A stablecoin is a cryptocurrency designed to have a stable value relative to a specific asset or basket of assets, usually a fiat currency such as the U.S. dollar, euro or yen.
Stablecoins are designed to provide a “stable” store of value and medium of exchange, in contrast to more traditional cryptocurrencies such as Bitcoin (BTC) and Ether (ETH), which can be highly volatile.
Fiat currencies, cryptocurrencies, and commodities such as gold and silver are examples of assets used to collateralize or “back” stablecoins. Tether (USDT), USD Coin (USDC) and Dai (DAI) are a few examples of USD-pegged stablecoins.
Stablecoins can also be algorithmically stable through smart contracts and other mechanisms that automatically adjust the stablecoin supply to keep it pegged to the underlying asset.
Despite their potential benefits, stablecoins are not without risks. The biggest risk with any stablecoin is that its peg could break, causing it to lose value relative to the underlying asset.
A de-peg is where the value of a stablecoin deviates significantly from its pegged value. This can happen for a number of reasons, including market conditions, liquidity issues and regulatory changes.
USDC is a fully reserved backed stablecoin, meaning that each dollar coin is backed by actual cash and short-term U.S. Treasury bills. Nonetheless, USDC issuer Circle announced on March 10 that USDC had depegged from the U.S. dollar, with roughly $3.3 billion of its $40 billion USDC reserves held at the now-defunct Silicon Valley Bank. The 16th largest bank in the US collapsed on March 10, one of the largest bank failures in US history. Given the fallout from USDC, other stablecoins have followed suit in depegging the dollar.
USDC Drops as Circle Confirms Silicon Valley Bank Stuck $3.3B
2/ Like other customers and depositors who rely on SVB for banking services, Circle joins calls for this important bank to maintain continuity in the U.S. economy and will follow guidance provided by state and federal regulators.
— Circle (@circle) March 11, 2023
MakerDAO — a protocol based on the Ethereum blockchain — issues DAI, an algorithmic stablecoin designed to maintain an exact 1:1 ratio with the U.S. dollar. However, DAI also fell off the peg due to the collapse of Silicon Valley banks, mainly due to the contagion effect of the decoupling of USDC. Over 50% of reserves backing DAI are held in USDC.
Tether issues USDT, each USDT token is equivalent to the corresponding legal tender at a ratio of 1:1, and is fully backed by Tether’s reserves. However, USDT also experienced a de-pegging in 2018, raising concerns about the stablecoin’s overall stability mechanism.
The Importance of Stablecoin Pegs
The importance of a stablecoin peg is to provide a stable and predictable value relative to an underlying asset or basket of assets—usually a fiat currency such as the U.S. dollar. Due to their stability and predictability, stablecoins are ideal alternatives for a variety of use cases, including cryptocurrency transactions, payments, and remittances.
With stablecoin pegs, traders can enter and exit positions without being affected by the price fluctuations of cryptocurrencies like BTC or ETH. This is important for institutional investors and companies that rely on a reliable store of value and medium of exchange to do business.
Using a stablecoin peg could also make cross-border transactions easier, especially in countries with volatile currencies or limited access to traditional financial services. Stablecoins can provide a more efficient and affordable way to pay and transfer value across borders than more traditional methods such as wire transfers or remittance services.
Stablecoin pegs can also increase financial inclusion, especially for individuals and businesses without access to traditional financial services. Stablecoins can be used to make Crypto asset payments and transactions without the need for bank accounts or credit cards, which is crucial in developing and emerging markets.
Why Stablecoins Are Depegging?
Stablecoins may be de-pegged due to a combination of micro and macroeconomic factors. Micro factors include changes in market conditions, such as sudden increases or decreases in stablecoin demand, liquidity issues, and modifications to underlying collateral. Macro variables involve changes in the overall economic landscape, such as inflation or rising interest rates.
For example, if an increase in cryptocurrency trading activity leads to a surge in demand, the price of a stablecoin could temporarily exceed its pegged value. However, if the lack of liquidity matches increased demand, the price of the stablecoin could drop below its fixed value.
