that hold the reserves. For example, when USDC’s issuer, Circle, disclosed that $3.3 billion of its reserves were held in Silicon Valley Bank (SVB), which was in danger of collapsing, the currency momentarily fell to about $0.88 in March 2023. Following the US government’s announcement of a backstop for SVB, it swiftly re-pegged.
- Custodial Risk/Counterparty Risk: The possibility that the financial institution or centralized issuer that holds the reserves would default, mismanage the money, or be hacked.
- Operational risk: Technical issues, network congestion, or redemption issues may prevent redemptions and cause price fluctuations.
Crypto-backed stablecoins like sUSD and DAI:
In order to accommodate for cryptocurrency volatility, these are frequently over-collateralized and backed by other cryptocurrencies (e.g., £150 worth of ETH to back £100 of DAI).
- Despite over-collateralization, under-collateralization can result from a sharp and quick decline in the value of the underlying crypto collateral. If the system is unable to rebalance quickly enough, this might lead to liquidations and perhaps a de-peg.
- Failure of the Liquidation Mechanism: When the value of the collateral declines, the system depends on its effective liquidation. The peg may break if this system malfunctions or operates too slowly during periods of high market volatility.
- Oracle Failure: These stablecoins frequently use decentralized “oracles” to provide the smart contracts with up-to-date collateral price information. An inaccurate liquidation or a de-peg could result from a flawed or manipulated oracle.
- Smart Contract Bugs: The collateralization and liquidation process’s smart contracts have vulnerabilities that could be used to de-peg and lose collateral. For instance, DAI includes measures to restore the peg even when it occasionally deviates a few cents during periods of high market stress.
Algorithmic stablecoins, such as Frax (now partially collateralised) and the old TerraUSD (UST):
These stablecoins, which frequently use a dual-token system, use algorithms and market incentives to try to keep its peg.
- The most notorious risk is “Death Spiral” or reflexivity. The algorithm encourages burning the stablecoin and minting the volatile “sister” token in an attempt to restore the peg if the stablecoin de-pegs downward. As a result, the sister token’s supply grows, lowering its price. The de-pegging of the stablecoin is thus more difficult to absorb when the price of the sister token declines, which causes more selling, more sister token minting, and a sharp decline in both tokens’ values. This is exactly what happened with UST (TerraUSD), which went into a death spiral and plummeted below £0.10 after losing its peg entirely in May 2022.
- Absence of Physical Support: Purely algorithmic stablecoins, in contrast to collateralized stablecoins, lack the physical reserves necessary to withstand significant shocks or offer a “floor” for their value in the event of intense selling pressure.
- Inadequate Market Liquidity: The arbitrage process depends on adequate market liquidity. The system may not be able to restore the peg if there is little trading volume or if arbitrageurs lose faith in it.
Overall Market Situation and Attitude
In addition to stablecoin kinds, de-pegging can occur from:
- Conditions: Sudden supply and demand swings can de-peg a stablecoin, especially if liquidity is insufficient.
- Market Sentiment: If faith in a stablecoin drops, negative news or opinions may prompt panic selling and de-pegging.
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Why Does De Pegging Happen?
Several factors can cause a stablecoin to de-peg:
| Cause | Description |
|---|---|
| Lack of Reserves | If the issuer doesn’t have enough assets to back the coins in circulation, confidence drops and people sell the coin. |
| Market Panic | Large sell-offs due to fear, uncertainty, or rumors can overwhelm the mechanisms keeping the peg. |
| Algorithmic Failure | Algorithmic stablecoins rely on incentives and supply adjustments but these mechanisms can fail under stress (as with UST). |
| Liquidity Crisis | If there’s not enough liquidity in exchanges to absorb large trades, the price can swing away from $1. |
| Regulatory or Legal Issues | Regulatory action or frozen bank accounts backing the stablecoin can cause loss of trust and de-pegging. |
Risks of De-Pegging
De-pegging can have serious consequences for investors, projects, and the broader crypto market.
| Risk | Impact |
|---|---|
| Financial Loss | If a stablecoin falls below $1 and you sell it, you get back less than you expected. |
| Loss of Trust | Users may lose confidence in the stablecoin or in stablecoins in general. |
| DeFi Contagion | Many DeFi protocols rely on stablecoins if a major stablecoin de-pegs, it can disrupt loans, pools, and liquidations. |
| Market Volatility | De-pegging events can trigger broader crypto market sell-offs. |
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Summary Table:
| Aspect | Details |
|---|---|
| What? | Stablecoin price moves away from its target (e.g., $1). |
| Causes? | Panic selling, insufficient reserves, algorithm failure, liquidity issues. |
| Risks? | Loss of funds, market contagion, loss of trust. |
| Mitigation? | Strong reserves, transparency, good design, risk management. |