Stability is what is valued above all else in the world of cryptocurrencies. The popularity of tokens pegged to real assets is growing precisely because of the promise of their unchanging value. However, recently there have been more and more reports that some stablecoins have lost their peg to certain assets.
What is the reason for this? How does it affect the market? Let’s understand the mechanisms of the work of stablecoins and find out why they sometimes lose stability.
How does the pegging of a stablecoin work
For many investors, volatility is the main drawback of cryptocurrencies. It is to solve this problem that stablecoins were created. Their purpose is to ensure the stability of the asset’s price. This allows investors to be confident that their funds will retain purchasing power.
How do stablecoins manage to neutralize the volatility of the crypto market? Through the use of the mechanism of pegging to stable assets. For example, the most popular stablecoins, such as Tether and DAI, peg their value to the U.S. dollar at a 1:1 ratio. That is, one token should always be worth approximately one dollar.
This peg to a reliable reserve currency is what keeps the price of stablecoins stable even during periods of turbulence in the crypto market.
What happens to a stablecoin when it loses its peg to fiat
As we have already mentioned, the link to stable assets is the key mechanism that allows such digital coins to maintain a stable value. However, it happens that this link is broken.
In the world of cryptocurrencies, this phenomenon is called «loss of peg». It means that the price of a token no longer follows its anchor asset. For example, if the rate of a stablecoin pegged to the dollar suddenly drops below $1.
What does this threaten investors? After all, they invested in stablecoins for the sake of reliability. The loss of the peg carries for them the risk of unexpected losses due to a sharp increase in volatility.
How do stablecoins maintain a peg to assets
In order to maintain a fixed value, stablecoins use a variety of asset-linking mechanisms. These can be categorized into two large groups:
Collateralization with real assets
This is the most common mechanism. Issued tokens in circulation in this case are partially or fully covered by valuable assets:
- Fiat money (dollars, euros, yuan). For example, the popular stablecoin Tether (USDT) is claimed by its creators to have a dollar reserve of 1:1.
- Other cryptocurrencies (BTC, ETH). Stablecoins of this group use an over-collateralized model. For example, for 1 token of stablecoin, there may be 1.5 or 2 units of Bitcoin in collateral. This is done to protect against a possible drop in the value of the securing crypto asset.
- Commodities (gold, silver, oil). For example, the popular PAX Gold token (PAXG) is tightly tied to the current price of one troy ounce of gold.
Note: it is worth noting that in practice, approaches to ensuring the stability of such assets are often not fully transparent. In this regard, every investor should carefully assess the risks of losing the peg of a particular stablecoin.
Algorithmic price stabilization
In addition to secured stablecoins, there is another approach to price stabilization — unsecured or algorithmic stablecoins. In this case, the balance between supply and demand is regulated by special mathematical formulas. They dynamically adjust the volume of tokens to maintain the reliability of the assets.
Mathematical algorithms, in addition to tracking the ratio of supply and demand of tokens, also regulate the current price in relation to the peg, for example, to the dollar. If the price falls — automatically reduces the number of coins in circulation. If the price rises — on the contrary, new tokens are issued.
In this way, stability is maintained without the use of collateral assets. However, in practice, algorithm failures can lead to the collapse of unsecured stablecoins, as happened with TerraUSD in May 2022.
Let’s look at specific cases of loss of pegging by stablecoins and the consequences of their exchange rate moving to below-market values.
Real cases of stablecoins peg loss
Unfortunately, there have already been several high-profile cases in the history of stablecoins where these assets failed to fulfill their primary purpose of maintaining stable value.
One of the biggest incidents occurred in May 2022 with the Terra ecosystem and flagship stablecoin TerraUSD. Its main token LUNA was in the top 10 in terms of capitalization at the time. The massive sell-off of UST and LUNA led to a 99% depreciation of these assets and caused a chain reaction across the entire cryptocurrency market.
Another high-profile case is the temporary loss of pegging by USDC and DAI tokens in March 2023. The reason was the collapse of American Silvergate Bank and other banks, which held part of the USDC reserves. This triggered a wave of panic and a sharp 12% drop in the USDC exchange rate. Since DAI was partially backed by USDC, its value also started to fluctuate. The situation managed to normalize only after the Fed’s support.
Another illustrative example — the collapse of the USDR algorithmic stablecoin in October 2023 against the backdrop of an acute liquidity shortage. What was the reason for this? USDR used both DAI stablecoin and tokenized real estate as collateral. As a result of the surge in withdrawal demand, the liquid DAI stock ran out. And the more illiquid real estate did not allow redemption requests to be met promptly. As a result, there was a shortage of reserves, which shook the confidence of users and as a result — to the collapse of USDR.
Final thoughts
To summarize, here are the key points regarding the problem of stablecoin losing its peg:
- Despite various stabilization mechanisms, no approach offers a 100% guarantee of maintaining value parity. Even the most seemingly reliable solutions carry risks under certain market conditions.
- Unsecured algorithmic stablecoins lose fixation more often than others. They are vulnerable to market volatility and errors in the code of smart contracts.
- But linking to real assets isn’t a cure-all if reserves are not stored optimally. For example, too large a share of illiquid or concentrated funds in one place.
Thus, to reduce risks, the investor should carefully analyze the collateral structure and algorithms of each stablecoin. And also diversify investments between assets.
