Depeg

What is Stablecoin?

Stablecoins are cryptocurrencies pegged to a stable asset like the United States Dollar, offering stability and consistency in price to the base asset it is pegged with. Their stable nature makes them a great place to park investors’ funds without fully exiting DeFi.

What Happens When a Stablecoin Depegs?

When a stablecoin depegs, its value deviates significantly from the underlying asset it is tethered to. This is an alarming situation that negatively affects users who rely on the stablecoin for trading and saving.

A depeg can also be the increase in value of a stablecoin to the base asset. This happens when the demand for the stablecoin increases in a short period.

Why Does Depeg Happen?

Although stablecoins are designed to be stable, there is a risk of depegs. The following are some of the major factors that contribute to stablecoin depegs:

• Insufficient Collateralization: Some stablecoins are backed by real-world assets like cash or government bonds. Users should be able to tender their stablecoins to get cash of equal value whenever they want. When the reserve assets value is less than the value of the stablecoins issued to users, a market sell-off that forces a depeg on the token can happen. This happened in March 2023 when a collapse of a crypto-friendly bank impacted the reserves of major stablecoins like USDC causing a temporary depeg.
• Algorithmic Problems: Algorithmic stablecoins use complex computing algorithms to adjust the supply and demand of stablecoins to maintain the peg. In extreme market conditions such as high volatility or low liquidity, the peg can drop significantly leading to a depeg in the stablecoin. An example of this was UST on the Terra blockchain which dropped by 99.99% in May 2022.
• Black Swan Events: Unpredictable events like regulatory changes, global economic crises and protocol hacks can trigger panic selling and depeg stablecoins. Black swan events are difficult to predict but can have a significant impact on the crypto market.

Depegs show the risk associated with stablecoins.

While they offer a high degree of stability compared to other cryptocurrencies, they are not entirely free from market circumstances.

Understanding the causes of past stablecoin depegs can help design stronger tokens with improved algorithmic designs, regulatory oversight and deeper reserves.

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