Stablecoins are a type of cryptocurrency designed to have a stable value relative to a specific asset or basket of assets, usually a fiat currency such as the US dollar, euro or Japanese yen.
Stablecoins are designed to offer a “stable” store of value and a medium of exchange compared to other traditional cryptocurrencies like Bitcoin (BTC) and Ether (ETH), which can be highly volatile.
Fiat money, cryptocurrencies, and commodities like gold and silver are examples of assets used to back or “back” a stablecoin. Tether (USDT), USD Coin (USDC) and Dai (DAI) are some examples of stablecoins pegged to the US dollar.
Stablecoins can also be algorithmically stabilized through smart contracts and other mechanisms that automatically adjust the supply of stablecoins to keep them pegged to the underlying asset.
Despite the potential benefits, stablecoins are not without risks. The most important risk with any stablecoin is the potential for the peg to break, resulting in a loss of value relative to the underlying asset.
Depegging is where the value of a stablecoin deviates significantly from its pegged value. This can happen for a variety of reasons, including market conditions, liquidity issues and regulatory changes.
USDC is a fully backed stablecoin, meaning that every USD Coin is backed by real cash and short-term United States treasuries. Despite this, the USDC issuer, Circle, announced on March 10 that the USDC had been depegged from the US dollar, with about $3.3 billion of the $40 billion in USDC reserves stuck in the now-defunct Silicon Valley Bank. The bank – the 16th-largest in the US – collapsed on March 10, and was one of the largest bank failures in US history. Due to the influence of the USDC collateral, other stablecoins followed the depegging of the US dollar.
related: USDC depegs as Circle confirms $3.3B stuck with Silicon Valley Bank
2 / Like other customers and depositors who depend on SVB for banking services, Circle joins the call for the continuation of this important bank in the US economy and will follow the guidance provided by state and Federal regulators.
– Circle (@circle) March 11, 2023
MakerDAO – a protocol based on the Ethereum blockchain – issued DAI, an algorithmic stablecoin designed to maintain an exact 1:1 ratio with the US dollar. However, DAI also collapsed amid the collapse of Silicon Valley Bank, mainly due to the contagion effect of the USDC depegging. More than 50% of the reserves backing DAI are held in USDC.
Tether issues USDT, with each USDT token being equal to the corresponding fiat currency at a 1:1 ratio and backed by Tether’s reserves. However, USDT also experienced depegging in 2018, which raised concerns about the overall stability mechanism of stablecoins.
The importance of stablecoin pegs
The importance of stablecoin pegs is that they provide a stable and predictable value relative to an underlying asset or basket of assets – usually a fiat currency like the US dollar. Stablecoin is a desirable alternative for various use cases, including cryptocurrency trading, payments and remittances, due to its stability and predictability.
With stablecoin pegs, traders can enter and exit positions without being exposed to price fluctuations of cryptocurrencies like BTC or ETH. This is important for institutional investors and companies that rely on reliable outlets and exchange media to run their operations.
Cross-border transactions can also be more accessible using stablecoin pegs, especially in countries with volatile currencies or limited access to conventional financial services. Compared to more traditional methods like wire transfers or remittance services, stablecoins can provide a more effective and affordable way to make payments and transfer value across borders.
Stablecoin pegs can also improve financial inclusion, especially for people and companies without access to traditional financial services. Stablecoins can be used to make payments and transactions in digital assets without the need for a bank account or credit card, which can be important in developing and emerging markets.
Why are stablecoins depeg?
Stablecoins can depeg due to a combination of micro and macroeconomic factors. Micro factors include changes in market conditions, such as increases or decreases in demand for stablecoins, liquidity issues and modifications to underlying collateral. Macro variables include changes in the overall economic landscape, such as inflation or interest rate increases.
For example, the price of a stablecoin can exceed its specified value if demand increases due to increased cryptocurrency trading activity. However, stablecoin prices can fall below their fixed value if liquidity is insufficient to match higher demand.
On the macroeconomic front, if there is high inflation, the purchasing power of the underlying assets that support stablecoins may decline, leading to depeg events. In addition, adjustments to interest rates or other macroeconomic measures can affect the demand for stablecoins.
Regulatory changes or legal issues can also cause stablecoins to depeg. For example, if the government were to ban the use of stablecoins, the demand for stablecoins would drop, causing the price to drop. Depegging events can also be caused by technical issues like smart contract bugs, hacking attacks and network congestion. For example, a smart contract flaw could cause the value of a stablecoin to be incorrectly calculated, resulting in a sizable deviation from the peg.
How do stablecoins depeg?
Stablecoin depegging usually occurs in several steps, which can vary depending on the specific stablecoin and the circumstances that led to the depegging event. Here are some common features of depegging events:
The value of the stablecoin deviates from the peg
As noted, many factors, such as market turmoil, technology issues, lack of liquidity and regulatory issues, can cause a stablecoin depeg. The value of a stablecoin may change dramatically relative to the underlying asset or basket of assets.
Traders and investors react to depegging events
Whether they think the stablecoin value will eventually return to the peg or continue to diverge from it, traders and investors can respond by buying or selling the stablecoin when it dramatically departs from the peg.
How Fund will respond in $USDC depegging?
Panic selling $USDC or buy $USDC under?
1.
Here is the operation of the Fund
I hope it will be useful for you. pic.twitter.com/x4PYEyZbev
— Lookonchain (@lookonchain) March 11, 2023
Arbitrage opportunities arise
Arbitrage opportunities can occur if the value of the stablecoin is away from the peg. For example, a trader can sell a stablecoin and buy the underlying asset to benefit if the value of the stablecoin is higher than the peg.
Stablecoin issuers are taking action
Stablecoin issuers can take action to correct the problem if the value of the stablecoin continues to deviate from its peg. This may require changing the supply of stablecoins, collateralization ratios and other actions to increase confidence in stablecoins.
Stablecoin value is stable
If traders and investors adjust their positions and stablecoin issuers respond to depegging events, stablecoin values can stabilize. The value of a stablecoin can return to its peg if the issuer of the stablecoin succeeds in winning back public trust.
Risks and challenges associated with depegging stablecoins
Depegging stablecoins can present several risks and difficulties for investors, traders and the larger cryptocurrency ecosystem:
- Market volatility: When stablecoins depeg, the market can experience severe turbulence as traders and investors shift holdings in response to the depegging event. This can lead to market uncertainty and increase the possibility of losses.
- Reputational risk: Depegging stablecoins endangers the reputation of the issuer and the larger cryptocurrency ecosystem. This can make it more difficult for stablecoin issuers to attract new users and investors and reduce the total market value.
- Liquidity risk: Liquidity problems can occur if a stablecoin depegs because traders and investors sell stablecoins in significant amounts. As a result, the value of stablecoins can decrease, making it challenging for traders and investors to liquidate their holdings.
- Counterparty Risk: Traders and investors may be exposed to default risk by stablecoin issuers or other parties involved in stablecoin operations due to depeg events.
- Regulatory risk: Depegging a stablecoin can also lead to regulatory issues. Governments and authorities can impose restrictions on stablecoins if they believe the asset threatens the stability of the broader financial system.
Related: USDC Circle instability causes domino effect on DAI, USDD stablecoin
Considering the above risks, investors and traders alike should monitor the performance of stablecoins in their portfolios. Research stablecoin issuers and collateralization, and be on the lookout for indications of depegging or other issues that could affect the stablecoin’s value. They can also think about diversifying their holdings by using different stablecoins or other assets. This can reduce the chances of suffering losses in the event of stablecoin depegging.