Why stablecoins lose their peg

What is Stablecoin Pegging?

A stablecoin is a type of cryptocurrency asset designed to maintain a relatively stable value. Unlike traditional cryptocurrencies characterized by high volatility, stablecoins are engineered to provide protection against sudden price fluctuations.

This stability is achieved through a mechanism called pegging, which ensures the long-term stability of the asset's value. For instance, countries may peg the value of their national currency to the currency of another nation to preserve its stability. Stablecoins employ a similar mechanism. Many of them, such as USDT and DAI, aim to keep their value pegged to $1.

Consequences of Stablecoin Decoupling and Their Management

The decoupling of stablecoins occurs when their market value deviates from the pre-established price. Over the years, stablecoins have gained tremendous popularity, with their daily trading volume estimated in billions of dollars.

The loss of stability in such an asset can have significant repercussions. Below, we will examine real examples of such events, but first, let's understand how stablecoins manage their pegs.

Maintaining Stability in Stablecoins

1. Collateralized Stablecoins:

• Asset-Backed Stability: The majority of stablecoins in circulation rely on collateralization, where their value is supported by various assets. These assets may encompass fiat currencies, other cryptocurrencies, or commodities like gold. In theory, each issued stablecoin should have a corresponding reserve asset.

• Fiat Support: Each circulating token must be secured by an equivalent amount of fiat currency, such as US dollars, ensuring that every stablecoin is exchangeable for its underlying fiat. Examples include FDUSD and USDT.

• Cryptocurrency Support: These stablecoins are backed by a cryptocurrency or a basket of cryptocurrencies, requiring surplus collateral to safeguard against potential price fluctuations. Notable examples are DAI, crvUSD, among others.

• Commodity Linkage: Some stablecoins are tied to commodity prices, like gold. These stablecoins offer potential inflation hedging and access to tangible assets. Pax Gold (PAXG) is an instance. Cautionary Note: Despite claims of ample reserves and robust pegging mechanisms, verification of such assertions is not always feasible. Caution is advised, considering that the chosen asset may not be backed 100%.

2. Algorithmic Stablecoins (Unbacked Stablecoins):

• Algorithmic stablecoins, also termed unbacked stablecoins, leverage encoded algorithms and smart contracts for automatic supply adjustments based on market demand, thereby maintaining a close peg.

• In instances where the price falls below the tracked fiat currency's value, the algorithm trims the circulating supply to elevate the price. Conversely, if the price surpasses the fiat value, new tokens are introduced to diminish the stablecoin's value. TerraUSD (UST) serves as an example.

Potential Ramifications of Peg Deviation:

• Exploring specific instances, what unfolds when these stablecoins lose their pegs and commence trading below market value?

Examples of Peg Loss in Stablecoins:

Below are notable instances of stablecoins losing their pegs.

May 2022 — UST:

In May 2022, a significant event unfolded in the cryptocurrency space: the stablecoin UST from the Terra project lost its peg. Prior to this incident, Terra's native token, known as LUNA, held the eighth position among the world's largest coins with a market value of $40 billion. As a result of the peg loss, both UST and LUNA virtually became worthless, triggering a chain reaction and substantial losses for many crypto projects and businesses associated with Terra. During this period of instability, other stablecoins like Tron's USDD and Near Protocol's USN also temporarily lost their pegs but later regained stability.

March 2023 — USDC and DAI:

In March 2023, two leading stablecoins, USDC and DAI, faced a loss of their pegs due to the collapse of three American banks: Silicon Valley Bank (SVB), Signature Bank, and Silvergate Bank. Circle, the issuer of USDC, reported that $3.3 billion from the reserves used to back the stablecoin were held in SVB. This led to a temporary loss of peg for the USDC token and a more than 12% decline in its price within a single day.

The value of DAI also experienced fluctuations, primarily because at that time, more than half of the collateral reserves were tied to USDC and related instruments. The situation stabilized after the Federal Reserve announced support for the creditors of the banks, allowing USDC and DAI to restore their pegs.

As a result of this incident, both stablecoins adjusted the composition of their reserves. USDC placed its cash reserves predominantly in the Bank of New York Mellon, while DAI diversified its reserves among several stablecoins and increased the share of physical assets in its portfolio.

October 2023 — USDR:

USDR, or Real USD, is a stablecoin from the Tangible project (with the native token TNGBL), launched in 2022. It was pegged to USD and was designed to utilize a combination of tokenized real estate and the DAI stablecoin as collateral.

USDR also featured an automatic collateral replenishment mechanism where half of the income from property tenants was automatically directed to the treasury to stabilize the peg. Unfortunately, despite these measures, on October 11, 2023, USDR lost its peg.

Events:

On October 11, there was a surge in redemption requests for USDR totaling 10 million USDR.

This depleted the liquid reserves of USDR, and the project lost all its liquid reserves in the DAI stablecoin.

As a result, the remaining collateral consisted of illiquid tokenized real estate, and the Tangible team could not instantly satisfy the redemption requests.

The sudden liquidity deficit caused fear, uncertainty, and doubt (FUD) among USDR holders, leading to the loss of peg. Independent researchers and community members noted that using the ERC-721 token standard for tokenized real estate hindered timely redemptions due to its limited flexibility compared to the more common ERC-20 standard.

Conclusion

Given the considerable volatility of cryptocurrencies, stablecoins, offering stability, have emerged as a crucial asset for investors. Nevertheless, real-world incidents, such as the loss of pegs witnessed with UST and USDR, underscore the fact that stablecoins may encounter external financial pressures, and their structural design may expose them to vulnerabilities. It is strongly advised for investors to conduct their own comprehensive risk research before engaging in financial markets.