August 11, 2023
Why do stablecoins depeg?
That’s an interesting question, with both a short and a long answer. The short answer is that the collateral or collateralization algorithm that backs their value fails.
The long answer?
Well …
What are Stablecoins?
Bitcoin was first created with the idea that people would use it like cash – earning it and spending it – but its volatility has made it more attractive as an investment asset. Millions of people hold bitcoin as an investment, but not very many actually spend it on small purchases.
Nonetheless, if you want to transact on a blockchain, you need a digital currency to do so, and preferably a non-volatile one. Stablecoins were invented with this use case in mind.
Stablecoins are a particular kind of crypto that, if properly designed, will hold a consistent value relative to some real-world currency or asset, usually the U.S. Dollar. The idea is that one dollar-pegged stablecoin will always be worth $1.00, or something very close, like $0.9995.
During the beginning of the crypto era, stablecoins were thought to be the big thing that would drive crypto adoption. Cutting-edge, crypto savvy users would use them to purchase products or transfer money on blockchain. Sooner or later, Mom and Pop users all over the world would use crypto, and paper currency would become a distant memory.
But, as is often the case, an interesting thing happened on the way to the marketplace.
Stablecoins did indeed become important, but not as the way to buy a cup of coffee. They became a cornerstone of decentralized finance (DeFi), used for trade settlement, to facilitate DeFi lending, as a safe asset during volatile markets, as an on/off-ramp to blockchains, and so forth. Currently, the total market cap of all stablecoins is approximately $125 billion, with the largest five (Tether, USDC, DAI, Binance USD, TrueUSD) making up 98 percent of the total.
Two Types of Stablecoins
There are two general types of stablecoin: algorithmic and asset-backed.
Algorithmic Stablecoins
These stablecoins maintain their value by a mathematical construct that controls the supply of coins. Think of this construct as an algorithmic Central Bank. When coins are too plentiful, and their value begins to drop, an algorithm on the issuing blockchain buys/burns some to take them out of circulation. When coins are too scarce, and their value begins to rise, the algorithm issues more into circulation.
Various algo coins use different, sometimes very complicated, price-stabilization methodologies. At heart, they're all, in one way or another, controlling their money supply.
Algorithmic stablecoins have the advantage that the issuer doesn’t need any money to create them; just math, and algo coins can easily be fully decentralized. The disadvantage is that many users remain unconvinced that they work as proposed, especially during times of stress. Because of this, algorithmic stablecoins aren't as widely used as asset-backed stablecoins.
Asset-backed Stablecoins
These are coins backed (or “collateralized”) by some other asset. That asset is usually something from the real world that has actual value. The three most common types of asset-backed stablecoins are fiat-backed, commodity-backed, and crypto-backed.
Fiat-backed - These are backed 100% by the actual cash currency they're pegged to, and what are called “cash equivalents. So, for dollar-pegged stablecoins, every dollar of stablecoin issued is backed by a dollar in a bank account or some other cash equivalent, like short-term US Treasury bills. The point is that, in theory, all coin holders can be cashed out of their coins at a moment’s notice. This isn’t exactly the case sometimes, as some stablecoin issuers aren’t completely transparent about their collateralization.
There’s been a great deal of controversy that coins backed this way aren't 100% liquid. In other words, that they are partially backed by other assets that may not be immediately liquid. If you try to cash out, you might not be able to. A full-scale withdrawal of coins by many holders could create a run on the bank(s) holding the underlying assets, a situation where the bank literally doesn't have enough dollars to cash out stablecoin holders. These concerns, and others, are causing banking regulators around the globe to take a hard look at stablecoins.
Commodity-backed - These are stablecoins backed by some commodity, usually gold or silver, although there are many niche variations, like oil-backed or even stablecoins backed by diamonds. The point to these coins is simply to assure holders that there is some actual asset value behind the coin. However, the design of these coins can be problematic if the underlying asset is volatile.
Cryptocurrency-backed - These stablecoins are backed by one or a basket of cryptos. Usually, these require users to stake and lock a cryptocurrency via a smart contract to a particular blockchain, and then that chain issues the stablecoin. The advantages these stablecoins offer is that they’re a truly decentralized alternative to fiat and commodity-backed stablecoins, and they offer quick liquidation from one cryptocurrency to another. The current market leader among this type of stablecoin is MakerDAO’s DAI.
What is Depegging?
A stablecoin that's designed to maintain its value versus the U.S. dollar is said to be “pegged” to the dollar. One stablecoin = $1, or something very close. If suddenly, for whatever reason, that coin is no longer worth near a dollar, it’s said to have “depegged.” Not counting very short-term fluctuations, stablecoins generally depeg in very obvious ways.
