Depegging: Why Stablecoins Fail
Explains why stablecoins depeg - liquidity, weak reserves, algorithm flaws, and regulation - plus examples and ways to reduce risk.
Stablecoins are designed to maintain a fixed value, often $1.00, but they sometimes fail, a process called depegging. This happens when their market price deviates from the intended value, leading to financial losses, market disruptions, and loss of trust. Here’s a quick breakdown:
- What is Depegging? It occurs when a stablecoin’s value strays from its target (e.g., trading at $0.95 instead of $1.00).
- Why It Matters: Stablecoins are crucial for crypto transactions, processing $2.6 trillion in the first half of 2024 alone. They serve as a safe haven during volatility.
- Causes of Depegging:
- Liquidity issues and market volatility
- Insufficient collateral reserves
- Flawed algorithmic designs
- Regulatory or technical risks
- Examples: TerraUSD’s collapse in 2022 wiped out $60 billion, while USDC briefly dropped to $0.88 in March 2023 due to reserve concerns.
- How to Protect Yourself: Diversify holdings, monitor peg stability in real time, choose regulated stablecoins, and prioritize those with transparent reserves.
Depegging is a real risk that can lead to sudden losses. Understanding its causes and taking preventive steps can help you navigate the stablecoin market more safely.
What Causes Stablecoin Depegging
4 Main Causes of Stablecoin Depegging Explained
Stablecoins are designed to maintain a steady value, often pegged to $1.00. However, various factors can disrupt this balance, causing a stablecoin to lose its peg. Understanding these factors sheds light on why even well-constructed stablecoins can falter during periods of stress.
Liquidity Problems and Market Volatility
Stablecoins rely heavily on liquidity and active trading to maintain their value. When liquidity is thin or trading volumes drop, stablecoin prices can drift from their target. Arbitrageurs - traders who buy undervalued coins and redeem them for $1.00 - play a key role in stabilizing prices. But if redemption mechanisms slow down or stall, maintaining the peg becomes challenging.
For example, in June 2023, Tether (USDT) temporarily depegged to $0.977 due to a liquidity imbalance in Curve's 3pool, a major decentralized liquidity pool. The pool's composition became skewed, with USDT making up over 70% of the pool after significant trader swaps. Because Tether requires a minimum redemption of $100,000, smaller holders had no choice but to use these secondary markets, which were already strained, prolonging the depeg.
Market volatility makes these problems worse. During the March 2023 financial crisis, trading volumes on decentralized exchanges surged to over $20 billion on March 11 - far above the usual daily range of $1 billion to $3 billion. When centralized exchanges paused conversions, users turned to decentralized platforms. If these liquidity pools were shallow, the influx of sell orders caused significant price slippage, amplifying depegging risks tied to both liquidity and collateral issues.
Insufficient Collateral Backing
The strength of a stablecoin's reserves is critical to maintaining its peg. Stablecoins promise to hold $1.00 in value, but this depends on the quality and accessibility of their reserves. Fiat-backed stablecoins rely on cash and Treasury bills, while crypto-backed stablecoins use other digital assets as collateral. Problems arise when these reserves are mismanaged, impaired, or inaccessible.
A notable example occurred in March 2023, when USDC depegged following reserve challenges linked to disruptions at Silicon Valley Bank. This event also affected DAI, a prominent stablecoin relying partly on USDC as collateral.
Crypto-backed stablecoins are not immune, either. In October 2023, USDR (Real USD) depegged after $10 million in redemption requests overwhelmed its treasury. The liquid DAI reserves were quickly depleted, leaving only illiquid tokenized real estate as collateral. This lack of liquidity made it impossible for the issuer to meet redemptions promptly.
Flawed Algorithmic Designs
Algorithmic stablecoins take a different approach, relying on code and market incentives instead of tangible reserves. However, these designs are particularly vulnerable because they often use "circular backing", where the stablecoin's value depends on demand for its own collateral.
While algorithmic models offer new mechanisms, they are prone to failure under stress. A loss of confidence in the system can trigger a "death spiral", where the value of the collateral collapses, making it impossible to maintain the peg. Russell Wong, Senior Economist at the Federal Reserve Bank of Richmond, explains:
"When the confidence of this circular backing is shaken, the liquidity of algorithmic stablecoin becomes flighty. In this case, the algorithm does not fully function because Terra needs to (but can't always) defend both UST and LUNA."
A striking example is the collapse of TerraUSD, where fragile design led to rapid failure. More recently, in April 2025, Synthetix's sUSD stablecoin depegged to $0.66. The issue stemmed from a protocol update (SIP-420) that shifted to a shared debt pool and reduced the collateralization ratio from 750% to 200%. This change removed the incentive for stakers to buy cheap sUSD to repay debts, leading to the depeg.
