Why Stablecoins Lose Their Peg and What It Means for Your Investments

In May 2022, the crypto world was rocked when TerraUSD (UST), a stablecoin supposedly pegged to the US dollar, collapsed to just 10 cents. This wiped out over $60 billion in market value almost overnight. It was a stark reminder: not all stablecoins are truly stable.

Despite the name, stablecoins—cryptocurrencies designed to maintain a 1:1 peg to fiat currencies like the USD—are not immune to volatility. In fact, more than 50 depegging events were recorded in 2023 alone, according to CoinGecko, with some lasting mere hours, and others triggering widespread panic.

But why does this happen? How can a coin engineered for “stability” lose its peg?

Whether due to liquidity crunches, flawed algorithms, market manipulation, or a loss of trust, the reasons are deeper than most realize—and often hidden until it’s too late.

Key Takeaways 

• Stablecoins are designed to maintain a stable value relative to a specific asset or basket of assets.

• Maintaining a stable peg is crucial for stablecoin reliability and intended use.

• Depegging can trigger market downturns due to interconnectedness and loss of confidence.

• Transparency, audits, market depth, and liquidity are essential for maintaining peg stability.

• Effective risk management and collateralization are critical for stablecoin stability.

What it Means for a Stablecoin to Depeg

In the context of stablecoins, “depeg” refers to the loss of the stablecoin’s peg to a specific asset, usually a fiat currency like the US dollar. 

This means the stablecoin’s value is no longer tied to the value of the underlying asset, and its price can fluctuate freely.

When a stablecoin depegs, its value can increase, decrease, or experience significant price swings.

When a stablecoin depegs, it can have significant consequences for investors, traders, and the broader cryptocurrency market. Depegging can occur due to various reasons.

Regulatory Implications of Stablecoin Depegging

When stablecoins lose their peg, it’s often a regulatory wake-up call. The first concern is protecting investors from losses, which means stablecoin issuers will face increased scrutiny. 

But it’s not just about individual investors – widespread stablecoin adoption could pose a systemic risk to financial stability if a depegging event occurs.

Stablecoin issuers will also be under the microscope for anti-money laundering (AML) and know-your-customer (KYC) compliance. Regulators will verify their protocols and procedures to prevent illicit activities.

Types of Stablecoins and Their Depegging Risks

There are several types of stablecoins, each with its own pegging model and associated depegging risks. Find them below:

Fiat-Backed Stablecoins

Fiat-backed stablecoins are the most straightforward type of stablecoin. Fiat-backed stablecoins work by allowing users to deposit fiat currency into a reserve account. The stablecoin issuer then mints new stablecoins and distributes them to the user. 

Examples of fiat-backed stablecoins include USDT (Tether) and USDC (Circle). These stablecoins are backed by a reserve of US dollars and are designed to maintain a 1:1 peg with the dollar.

Fiat-backed stablecoins are relatively stable and less volatile than other types of stablecoins. 

The Risks of Fiat-backed stablecoins 

1. Mismanagement of Reserve

If the issuer mismanages the reserve or doesn’t maintain adequate collateral, the stablecoin’s value could deviate from its peg. 

For example, if the issuer uses the reserve funds for other purposes or invests them in risky assets, the stablecoin’s value could be affected.

2. Regulatory Risks 

Changes in regulations or laws could impact the stablecoin’s ability to maintain its peg. 

For example, if a government were to ban the use of stablecoins or impose strict regulations on their issuance, the stablecoin’s value could be affected.

3. Counterparty Risks

If the issuer faces financial difficulties or bankruptcy, the stablecoin’s value could be affected. 

For example, if the issuer goes bankrupt and the reserve funds are frozen, the stablecoin’s value could plummet.

Examples of fiat-backed stablecoins include USDT (Tether) and USDC (Circle). These stablecoins are backed by a reserve of US dollars and are designed to maintain a 1:1 peg with the dollar.

Crypto-Backed Stablecoins

Crypto-backed stablecoins are collateralized by other cryptocurrencies rather than fiat currency. They’re designed to maintain a stable value through over-collateralization, meaning the value of the collateral is greater than the value of the stablecoins issued.

Examples of crypto-backed stablecoins include DAI (MakerDAO) and MIM (Abracadabra). These stablecoins are collateralized by other cryptocurrencies and are designed to maintain a stable value through over-collateralization.

