Stablecoin is one of the most practical types of digital currencies that not only facilitates trading and investing in digital currencies but also connects centralized and decentralized financial systems.
Stablecoins derive their value from other assets such as the dollar, euro, and gold, and must have an equivalent backing to maintain their value. If for any reason the value of a stablecoin deviates from the value of its underlying asset, the issue of Depegging arises. In this article, we will delve into the complete concept of Depegging in digital currencies and examine its reasons.
What is Depegging (Dpeg)?
Dpeg in the digital currency market refers to the deviation of a stablecoin’s price from its underlying asset value. Peg refers to the price dependency of a stablecoin on another asset, and when there is a deviation in this dependency, the term depegging is used. For example, if a stablecoin with the US dollar backing is traded below one dollar, it is said to have decreased and lost its price dependence on the US dollar.
The term depegging is not only limited to the digital currency market, and in traditional financial markets, when an asset is supported by another asset but its price is lower than its support, depegging is also used. However, depegging is a very bad event for a stablecoin and has a crisis in supporting digital currencies. Removing a stablecoin can have a very negative impact on the entire market and cause a severe recession.
In the past few days (late March 2023), the disconnection of USDC and DAI stablecoins due to the bankruptcy of several major US banks had an immediate impact on the digital currency market and caused the price of Bitcoin to drop below $20,000. With the intervention of the US Treasury and the Federal Reserve and their assurances, the price of these stablecoins returned to one dollar, but there are previous examples of stablecoins being removed, such as UST, which returned to its one dollar price and mostly disappeared.
Why does a stablecoin become depegged?
We have understood so far what digital currency depegging means, but an important question that has not yet been answered is why stablecoins do not require depegging. To answer this question, we can examine previous real-life examples of stablecoins and analyze the conditions that led to their depegging.
Use of impractical methods
One of the deepest depegging stablecoins in the digital currency market was the UST stablecoin in the Terra project. This stablecoin was designed and operated algorithmically based on burning and multiplying Luna and UST tokens. If the price of UST drops below $1, users can burn their $1 UST tokens to create Luna tokens and reduce the supply of UST to $1. If the price of UST rises above $1, users can burn their Luna tokens to multiply new UST tokens and increase the supply of UST to $1.
Although this idea seems very practical at first glance, it is not suitable for market downturns and the plummeting of Luna token prices. In such conditions, when UST stablecoin is depegged, users do not take the risk of buying UST and converting it to Luna because it is unclear whether this conversion will be in their favor or not, given the declining Luna prices. In practice, the same thing happened with the Terra project, and with the sharp drop in the Luna price, the ability to convert UST to Luna was lost, and the developed algorithm could not prevent the depegging of this stablecoin.
Insufficient financial support
Decentralized stablecoins need to deposit their collateral assets with reputable banks and financial institutions in order to be able to convert their stablecoins into real money or other physical assets such as gold.
Tether (USDT) is one of the most important and oldest stablecoins in the digital currency market, which was almost always accused of not having sufficient backing, and sometimes this problem led to its separation. However, this separation was quickly compensated and the price of Tether returned to one dollar.
Another issue in this section is the risks associated with various types of backings and their maintenance. Some of the USDC stablecoin supports at Silicon Valley Bank are held in the form of dollars and government bonds. Due to the reckless increase in interest rates in the United States, this bank went bankrupt and its activities stopped, while part of the USDC support in this bank was locked. This led to pressure to sell this token and convert it to other stablecoins, resulting in the disappearance of USDC stablecoin.
The decentralized stablecoin DAI was another stablecoin that was pegged to USDC at the same time as USDT. In the early years of the MakerDAO project, DAI tokens were only supported by major market coins such as Ethereum and Bitcoin, and their support was also maintained by copying user collateral. In recent years, the use of USDC as support for creating this stablecoin has also been accepted, which is why USDC stablecoin depegging indirectly led to DAI depegging. Both of these stablecoins returned to their one-dollar prices with the guarantee of US authorities regarding Circle’s access to their assets.
The dangers associated with government regulations
Many popular stablecoins in the market have centralized focus, allowing governments and legislative bodies to influence their activities. This effect sometimes manifests itself in the form of stablecoin pegging. BUSD stablecoin was launched in collaboration with the digital currency exchange Binance and Pexos. In early February 2023, the US Securities and Exchange Commission (SEC) announced its intention to sue Pexos for violating investor protection laws, claiming that BUSD is an unregistered security.
This caused BUSD to reduce the price of Binance Coin. Following this incident, Pexos decided to stop issuing BUSD stablecoin but allowed users to convert their BUSD to dollars or USDP stablecoin. Another example of the impact of this law on stablecoin prices is related to the lack of connection of HUSD, which as a result of changes in some regulations, caused several market maker accounts to be closed and resulted in the lack of connection to this stablecoin.
Depegging due to market exits
One of the factors that usually causes stablecoins to disappear in the short term is the exit of funds from the digital currency market, which increases the supply pressure of stablecoins. When the digital currency market is heading towards a downward trend and interest rates are close to zero, holding the relevant fiat or stablecoins does not benefit investors and they try to convert their stablecoins into real money and invest in traditional markets. This event leads to supply pressure and temporary depegging of stablecoins as there is enough support to create this transformation and only a matter of time will achieve it.
Which stablecoin is less likely to become pegged?
So far, there are many stablecoins in the digital currency market, among which stablecoins backed by fiat currencies, especially the US dollar, have been the most popular. These types of stablecoins can generally be categorized into three centralized, decentralized, and algorithmic categories. Centralized stablecoins are created by reputable companies and with the approval of regulators. Decentralized stablecoins are backed by digital currency collateral and algorithmic stablecoins are created without backing and based on mathematical algorithms.
Since support for centralized stablecoins is reviewed by legal entities and their activities are regulated by laws, it seems unlikely that this category of digital currencies can be separated, but there are two important questions in this regard. The first issue is the risks associated with financial institutions such as banks, whose bankruptcy can lead to the removal of stablecoins. Similar to USD stablecoins, risk management is necessary to prevent this from happening. The second problem is the involvement of centralized institutions in these companies, which makes the use of these stablecoins highly risky.
Decentralized stablecoins, which have a high collateral compared to established stablecoins and are supported by reputable digital market currencies such as Bitcoin and Ethereum, have a very low probability of losing their collateral due to liquidity price decline. This is because stablecoins always maintain their value. Using other centralized stablecoins to support decentralized stablecoins adds the risks of centralized stablecoins to decentralized stablecoins, similar to the MakerDAO project with USDC.
Finally, algorithmic stablecoins have a very high risk for depth reduction because there is no physical support for them and during sudden market events, these stablecoins can be devalued, like UST. It seems that the idea of an algorithmic stablecoin is not as mature as it should be and there is a need to examine its different aspects to prevent them from being separated.
In conclusion, stablecoins are one of the most practical categories of digital currencies, and separating them means a difference in their price with the underlying asset. In recent years, many stablecoins such as USDT, USDC, and DAI have experienced temporary depegging and have returned to their original value. In contrast, some stablecoins such as UST have generally lost their value and disappeared.