Why Do Stablecoins Depeg?
Stablecoins have established themselves as an integral part of the global crypto ecosystem, acting as a payment and remittance rail and as trading capital for active crypto traders.
A stablecoin is a type of cryptocurrency pegged to another asset - such as a fiat currency like the US dollar - to resolve the volatility issues faced by digital currencies while providing a more stable store of value.
Just like all other types of cryptocurrencies, you can easily and securely buy, sell, store, and swap stablecoins on Trust Wallet. With over 60M+ users, Trust Wallet is the most secure and easy-to-use self-custody cryptocurrency wallet that allows you to securely manage 9M+ digital assets across 70 blockchains in one single app.
In this guide, we will look at what stablecoins are, how they work, how they maintain their peg, and why they depeg.
What Are Stablecoins and How Do They Work?
Stablecoins are a type of cryptocurrency created to provide a price-stable digital currency by combining the benefits of open, borderless cryptocurrency with the trust and stability of fiat currencies, like the US dollar.
With stablecoins, crypto traders can preserve the value of their crypto holdings by placing them in “digital dollars” or gold-based stablecoins.
The price stability enables stablecoins to be used for payments, as a settlement layer, as trading capital to move in and out of “risky” crypto assets, and, in the case of dollar-backed stablecoins, also as a base currency to quote crypto trading pairs.
Stablecoins use different mechanisms to achieve price stability, with a full asset-backed being the most successful, as highlighted by the likes of USDT, USDC, and BUSD. However, there are also crypto-backed stablecoins, like DAI, that maintain their price peg using a basket of cryptocurrencies, while algorithmic stablecoins use algorithms to automatically mint and burn tokens to maintain their price peg.
Today, there are nearly 200 stablecoins that use different mechanisms to achieve their stability. The two most popular stablecoins include Tether USD (USDT) and USD Coin (USDC).
USDT
Tether USD is the dominant stablecoin by market capitalization, according to data on CoinMarketCap, with a circulating supply of over 70 billion. USDT is also widely used by crypto traders as its value is pegged 1:1 to that of the US dollar.
What does this mean? For every USDT available, there is a proportionate of one US dollar or dollar-denominated assets that Tether Limited - USDT’s parent company - holds in its reserves.
Essentially, the price of Tether USD retains a consistent value to that of the US dollar and changes at the same rate as the US dollar. It, therefore, isn’t faced with volatility issues as is typical with traditional digital currencies, such as Bitcoin (BTC) or Ether (ETH).
USDC
USDC is the second-largest stablecoin by market capitalization, and it functions in the same way as USDT, with each USDC backed 1:1 with dollars and dollar-based assets.
USD Coin is issued and backed by the CENTRE consortium (composed of Circle and Coinbase), which holds the reserves for USDC in segregated accounts at regulated financial institutions that independent auditors regularly review. As a result, it is widely considered a very trustworthy stablecoin because the main company behind USDC, Circle, puts a strong emphasis on compliance and regulations.
What Other Currencies Have Stablecoins?
Not all stablecoins are pegged to the US dollar. Instead, some stablecoins are pegged to other currencies, such as the euro, or commodities, such as gold.
Euro Coin (EUROC), for instance, is a fully reserved, euro-backed stablecoin created by USDC-issuer Circle. This means that instead of having a 1:1 ratio to the US dollar, it has a 1:1 ratio to the euro, backed by euros and euro-denominated assets.
Similarly, GYEN is another stablecoin that’s backed by the Japanese yen (JPY), while poundtoken, which trades under the ticker GBPT, is backed by the Pound Sterling.
Tether Gold (XAUT) is an example of a gold-backed stablecoin for investors who are looking to keep some of their portfolios in tokenized gold. One XAUT represents one troy fine ounce of gold on a London Good Delivery gold bar, enabling investors to benefit from holding gold but without the storage costs.
How Do Stablecoins Maintain Their Peg?
There are four main ways in which stablecoins maintain their peg. Each mechanism is different and functions in different ways.
Algorithmic Stablecoins
Algorithmic stablecoins are stablecoins that depend on smart contracts to maintain their price stability. These types of stablecoins don’t have any reserve assets. Instead, they use a pre-programmed algorithm - usually a computer program - created and optimized to control the stablecoin’s circulating demand and supply to keep the asset price stable.
Algorithmic stablecoins are known to have a weak architecture compared to other types of stablecoins, as they are uncollateralized and rely on financial engineering in a bid to peg their value. As a result, they are always susceptible to depegging risk. The failed UST stablecoin was an example of an algorithmic stablecoin.
Commodity-backed Stablecoins
Instead of using an algorithm, commodity-backed stablecoins use other types of assets for their backing. The type of asset used usually depends on the project. For instance, some stablecoins can be pegged to a precious metal like gold.
Similar to fiat-backed stablecoins, commodity-backed stablecoins introduce the value of other assets into the crypto sector. However, one of their biggest advantages is that investors can access assets that were previously hard to attain. Tether Gold (XAUT), which is from the same family as Tether USD, is a good example of a commodity-backed stablecoin.