How Crypto-backed stablecoins work 

They work by allowing users to deposit cryptocurrencies into a smart contract. The smart contract then mints new stablecoins and distributes them to the user. 

The user can then use the stablecoins for transactions, investments, or other purposes. For example, if a user deposits 1 ETH into a smart contract, the contract might mint 100 new stablecoins and distribute them to the user.

The main advantage of crypto-backed stablecoins is that they’re decentralized and don’t rely on a central authority to manage the reserve. 

The Risks of Crypto-backed stablecoins.

1. Collateral Volatility

If the value of the collateral drops significantly, the stablecoin’s value could deviate from its peg. For example, if the value of ETH drops by 50%, the stablecoin’s value could be affected.

2. Risk of Over-collateralization

If the collateralization ratio is too low, the stablecoin may not be sufficiently backed, leading to depegging risks. 

For example, if the collateralization ratio is 150% and the value of the collateral drops by 30%, the stablecoin’s value could be affected.

3. Smart Contract Risk

Bugs or vulnerabilities in the smart contract could impact the stablecoin’s ability to maintain its peg. 

For example, if a smart contract bug allows users to withdraw more stablecoins than they should be able to, the stablecoin’s value could be affected.

Algorithmic Stablecoins

Algorithmic stablecoins use an algorithm underneath, which can issue more coins when their prices increase and buy them off the market when their prices fall. 

It takes a different approach to maintaining their peg. Instead of holding collateral, they use clever algorithms to keep their value stable. There are two main types of algorithmic stablecoins:

1. Rebase Model: 

Imagine a stablecoin that can adjust its supply to match demand. That’s what the Rebase Model does. 

When the price of the stablecoin goes up or down, the algorithm automatically increases or decreases the supply to bring it back to the pegged value. This change applies to all wallets, so everyone’s holdings are adjusted proportionally.

2. Coupon Model: 

This type of algorithmic stablecoin uses a different strategy. When the stablecoin’s value drops below its peg, users can trade their stablecoins for special bonds or coupons. 

These coupons can be redeemed for a profit later on. When the stablecoin’s value rises above its peg, the algorithm creates more coins to bring the price back down.

Note: The catch with algorithmic stablecoins is that they don’t have any collateral backing them up. This makes them more vulnerable to collapse if users lose confidence or if there’s a bank run. We saw this happen with TerraUSD in 2022 when it lost its peg and never recovered.

While these are the two main types of algorithmic stablecoins, some stablecoins such as Frax, Reserve (RSV), sUSD (Synthetix USD), and Liquity USD (LUSD) use a mix of different models or assets to maintain their peg. They might use a combination of fiat currency as previously discussed, cryptocurrency, or even commodities like gold to back their value. 

Why do Stablecoins Depeg?

Stablecoins depeg for multiple reasons, these include:

1. Loss of Confidence

Loss of confidence is a major reason why stablecoins can depeg. If users lose faith in a stablecoin’s ability to maintain its peg, they may start selling their holdings, which can cause the value to drop. 

This can create a self-reinforcing cycle where more users lose confidence and sell their holdings, further driving down the value. Loss of confidence can be triggered by various factors, such as:

Lack of Transparency 

about the stablecoin’s reserves or collateral. For example, if a stablecoin issuer is opaque about its reserve management practices, users may start to doubt the stablecoin’s ability to maintain its peg, leading to a loss of confidence and potential depegging.

2. The Volatility of the Market 

Significant market fluctuations can cause stablecoins to lose their peg, especially if the underlying collateral is volatile. This is called market volatility.

If a stablecoin is replaced by a cryptocurrency that experiences a significant price drop, the stablecoin’s value may also drop, causing it to depeg. The examples of what triggers market volatility are:

• Economic downturns or global market shocks
• Changes in market sentiment or investor behavior
• Regulatory changes or announcements

3. Reserve Management Issues

Stablecoins also depeg because of this. Poor management of reserves can lead to depegging. A stablecoin issuer may fail to maintain adequate reserves or uses reserve funds for other purposes, the stablecoin’s value may drop, causing it to depeg.

Examples of what causes these issues are:

• Inadequate collateralization or reserve requirements
• Poor investment decisions or risk management practices
• Lack of transparency or auditing of reserve management practices

4. Regulatory Changes

Regulatory changes are another reason why stablecoins can depeg. Changes in regulations or laws can impact a stablecoin’s ability to maintain its peg. 

