What happens if a stablecoin loses its peg?

If a stablecoin loses its peg, it faces a massive sell-off from the holders, which, if severe, could crash its price. This happens because people invest in stable to keep the value of their assets pegged to some fiat currency, such as the US Dollar or the Euro. A de-peg in that scenario results in an absolute loss without the ability to make a profit, making the stable non-desirable.

Put simply, if a stablecoin loses its peg, it becomes useless to its holders if immediate confidence-building measures are not taken.

What is a De-Peg?

A de-peg is the scenario where the price of a stablecoin moves below its set price.

To understand a de-peg better, it is essential to understand how stablecoins work. Crypto markets are inherently volatile, which means there is a risk of depreciation if you keep your coins parked in a particular asset, even if it is Bitcoin. As a result, stablecoins were created to hold the value of the assets at a fixed point. These stablecoins are pegged to fiat currencies (e.g., 1:1 with the US dollar) because fiat serves as the basic unit of account in economics.

If a stablecoin moves below this peg, say, becomes 0.98 per dollar, there is a net loss of 2% for the investor. This loss becomes unbearable because it means that the coin economics have broken down.

What are the Common Reasons for a De-Peg?

1. Lack of sufficient reserves that back the value of the coin.
2. Risk of algorithmic failure in Algorithmic Stablecoins, such as Terra UST.
3. Regulation that might result in redemption.
4. Fake news in the markets.
5. Excessive shorts in the stablecoin. Yes, it can also be shorted with Futures and Options.
6. Risk of loss of reserves, as it happened with USDC in March 2023.

Do Stablecoins Recover Their Peg?

Yes, if the de-peg is due to a market scare or a temporary reason, it gradually recovers within a couple of weeks. The same has already happened with USDT in May 2022 and USDC in March 2023.

Notable De-Pegs in the Past

There have been three notable de-pegs in the history of the crypto markets.

1. Terra’s UST de-pegged in May 2022 due to excessive shorting, taking down the entire Terra Luna ecosystem because UST was algorithmically linked to LUNA, the native token.
2. USDT has faced de-pegging several times in the past, including one involving Terra UST, due to shorts, opaque reserves, and other factors. However, each time it has come back from the dep-eg.
3. USDC faced a de-peg when about $3 billion of its reserves were tied up with the collapsed Silicon Valley Bank in California. It faced huge sell-offs and lost its market dominance to Tether.

What to do if my Stablecoin De-Pegs?

If it is a large stablecoin with a market cap of at least $1 billion, it is likely to recover its peg within a month. The same has happened with USDT and USDC.

However, smaller coins may never recover due to limited access to emergency funds and a lack of trust in crypto markets.

Frequently Asked Questions

Disclaimer: BFM Times acts as a source of information for knowledge purposes and does not claim to be a financial advisor. Kindly consult your financial advisor before investing.