TL;DR
Stablecoins use a "peg" mechanism to maintain a consistent price.
Stablecoins can be either collateralized (backed by fiat, crypto, or commodities) or non-collateralized (regulated by algorithms).
Historical instances like UST in 2022, USDC and DAI in 2023, and USDR in 2023 illustrate the vulnerabilities and complexities of maintaining a peg.
What Is a Stablecoin Peg?
A stablecoin is a type of crypto asset that’s designed to have a relatively stable value. While cryptocurrencies are usually known to be volatile, stablecoins have been specifically created to be a hedge against price fluctuations.
Stablecoins maintain stability by using a "peg." A "peg" is like an anchor for value. Just as countries might tie their money's value to another country's currency to keep it stable, stablecoins do something similar. Many stablecoins, like USDT and DAI, aim to have the same value as $1.
What Happens When a Stablecoin Depegs?
When a stablecoin is no longer trading for its predetermined peg value, it's called a "depegging event." Over the years, stablecoins have found immense utility and currently account for billions of dollars in daily trading volume.
This is why a depegging event could potentially have far-reaching consequences. Later on in the article, we will be looking at historical instances of stablecoin depegs. Before that, let's look at how stablecoins manage their pegs.
How Does a Stablecoin Maintain Its Peg?
Stablecoins usually fall under two categories – collateralized and non-collateralized.
1. Collateralized stablecoins
Most stablecoins in circulation today are collateralized stablecoins, meaning their values are backed by other assets. These stablecoins are supposed to be backed or "collateralized" by fiat, other cryptocurrencies, or commodities like gold. In these cases, every stablecoin issued should theoretically have a corresponding asset held in reserve.
Here is how they work:
Fiat-collateralized: Every token in circulation should be backed by an equivalent amount of fiat currency, like the US dollar. As such, every single stablecoin issued should be redeemed for the underlying asset. FDUSD and USDT are examples of fiat-collateralized stablecoins.
Crypto-collateralized: These stablecoins are overcollateralized by a crypto asset or a basket of crypto assets. This means more cryptocurrency is held as collateral than the stablecoin's value, providing a buffer against potential price fluctuations. DAI and crvUSD are examples of crypto-collateralized stablecoins.
Commodity-collateralized: These stablecoins are anchored to the price of commodities like gold. These coins may potentially provide a hedge against inflation and exposure to the commodity. Pax Gold (PAXG) is an example of a commodity-collateralized stablecoin, backed by gold.
Note: While stablecoin projects often make claims regarding their reserves and pegging mechanisms, the verifiability and accuracy of such claims may vary. Therefore, it is crucial to exercise caution and acknowledge that the level of collateralization may not always be 100% as asserted.
2. Non-collateralized stablecoins
Non-collateralized stablecoins, also known as algorithmic stablecoins, use coded algorithms and smart contracts to auto-regulate their supply based on market demand, ensuring the stablecoin's price remains close to its peg.
If price drops below the value of the fiat currency it tracks, the algorithm reduces the circulating supply, aiming to push the price back up. On the other hand, if the price goes above the value of the fiat currency, new tokens are introduced to bring down the stablecoin's value. TerraUSD (UST) was an algorithmic stablecoin.
So, what happens when these stablecoins lose their pegs and start trading below market value? Let’s take a look at some examples.
Historical Instances of Stablecoin Depegging
Here are some of the most infamous incidents of stablecoin depegs.
May 2022 - UST
In May 2022, the crypto world experienced a historic event when Terra's UST stablecoin lost its peg. Before this incident, Terra's native token, LUNA, was the 8th largest coin globally, boasting a market cap of $40 billion. This depegging left both UST and LUNA virtually worthless, sparking the "crypto contagion," a chain reaction where numerous crypto projects and businesses interconnected with Terra faced significant losses. During this volatile period, other stablecoins like Tron's USDD and Near Protocol's USN also temporarily lost their pegs before returning to parity.
March 2023 - USDC and DAI
In March 2023, two leading stablecoins, USDC and DAI, depegged because of the collapse of three US banks: Silicon Valley Bank (SVB), Signature Bank, and Silvergate Bank. USDC issuer Circle disclosed that $3.3 billion of the cash reserves used to collaterize the stablecoin were held at SVB. As a result, USDC temporarily lost its peg, dropping over 12% in a single day.
DAI also experienced value fluctuations, mainly because over half of its collateral reserves were tied to USDC and its associated instruments at the time. The situation stabilized when the Federal Reserve announced its support for the banks' creditors, leading to USDC and DAI returning to their respective pegs.
Following the incident, both stablecoins adjusted their reserve compositions, with USDC predominantly placing its cash reserves with the Bank of New York Mellon and DAI diversifying its reserves across multiple stablecoins and increasing its holdings in real-world assets.
October 2023 - USDR
USDR, or Real USD, is a stablecoin launched by Tangible (native token TNGBL) in 2022. It is a USD-pegged stablecoin that was meant to utilize a combination of tokenized real estate and the DAI stablecoin as its collateral.
USDR also had an auto re-collateralizing mechanism wherein half of the rental yield collected from tenants is auto-redirected to the treasury. This was supposed to be a peg-stabilization mechanism. Unfortunately, despite these stability measures, USDR depegged on October 11, 2023.
Here is what happened:
On October 11, USDR experienced a surge of redemption requests, which eventually totaled 10 million USDR.
This huge redemption request drained the USDR treasury of all its liquid DAI stablecoin reserves.
Since the remaining collateral was illiquid tokenized real estate reserves, the Tangible team couldn’t immediately meet the redemption requests.
This sudden liquidity crunch caused major FUD among USDR holders as the coin depegged.
As per independent researchers and members of the USDR community, the tokenized real estate used by USDR as collateral utilized the ERC-721 token standard, which isn’t as flexible as the commonly used ERC-20. Since ERC-721 tokens can’t be easily fractionalized, it makes timely redemptions challenging.
Closing Thoughts
In the volatile world of cryptocurrencies, the stability promised by stablecoins has been a crucial safe haven for investors. However, as history has shown, these stablecoins are definitely not impervious to challenges. The massive depegging incidents of UST and USDR show they are susceptible to external financial pressures and inherent design flaws. As with anything in financial markets, it is crucial to do your own research before taking risks.
Further Reading
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