Stablecoins are digital currencies designed to maintain a stable value, often pegged to a traditional currency such as the US dollar. They are considered a crucial component of the crypto ecosystem as they provide a way for traders and investors to hedge against the volatility of cryptocurrencies. However, some stablecoins have been facing challenges with maintaining their peg, with many depegging from their intended value. There are several reasons why stablecoins depeg in crypto, including a lack of market liquidity, market manipulation, and flaws in their design.

Lack of Liquidity

One of the primary reasons why stablecoins depeg is due to a lack of market liquidity. Liquidity refers to the ability to buy or sell an asset quickly without affecting its price. In the case of stablecoins, when there is not enough demand for the currency, the price may start to drop, causing it to depeg from its intended value. Conversely, if there is too much demand, the price may rise above its intended value, leading to over-pegging. This issue is particularly prevalent in smaller markets with limited trading volume, making it easier for large trades to move the market.

On March 11, 2023, USDC, which is a stablecoin backed by US dollars and treasuries and issued by Circle, experienced a sharp decline to $0.88. This drop was caused by the collapse of two major banks, Silicon Valley Bank (SVB) and Silvergate Bank (SI), that served crypto firms. Circle had $3.3 billion of USDC’s cash reserves held on SVB, and it was uncertain how much could be recovered after its collapse over the weekend.

This caused market uncertainty and triggered widespread selling of USDC. Moreover, Circle was unable to offer redemptions due to the banks being closed on the weekend. As a result, the sudden decrease in demand for USDC exceeded its supply in the market, causing its price to fall below its intended value.

Market Manipulation

Another reason why stablecoins depeg is due to market manipulation. Cryptocurrency markets are notorious for their susceptibility to manipulation, and stablecoins are no exception. Some market players can artificially inflate or deflate the price of stablecoins through large buy or sell orders, leading to an imbalance in supply and demand. These players often engage in wash trading, a tactic where they simultaneously buy and sell the same asset to create the illusion of trading activity. This manipulation can destabilize the price of stablecoins, causing them to depeg from their intended value.

In 2017, Tether (USDT), a stablecoin issued by Tether Limited and backed by US dollars held in reserve accounts, faced allegations of manipulating Bitcoin prices. The company was accused of issuing more USDT than it had reserves for, artificially inflating Bitcoin’s price by creating fake demand. Researchers at the University of Texas at Austin conducted a study that found Tether was used to buy Bitcoin during its decline, leading to price inflation. The study also claimed that Tether was not fully backed by US dollars, as it had claimed, but instead by loans from Bitfinex, a crypto exchange affiliated with Tether Limited. These revelations sparked concerns about Tether’s solvency and credibility and led to regulatory and law enforcement investigations.

Flaws in Design

Flaws in the design of stablecoins can also contribute to their depegging. Stablecoins can be broadly categorized into three types: fiat-collateralized, crypto-collateralized, and algorithmic stablecoins. Fiat-collateralized stablecoins are backed by traditional currencies such as the US dollar and require trust in the issuing institution to maintain the value of the currency. Crypto-collateralized stablecoins are backed by other cryptocurrencies, which can lead to volatility and uncertainty. Algorithmic stablecoins, on the other hand, use complex algorithms to adjust the supply of the currency in response to market demand. However, flaws in these algorithms or unforeseen market events can cause them to fail, leading to a depegging of the stablecoin.

In May 2022, during a market downturn, there was a bank run on TerraUSD (UST) and LUNA, which were among the top 10 most valuable cryptocurrencies at the time. As a result, the peg of UST to $1 was broken due to its design that allowed for claiming $1 of UST for $1 of LUNA. However, the rush of investors trying to exit caused both UST and LUNA to plummet, leading to a downward spiral effect and ultimately, the collapse of the LUNA ecosystem. This event caused a loss of over $60 billion in value, and UST is now trading at a fraction of its intended value.

Conclusion

In conclusion, stablecoins are an essential part of the crypto ecosystem, but they face challenges with maintaining their peg. A lack of market liquidity, market manipulation, and flaws in their design are all contributing factors to their depegging. As the crypto industry continues to grow, it is crucial to address these issues and develop more robust stablecoin solutions to ensure their continued usefulness and stability in the market.