Crypto-Backed Stablecoins
A crypto-collateralized stablecoin is a type of stablecoin pegged to other digital currencies. This means that instead of their reserves being held in a fiat currency, it’s held in another cryptocurrency. However, since their reserve cryptocurrency is susceptible to high volatility, crypto-collateralized stablecoins are usually overcollateralized. For instance, a digital currency valued at $4 million can be held as a reserve to offer $2 million for a crypto-backed stablecoin. This way, if the digital currency were to lose a percentage of its value, the stablecoin would still have enough collateral to bounce back.
DAI, for instance, is a popular crypto-collateralized stablecoin that has a soft peg to the US dollar.
Fiat-backed Stablecoins
Fiat-backed stablecoins are the most common type of stablecoins. These stablecoins maintain their 1:1 reserve in the form of a fiat currency like the US dollar or euro, which works to keep the stablecoin’s value. This means that if you hold one USDT, Tether also holds one dollar (or liquid dollar-denominated asset) in its reserve.
Typically, the US dollar reserves are controlled and managed by independent custodians such as audit firms conducting t regular audits. USDT and USDC are good examples of fiat-backed stablecoins.
Why do stablecoins depeg?
Depegging occurs when a stablecoin’s value deviates significantly from its intended pegged value.
As discussed, stablecoins are cryptocurrencies that are pegged to another external asset. Despite the peg, there are instances where stablecoins may depeg from their intended value. Below are four main reasons why.
Market Manipulation
Market manipulation is one of the reasons why stablecoins can depeg. Market manipulation is any activity that purposely distorts or influences an asset’s price for personal gain. Similar to other digital currencies, stablecoins are susceptible to market manipulation.
A good example is how, back in 2017, Tether Limited was accused in a study of engineering the price of Bitcoin by supplying more USDT than it had reserves for. The accusations led to Tether Limited being investigated by law enforcement agencies and regulators as the study raised doubts about the company’s credibility and solvency. The study went as far as suggesting that USDT wasn’t fully backed by US dollars, affecting the stablecoin’s price peg.
Insufficient Collateralization
Insufficient collateralization is another reason why stablecoins can depeg. Stablecoins that are largely backed 1:1 with a fiat currency like the US dollar need to have enough market liquidity to retain their peg. This way, collateralization is guaranteed. For instance, if the market has few buyers and sellers, the value of a stablecoin can be depeg from its underlying asset.
This happened on March 11, 2023, when USD Coin, a stablecoin with a 1:1 backing by the US dollar, dropped and was trading at a low of $0.87. The depegging of USDC to the dollar was caused by the collapse of Silicon Valley Bank (SVB) and Silvergate Bank (SI), major banks that serve the crypto sector. Circle, USDC’s parent company, held its cash reserves worth $3.3 billion at SVB.
USDC’s depegging also caused havoc for other stablecoins and other cryptocurrencies as investors rushed to move their money resulting in high gas fees.
Design Flaws
A flawed design in a stablecoin’s mechanism can cause a stablecoin to depeg. As mentioned earlier in our guide, different stablecoins use different methods to maintain their peg. However, there are instances where these mechanisms may fail to account for external risks and factors that can affect both its stability and security.
A good example is how TerraUSD (UST) and LUNA collapsed back in 2022 following the depegging of UST from one US dollar. UST was designed so that investors could claim $1 of UST for $1 of LUNA. Following the drop in the value of UST, investors rushed to exit the market, further accelerating the collapse of UST and LUNA. The collapse of UST and LUNA wiped out over $60 billion in value leading to a further plummet in the crypto industry.
Lack of Trust
Stablecoins can depeg from their original asset if investors no longer trust that the stablecoin can maintain its price peg. For instance, when USDC started to depeg from the US dollar, investors panicked, leading to a widespread sale of USDC, resulting in a steep price drop in the stablecoin.
Trust in the price stability of a stablecoin is arguably the biggest factor determining the strength of a stablecoin’s price peg. The more investors trust the stability provided, the more robust the price peg will be.
Conclusion
Stablecoins were designed to provide price-stable digital currencies for a variety of use cases, including payments, remittances, and more.
They achieve price stability using various mechanisms that peg their value to an asset, such as a fiat currency. However, even though they are pegged to assets, such as a currency like the US dollar, stablecoins can still depeg from their underlying assets resulting in a severe price drop, as we witnessed with UST in 2022 and USDC in 2023. While stablecoins are crucial in the crypto industry, they are not void of risks – so we encourage you to always DYOR (do your own research).
All that said, Stablecoins play a critical role in the global crypto ecosystem by providing digital currencies that can be deployed for a wide range of use cases, ranging from payments and remittances to DeFi lending and yield farming, and acting as the trading capital for crypto investors looking to move in and other risky digital assets. Trust Wallet allows you to send, receive, store and swap stablecoins. Get started today at https://trustwallet.com/download.
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