29 March 2023 | ZebPay Trade-Desk
Stablecoins represent a type of crypto that aims to maintain a constant value relative to an asset such as fiat currencies or gold. They have found widespread use in the DeFi space and as proxies for the volatility associated with Bitcoin and other crypto assets. However, these assets may not always possess the stability they are meant to show.
Several factors can cause stablecoins to depegg from the asset it is linked to. This means they trade at a different price than their reference value. For example, USDC, a stablecoin backed by US dollar cash reserves and short-term Treasuries, should always be worth a dollar. It is possible that sometimes there isn’t enough supply or demand for USDC in the market. In such cases, it might trade at a discount or premium depending upon the conditions. Unpegging can undermine the trust and utility of stablecoins, which are designed to provide fast, cheap, and global transactions without sacrificing price stability and predictability. It can also hurt your profitability for both users and stablecoin issuers.
Not Enough Liquidity in the Market
Stable coins need sufficient market liquidity to maintain their peg. Market liquidity means the ease with which an asset can be traded without affecting its price. If there are too few buyers and sellers in the market, the value can deviate from its parity. This happened on March 11, 2023 when USDC, a stablecoin backed by US dollars and government bonds and issued by Circle, crashed to $0.88. The reason was the collapse of two major banks serving crypto companies: Silicon Valley Bank (SVB) and Silvergate Bank (SI).
Read more: USDT vs USDC
Circle held $3.3 billion in USDC cash reserves in SVB, and over the weekend when SVB collapsed, it was unclear how much it would recover. This spooked the market and caused USDC to sell off heavily. Meanwhile, Circle couldn’t offer refunds because banks were closed over the weekend. The sudden drop in demand for USDC exceeded its supply in the market, causing its price to fall below par.
Manipulation of the Market
Market manipulation is another reason why stablecoins can break loose. Market manipulation means any activity that intentionally influences or distorts the price of an asset for personal gain. Stablecoins, just like other crypto assets, can be subject to market manipulation. We can take an example to elaborate on this. In 2017 Tether (USDT), a stable coin created by Tether Limited which is backed by US dollars in reserve accounts, was accused of playing with bitcoin prices by issuing more USDT than it had in reserves. A study conducted by the University of Texas at Austin discovered that Tether was utilised to buy bitcoin at key times when it was falling, creating artificial demand and driving up the price.
The study also suggested that Tether was not fully backed by US dollars as claimed, but by loans from Bitfinex, a crypto exchange affiliated with Tether Limited. This raised questions about Tether’s solvency and credibility, and led to legal investigations by regulators and law enforcement agencies.
A third reason why stablecoins can break free is flaws in the design of the stablecoin mechanism. Stablecoin mechanism refers to how a stablecoin maintains its peg through various methods such as: Collateral, algorithmic adjustment or governance. Stablecoin mechanisms may not consider external factors or risks affecting their stability or security.
For example, in the midst of a market crash in May 2022, a bank run on the algorithmic stablecoins TerraUSD (UST) and LUNA, which were once among the top 10 most valuable crypto assets, caused UST’s peg to fall. Because of its design, $1 UST could be claimed for $1 LUNA. However, when the price crashed, it accelerated the demise of UST and LUNA, leading to a spiral effect and eventual implosion of the LUNA ecosystem. Over $60 billion in value has been wiped out and UST is now trading at pennies on the dollar.