Stablecoins reduce cryptocurrency volatility by using fiat, crypto, or other types of collateral as backing to maintain price stability. Pegging allows stablecoins to combine traditional financial stability methods with innovative blockchain technology. But what if the peg is broken?
This article explains what depegging is in crypto and the factors that could lead to this happening.
Stablecoins are cryptocurrencies whose values are linked to a more stable asset – usually a fiat currency such as the dollar or a commodity such as gold – to provide price-stable digital currency.
Leading fiat-backed stablecoins pegged to the US dollar include USDT, USDC, and BUSD. Their issuers hold US dollars and near-cash dollar assets in regulated bank accounts, typically with a 1:1 ratio to the issued stablecoin tokens.
Other leading stablecoins have collateral in crypto, such as Ethereum-based DAI, which uses smart contracts to maintain the coin’s price stability. In most cases, these stablecoins maintain higher collateral to account for a certain percentage of price volatility.
What Is Depegging in Crypto?
Depegging occurs when a stablecoin loses its peg significantly or loses its value entirely.
While depegging is relatively uncommon, several reasons can lead to a stablecoin falling under or exceeding its pegging ratio. Therefore, understanding the possibilities and causes of such events is crucial for investors to prevent significant losses.
Factors That Could Trigger Stablecoin Depegging
Let’s take a look at what can lead to stablecoin depegging.
Market Forces and Volatility
If the underlying pegging asset undergoes severe price shifts, there is a high chance the stablecoin will not maintain its pegged value. Any other market force capable of changing the price action or market sentiment may trigger a depeg.
Lack of Liquidity
Depegging may occur if the stablecoin’s reserves dwindle or fail to sustain its circulation in the market. Usually, the stress in a stablecoin’s liquidity is caused by high market volatility. This is more of an issue for crypto-backed than fiat-backed stablecoins.
Talk of new crypto or stablecoin regulations often triggers initial fear due to uncertainty. Conversely, favorable regulations increase their demand in crypto and TradFi markets. Additionally, changes or strains in economic policies and additional government involvement in the space can create a similar outcome.
Rumors of a lack of collateral can lead to a fast depeg for stablecoins as the market loses confidence in a price-stable coin if the rumors cannot be adequately addressed and negated by the stablecoin issuer.
Effects of Depegging on the Crypto Market
Some of the impacts of depegging on the crypto markets include the following:
- Volatility: Depegging signifies instability for a currency, potentially changing market sentiment toward a coin or the market as a whole. Panic selling or impulsive buying could increase volatility, which, in turn, could lead to significant losses for investors.
- Lower adoption: Stablecoin depegging triggers Fear, Uncertainty, and Doubt (FUD), potentially leading to increased skepticism and lower adoption.
- Stringent regulations: Financial watchdogs may use this opportunity to introduce stricter laws for stablecoins and crypto markets.
- Improvements: Projects could learn from a depegged asset’s issues and conduct research and development, fueling innovations to their networks and improving future projects.
- Shifts in decentralized finance markets: Since many DeFi pairs depend on stablecoins for liquidity provision, trading, lending, and more, there will be positive or negative impacts on the markets.
Examples of Depegging Events in Crypto History
The crypto market has had several incidences of depegging in its history. Here are a few notable events:
Tether and its Depegging Scare
Tether USD has had several depegging controversies since its introduction. In May 2022, USDT lost its parity to the US dollar, falling below $0.96 due to stablecoin regulation rumors. Although it returned to around $0.99 later in the day, investors were still worried about its volatility and possible instability.
UST Depegging During the Crypto Winter
In May 2022, the Terra stablecoin, UST, lost its peg to the USD, falling to about $0.65. Its algorithmic mechanism was designed to maintain its price at $1 UST for $1 of LUNA. However, the latter’s market value dropped significantly, causing the depegging.
USDC ‘Black Swan’ Depegging
After Silicon Valley Bank’s collapse, USDC fell victim to the depegging, falling to about $0.94 in March 2023. Notably, Silicon Valley Bank held significant amounts of USDC’s reserves. Around the same time, many entities speculated that the event could be avoided if there were better legal frameworks governing stablecoins.
Strategies to Mitigate Risks of Depegging
Now, let’s take a look at a few ways to reduce the risks of depegging.
- Diversification of holdings: Portfolio diversification reduces the exposure to significant risk in case of a stablecoin’s depegging event. If you are using stablecoins, perhaps use more than one.
- Monitoring of market conditions: Staying on top of stablecoin news to understand ongoing developments and market sentiment is advisable. This includes monitoring market conditions and regulations that could lead to a downward spiral.
- Keep an eye on audits: Look for stablecoins that regularly publish audit reports and transparently disclose their reserve holdings.
- Avoid over-leveraging: Be cautious with using stablecoins for highly leveraged positions, as depegging could amplify losses.
Stablecoins have become one of the most popular assets within the crypto markets as they enable you to hold dollars (and other stable assets) without leaving the crypto ecosystem. Primarily used as trading capital and lending collateral, stablecoins are the base currency of the crypto trading markets.
However, depegging can lead to serious losses for investors. It’s, therefore, important to keep an eye on the stablecoins you are using, mounting their regular audits and any news that may affect their peg, to reduce the risks of a dep affecting the value of your holdings.