Regulatory and Technical Risks
Regulatory actions and technical vulnerabilities also play a role in stablecoin depegging. Regulatory crackdowns can undermine trust, prompting users to redeem en masse. If the system cannot handle these redemptions smoothly, the peg can break. For instance, investigations or sanctions against a stablecoin issuer often lead to panic exits, overwhelming redemption mechanisms.
Technical issues further complicate matters. Smart contract bugs can drain reserves or disrupt pricing mechanisms. Oracle errors - when data feeds provide inaccurate information - can cause automated systems to malfunction. Additionally, network vulnerabilities, such as governance attacks on Proof of Stake systems, can destabilize a stablecoin entirely.
These risks often interact. A regulatory announcement might spark technical issues, which in turn create liquidity problems. This cascade effect can push a stablecoin even further from its intended peg.
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Major Depegging Events in History
Looking at past depegging events, like the collapse of TerraUSD and temporary fluctuations in USDT and USDC, we see how design flaws, inadequate reserves, and market panic can lead to failures. These incidents reveal the vulnerabilities baked into stablecoin mechanisms.
TerraUSD (UST) Collapse
The collapse of TerraUSD in May 2022 stands out as one of the most striking stablecoin failures. UST relied on a "mint-and-burn" mechanism tied to its sister token, LUNA. This system allowed users to exchange 1 UST for $1 worth of LUNA, creating a circular dependency where each token's value depended on the other. When confidence in the system wavered, everything unraveled.
On May 7, 2022, Terraform Labs pulled $250 million from Curve pools, reducing liquidity and triggering heavy trading activity. This led to a loss of UST's peg as trades worth nearly $200 million compounded the problem, sparking widespread market panic.
In the aftermath, LUNA's supply ballooned from 342 million to a staggering 6.5 trillion within days. This hyperinflation destroyed LUNA's value, making it impossible to maintain UST's peg. Even a desperate $3.5 billion deployment of bitcoin reserves failed to stabilize UST. The fallout erased an estimated $60 billion in market value and contributed to a $300 billion decline across the broader crypto market. US Treasury Secretary Janet Yellen later pointed to UST as a warning sign of "rapidly growing risks" in the stablecoin market. The collapse also triggered a ripple effect - Tether processed over $13 billion in redemptions within just one week as panic spread.
While TerraUSD's failure was catastrophic, other stablecoins have faced temporary depegging events without collapsing entirely.
USDT and USDC Price Fluctuations
Unlike UST, major fiat-backed stablecoins like USDT and USDC have encountered short-lived depegging events that were eventually resolved. For instance, in March 2023, USDC dropped over 12% in a day, hitting approximately $0.88. This happened after Circle revealed that $3.3 billion of its $40 billion reserve was held at the failed Silicon Valley Bank. The peg was restored within days, thanks to the Federal Reserve, Treasury, and FDIC's announcement of the Systematic Risk Exception. Following this scare, Circle shifted most of its reserves to the Bank of New York Mellon to reduce counterparty risk in the future.
Tether (USDT) has also faced its own challenges. In October 2018, a liquidity crisis emerged when its primary banking partner, Noble Bank, encountered issues, and funds were frozen at its payment processor, Crypto Capital Corp. This sparked a bank run, causing USDT to temporarily trade below $1. To meet withdrawal demands, Bitfinex reportedly transferred $625 million of its corporate funds to Tether. Stuart Hoegner, General Counsel at Bitfinex/Tether, stated in an affidavit:
"As of the date I am signing this affidavit, Tether has cash and cash equivalents (short term securities) on hand totaling approximately $2.1 billion, representing approximately 74 percent of the current outstanding tethers".
These examples underline a key distinction: fiat-backed stablecoins can recover from short-term liquidity challenges, while algorithmic stablecoins often face complete collapse once trust is lost.
How to Reduce Depegging Risks
Reducing the risk of stablecoin depegging requires a mix of smart strategies like diversification, real-time monitoring, and choosing reliable providers. These steps can help protect your assets during volatile market conditions.
Diversify Holdings and Use Trusted Platforms
Spreading your stablecoin investments across different types can lower your risk. History has shown that no stablecoin is completely immune to depegging events. For example, combining fiat-backed coins like USDC or USDT with overcollateralized options like DAI can provide a more balanced approach.
It’s also important to research the track record of stablecoin issuers. How often has the coin depegged? How quickly did it recover? For instance, when USDC lost its peg in March 2023, regulatory actions helped it bounce back in just three days. In contrast, algorithmic coins like UST collapsed without recovery.