Asset-backed stablecoins depeg if the assets collateralizing the coin suddenly drop in value, causing the collateralization pool to contain less than, for example, $1 for each outstanding coin. Or, the issuer of the coin may not be transparent about the backing, and may in fact hold less than $1 per coin, or may hold assets that are not immediately liquid. (For years, this was rumored about Tether.)
Algo stablecoins depeg when their algorithmic stabilizing methodology turns out to be faulty or is overwhelmed by market conditions (which is another way of saying its methodology is faulty). Also, a depegging can be caused by tech problems such as a poorly written smart contract, hacks, or network congestion.
Generally speaking, that’s it. But the particulars are sometimes not so simple. Let’s skip the hypotheticals and look at two actual recent cases of a stablecoin depegging for the why, how, and fallout.
Terra Depegs
Once upon a time, there was a blockchain called Terra, created by Terraform Labs, to enable the issuance and management of algorithmic stablecoins. Terra grew in size and fame faster than anyone could have imagined, and its name was plastered on sports arenas around the world.
Terra’s two principal coins were the TerraUSD stablecoin and its reserve asset LUNA, and Terraform’s founder, Do Kwan, stated that his stablecoin would soon put all other algo stablecoins out of business. The stabilization mechanism was an incentive system that rewarded users to mint TerraUSD and burn LUNA when TerraUSD’s price rose above $1.00, and do the reverse when it fell below $1.00.
You already know how this ends.
In May 2022, TerraUSD lost its peg and it and LUNA collapsed, wiping out $45 billion in market cap in a matter of days. Some believe that the proximate cause was that some users, who were receiving 19.45 percent staking return, decided that the return was unsustainable, pulled their assets, and triggered a bank run on the reserves. There are others who contend that the entire thing was a Ponzi scheme from Day One.
Either way, the debacle not only crashed Terra but, because TerraUSD was staked all over the ecosystem, in other DeFi programs and D’Apps, contagion reached hundreds of other protocols and millions of users and investors. Many people who had nothing to do with Terra lost significant money. Nonetheless, because regulators had kept the crypto ecosystem walled off from the larger TradFi financial system, losses were mostly limited to crypto holders, so a crypto stablecoin problem didn’t lead to an IRL banking collapse.
A few months later, though, a real banking collapse would lead to a stablecoin problem.
USDC Depegs
USDC ($USDC) is an asset-backed stablecoin created by Circle and Coinbase. It's surmised to be equal to the U.S. dollar. In March of 2023, Silicon Valley Bank (SVB), a forty-year-old California bank which was created to cater to Silicon Valley startups, and which had become the biggest bank in the Valley, saw the impact of their actions. At the time, it was the second-largest bank failure in U.S. history.
SVB’s issues are pretty simple: It was holding a large amount of long-term treasuries, and interest rates spiked, leading to huge mark-to-market losses. Some of SVB’s biggest tech investors and depositors began worrying about solvency, pulled their assets, and triggered a bank run. On March 10, 2023, federal bank examiners showed up at SVB and held them accountable.
It turned out that eight percent of USDC’s reserves were uninsured deposits at SVB. As word of that leaked out, USDC depegged, dropping to a price of $0.88. $USDC was held as a “safe” crypto by literally millions of Americans and was used as one of the primary DeFi staking instruments. Fear and apprehension skyrocketed and touched other stablecoins; DAI depegged to $0.90 because half of its assets were held in USDC. Many holders panic sold; some bought on the hopes that the FDIC would cover SVB’s uninsured depositors, and USDC would quickly return to $1.00.
The latter were right, and scored a quick 13.5 percent return. Other than those few, this wasn’t a story with many winners. According to Bloomberg: “…regardless of all the talk about building a new and improved financial system, some of the most important pillars of crypto are still inextricably attached to the traditional system. Developments in one can ricochet very quickly back to the other. Just ask the equity bagholders in ‘crypto-friendly’ Silvergate Capital Corp. and Signature Bank who’ve seen their holdings vaporized.”
Stablecoins aren’t really meant for trading. If they operate correctly, there’s not much volatility to provide a worthwhile return. But…they can provide a big opportunity (or risk) if they depeg. How can Amberdata help you spot a depegging?
How Can Amberdata Help?
First, with consistent and reliable stablecoin data. If you see a stablecoin’s price varying beyond a penny or two in either direction, you should pay attention. It may be an opportunity to grab, or a risk to get away from.
Secondly, futures long/short ratios. Stablecoins by definition aren’t supposed to move very much. If their futures long/short ratio deviates too far in either direction, it may be a signal that the coin may be on the move.
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