How Stable Are Stablecoins? Depegging Explained

Stablecoins play a crucial role in crypto, helping traders avoid volatility and propping up the crypto derivatives market. It’s often thought that if stablecoins, which have a fixed value, were to fluctuate, the crypto market would see a catastrophic price collapse.

So how likely is this doomsday scenario to happen?

What are Stablecoins?

A stablecoin is a type of cryptocurrency designed to maintain the same fixed, constant value as another asset. For example, the value of some stablecoins is pegged 1:1 to the value of the US dollar, meaning one unit of those stablecoins should always be worth one dollar.

Stablecoins help traders avoid the volatility of the crypto market, as their value should theoretically always remain flat in relation to their pegged asset, like the dollar. This is also useful for people wishing to get paid in crypto but unwilling to receive an asset like Bitcoin which could fluctuate drastically overnight.

What is Depegging?

Stablecoins can sometimes break away from their pegged asset, no longer maintaining a stable value as designed. This usually happens due to a lack of liquidity, but could also occur due to other market conditions, changes in regulation, or errors in the coding of an algorithmic stablecoin.

Depegging due to Supply Shortage

Stablecoins typically work by minting a new stablecoin when the demand for one arises, and destroying a stablecoin when there is an excess due to people selling their stablecoins. 

However, if there is a spike in demand, which often happens during a crypto price collapse when people are looking to avoid volatility by trading their crypto for stablecoins, many new stablecoins are created. In theory, those stablecoins must be backed by real assets, otherwise if people were to try to cash them all out, there wouldn’t be enough cash and the coin would collapse or depeg from the value of the pegged asset.

Depegging due to Smart Contract Failure

Stablecoins rely on self-executing pieces of code on blockchain networks, called smart contracts, to function. An error in the programming of these smart contracts could be vulnerable to failure or attack, and this could also cause the coin to depeg.

Examples of Depegging

Let’s take a look at some examples of stablecoin depegging, including the UST depeg, the Tether depeg, and USDC depeg. This is by no means an exhaustive list of depegging events in crypto.

Make note of Silvergate connection to FTX and to the USDC depegging event. Cite Tether depeg events as well, leading into the next section.

UST Depeg

The UST depeg was a particularly catastrophic event in crypto. From May 07 to May 09 2022, the UST stablecoin attached to the Terra project depegged from its $1 value multiple times.

Terra is a blockchain network created in 2018 by Terraform Labs to facilitate the creation of stablecoins and decentralized apps. LUNA is the native cryptocurrency of Terra, and UST is a stablecoin attached to the project. When selling pressure threatens UST, algorithms use LUNA to buy UST to prop up the price, and vice versa, ideally keeping the price of UST stable and preventing a UST depeg.

The market was undergoing a major downturn during early May 2022, and LUNA’s price was falling. Someone withdrew $2 billion worth of staked UST, Terra’s stablecoin, from a major staking platform called Anchor, which issued rewards for locking up crypto funds. 

This person or persons then sold hundreds of millions of dollars worth of the unstaked UST, creating serious selling pressure during what was already an intense market correction.

The selloff created a supply shortage of UST, depegging the price to $0.91. The Luna Foundation Guard was obligated to sell its BTC reserves to try and prop up the price of UST, and this caused the BTC price to drop further, triggering a marketwide collapse. Its fallout is still being felt today.

Tether Depeg

Tether, or USDT, is the world’s largest stablecoin. There has never been a serious Tether depeg event, although the price did drop 3% in November 2022 following the failure of the FTX exchange and subsequent market fallout.

While Tether has been subject to rumors over the years on whether the coin is fully collateralized, there has never been solid evidence of a major issue behind the scenes at Tether, and USDT remains the market’s most popular stablecoin. Read more about the Tether use case here.

USDC Depeg

USDC is a major stablecoin within the crypto ecosystem. A USDC depeg occurred in March 2023 following the collapse of the Silvergate bank where a lot of USDC collateral reserves were being held.

USDC depegged below 90 cents on the dollar, leading to serious concerns around the viability of the coin and marketwide panic in general. However, the depeg was short-lived. The US government announced that all Silvergate bank debts would be paid federally, meaning that the USDC reserves are not in danger, and this prevented a more serious run on USDC that could have collapsed the coin entirely.

Depegging: Stablecoin Regulation

Stablecooin regulation has increased and improved in recent years, with the US congress passing the Stablecoin Transparency Act which requires stablecoin issuers to hold all reserves backing up their fiat-pegged stablecoins in government securities or dollars – essentially, the purpose of the act is to prevent issuers like Tether from backing up their stablecoin crypto with more crypto as collateral.

Are Stablecoins Safe? Final Thoughts

As you can see, stablecoins are not entirely bulletproof, and severe market forces can threaten the stability of even the largest stablecoins on the market. However, as the crypto ecosystem grows in size, and as stablecoin regulation continues to tighten, depegging events can be expected to become less common over time.

FAQ