When a government imposes strict regulations on stablecoins or bans their use altogether, the value of a stablecoin may drop, causing it to depeg.

Also if a government announces plans to regulate stablecoins more strictly, users may lose confidence in the stablecoin’s ability to maintain its peg, leading to depegging.

Situations where changes in regulation may occur are:

• Government announcements or policy changes
• Regulatory enforcement actions or fines
• Changes in laws or regulations governing stablecoins

5. Smart Contract Risks

Smart contract risks are a technical reason why stablecoins can depeg. Bugs or vulnerabilities in smart contracts can cause stablecoins to depeg. 

A smart contract bug may allow users to withdraw more stablecoins than they should be able to, the stablecoin’s value may drop, causing it to depeg.

If a stablecoin’s smart contract is found to have a critical vulnerability, users may lose confidence in the stablecoin’s ability to maintain its peg, leading to depegging.

Smart contract risks can be triggered by various factors, such as:

• Coding errors or bugs
• Security vulnerabilities or exploits
• Lack of testing or auditing of smart contracts

How to Mitigate Depegging Risks of Stablecoins 

To mitigate depegging risks of stablecoins, the following should be applied:

1. Robust Reserve Management: 

Think of reserve management like keeping a safety net. You want to make sure you have enough assets set aside to cover any unexpected issues.

By keeping a clear record of reserve assets, conducting regular audits, and providing transparent reporting, stablecoin issuers can build trust with users and maintain stability.

2. Diversification of Collateral: 

Diversifying collateral across different asset classes or markets can help reduce the risk of collateral value fluctuations impacting the stablecoin’s peg. This is similar to spreading your investments to minimize risk.

3. Stress Testing: 

Stress testing involves simulating extreme market scenarios to evaluate the stablecoin’s ability to maintain its peg under adverse conditions. By doing this, stablecoin issuers can identify potential vulnerabilities and take steps to mitigate them.

4. Liquidity Provision: 

Having sufficient liquidity is essential for stablecoin issuers. They need to ensure they have access to sufficient liquidity providers or market makers to facilitate redemptions and maintain market stability.

5. Transparency and Communication: 

Providing clear and timely communication about stablecoin operations, reserves, and risks is crucial for building trust with users and maintaining market confidence.

6. Regulatory Compliance: 

Regulatory compliance is critical for maintaining the legitimacy and stability of a stablecoin. Stablecoin issuers need to stay on top of relevant regulations and laws to avoid reputational damage and regulatory action.

7. Smart Contract Security: 

Smart contract security is vital for maintaining the integrity of the stablecoin’s underlying code and preventing potential exploits. By implementing robust security measures, stablecoin issuers can protect users’ assets and maintain trust.

8. Risk Management Framework: 

A risk management framework involves identifying potential risks, assessing their likelihood and impact, and implementing measures to mitigate or manage those risks. This helps stablecoin issuers proactively address potential issues and maintain stability.

9. Collateralization Ratio: 

Maintaining a sufficient collateralization ratio is critical for ensuring the stablecoin’s stability and building trust with users. The collateralization ratio refers to the ratio of collateral value to stablecoin value.

10. Ongoing Monitoring:

Continuously monitoring market conditions, user behavior, and potential risks can help stablecoin issuers identify potential issues and make adjustments as needed. This helps maintain the stablecoin’s stability and build trust with users.

By following these measures, stablecoin issuers can reduce the risk of depegging and maintain the stability of their stablecoins, which is essential for building trust and confidence with users.

Conclusion 

In the end, stablecoins play a major role in the world of cryptocurrency, providing a relatively stable way to store value and make transactions. This stability is especially important for people who want to use cryptocurrency for everyday purchases or as a safe haven during market volatility. 

However, their success hinges on finding a balance between following rules, managing risks, and being transparent. If stablecoin issuers can get this balance right, they can build trust with their users and ensure their coins remain stable over time.

By focusing on these key areas, stablecoin issuers can demonstrate their commitment to protecting users and maintaining the integrity of their coins. This, in turn, can help drive the growth and widespread adoption of cryptocurrency, making it more accessible and reliable for everyone. 

The future of stablecoins will depend on getting this balance right, allowing these digital assets to deliver on their promise of stability and reliability. If done well, stablecoins could become a cornerstone of the cryptocurrency ecosystem, providing a trusted and stable foundation for users to build on.

Frequently Asked Questions on Stablecoins Depegging