On the macroeconomic front, in the event of high inflation, the purchasing power of the underlying asset backing the stablecoin could decline, triggering a decoupling event. Likewise, adjustments in interest rates or other macroeconomic measures could affect stablecoin demand.
Regulatory changes or legal issues could also lead to stablecoin decoupling. For example, if the government bans the use of stablecoins, the demand for stablecoins will drop, causing their value to drop. Decoupling events can also be caused by technical issues such as smart contract vulnerabilities, hacking attacks, and network congestion. For example, smart contract flaws could cause the value of a stablecoin to be miscalculated, causing the exchange rate pegged to it to deviate significantly.
How can stablecoins be de-pegged?
Stablecoin decoupling typically requires several steps, which may vary depending on the specific stablecoin and the circumstances leading up to the decoupling event. The following are some general characteristics of decoupling events:
The value of the stablecoin diverges from its peg
As mentioned earlier, a number of factors, including market volatility, technical issues, illiquidity, and regulatory concerns, can lead to stablecoin decoupling. Stablecoins can change dramatically in value relative to the pegged asset or basket of assets.
Traders and investors react to decoupling events
Whether they believe the value of the stablecoin will eventually return to the peg or continue to diverge from the peg, traders and investors are likely to buy or sell stablecoins when they deviate significantly from the peg.
How will funds respond to $USDC decoupling?
Panic selling $USDC or buying $USDC at the bottom?
The following is the operation of the fund
Hope it helps you. pic.twitter.com/x4PYEyZbev
— Lookonchain (@lookonchain) March 11, 2023
Arbitrage opportunities arise
If the value of a stablecoin deviates from its peg, arbitrage opportunities may arise. For example, if a stablecoin is worth more than its peg, a trader might sell the stablecoin and buy the underlying asset for a profit.
Stablecoin Issuers Take Action
If the value of a stablecoin continues to deviate from its peg, the stablecoin issuer may take action to correct the problem. This may require changes to stablecoin supply, collateralization ratios, and other actions to increase trust in stablecoins.
Stablecoins stabilize in value
If traders and investors adjust their positions and stablecoin issuers respond to decoupling events, the value of stablecoins could stabilize. If the stablecoin issuer succeeds in winning back public trust, the value of the stablecoin may return to the peg.
Risks and challenges associated with stablecoin decoupling
Decoupling from stablecoins presents several risks and difficulties for investors, traders, and the larger cryptocurrency ecosystem:
Market Volatility: When stablecoins are de-pegged, the market may experience severe volatility as traders and investors shift their holdings in response to the de-peg event. This could lead to market uncertainty and increase the likelihood of losses. Reputational risk: Decoupling from stablecoins creates reputational risk for issuers and the larger cryptocurrency ecosystem. This could make it harder for stablecoin issuers to attract new users and investors, and reduce the total market value. Liquidity risk: If stablecoins are de-pegged due to traders and investors selling stablecoins in large quantities, liquidity issues may arise. As a result, stablecoins could drop in value, making it challenging for traders and investors to liquidate their holdings. Counterparty Risk: As a result of a decoupling event, traders and investors may be exposed to the risk of default by the stablecoin issuer or other parties involved in the operation of the stablecoin. Regulatory risk: The decoupling of stablecoins will also bring regulatory issues. Governments and authorities may impose restrictions on stablecoins if they believe the asset threatens the stability of the wider financial system.
Given the above risks, investors and traders alike should pay close attention to the performance of stablecoins in their portfolios. Research stablecoin issuers and their collateral, and keep an eye out for any signs of decoupling or other issues that could affect the value of stablecoins. They could also consider diversifying their holdings by using various stablecoins or other assets. This can reduce the chance of incurring losses in the event of a stablecoin decoupling.
Information source: compiled by 0x information from COINTELEGRAPH.The copyright belongs to the author Guneet Kaur, without permission, may not be reproduced