When purchasing stablecoins, stick to regulated platforms that emphasize security and transparency. For example, Kryptonim - a platform regulated in the EU - offers fast fiat-to-crypto transactions without requiring an account. Transparent pricing and secure operations can help reduce counterparty and liquidity risks, both of which can contribute to depegging.
Monitor Peg Stability in Real-Time
Stablecoins naturally fluctuate slightly, but price deviations larger than 3% can lead to panic and market stress. Keeping an eye on stablecoin prices across both decentralized (DEX) and centralized (CEX) exchanges is crucial. During the March 2023 banking crisis, nearly 2 billion USDC tokens were removed from secondary markets in a single day as users rushed to exit.
Setting up alerts for when a stablecoin trades significantly below $1.00 can give you a heads-up to assess the situation. Is it a short-term liquidity issue, or something more serious? Remember, retail traders often rely on secondary exchanges, where price swings can be more pronounced compared to the primary markets used by institutions for minting and burning tokens. Timely notifications can help you act quickly to manage your risks.
Overcollateralization and Redemption Systems
Overcollateralized stablecoins, like those supported by Maker Vaults with a 150% collateral requirement, provide an extra safety net. Even if the price of ETH drops, there’s enough collateral to back each DAI token.
Redemption systems also play a vital role in maintaining the peg. When a stablecoin dips below $1, arbitrage traders can buy it at a discount and redeem it for $1 worth of collateral. This reduces the coin’s supply, pushing its price back up. However, some systems have limitations. For example, Tether requires a minimum redemption of $100,000, which forces smaller holders to rely on secondary market liquidity.
To ensure stability, make sure the stablecoin’s backing assets are liquid and high-quality, like cash or major cryptocurrencies. Illiquid assets can lead to problems during mass redemptions. Also, look for issuers that provide regular, independent audits or real-time on-chain proofs of reserves. These measures confirm that the collateral is actually there, which directly supports peg stability.
Choose Regulated Stablecoin Providers
Regulated stablecoin issuers are required to follow strict guidelines, including regular audits and transparent reporting, which can reduce the risk of bank runs. For instance, PayPal’s PYUSD, launched in August 2023, is issued through Paxos Trust Co., a provider regulated by the New York State Department of Financial Services (NYDFS). PYUSD is backed by U.S. dollar deposits and short-term Treasurys, ensuring it can be redeemed for U.S. dollars.
When evaluating providers, look for those licensed by reputable authorities or adhering to frameworks like the EU’s Markets in Crypto-Assets (MiCA) regulation. These regulations require stablecoins to be backed by high-quality, liquid assets that match the circulating supply. A good example is Circle’s USDC, which temporarily depegged in March 2023 due to $3.3 billion of its reserves being held at the failed Silicon Valley Bank. Thanks to the FDIC’s systemic risk exception, Circle was able to resume 1:1 redemptions and restore the peg.
"Regulatory ambiguity remains a significant hurdle to investor confidence, and by extension, to the wider adoption of stablecoins." - Moody's Ratings
Before investing, review the issuer’s redemption policies. Who can redeem coins directly? Are there minimum thresholds that might force you to rely on secondary market liquidity during a crisis?. It’s also wise to choose stablecoins that are widely accepted across regulated platforms and offer high liquidity. These factors help maintain stability during market stress and contribute to the overall resilience of the system.
Conclusion
Stablecoin depegging is a genuine risk that can result in immediate financial losses, forced liquidations, and disruptions across the market. To safeguard your assets, it's crucial to understand the root causes - whether they stem from liquidity challenges or flawed system designs.
The events of recent years drive home the importance of stronger oversight in the stablecoin space. For instance, the collapse of TerraUSD (UST) in May 2022 wiped out an estimated $60 billion in market value, while USDC briefly dropped to $0.88 in March 2023 following the failure of Silicon Valley Bank. These examples highlight why strategies like diversification, real-time monitoring, and choosing stablecoins with transparent reserves and reliable redemption mechanisms are critical for managing risk effectively.
Reliability in the stablecoin market also hinges on transparency and regulation. Issuers that offer regular, independent audits of their reserves and operate under established financial authorities provide users with a safer environment. Platforms such as Kryptonim - a regulated service in the EU focused on security and clear pricing - can help mitigate counterparty risks during periods of market volatility.
Whether you're a trader, investor, or business utilizing stablecoins for payments, adopting practices like diversification, verifying issuer credibility, and keeping a close eye on peg stability can make all the difference. With the stablecoin market processing over $2.6 trillion in value during the first half of 2024, understanding these risks and implementing smart strategies is essential for navigating this rapidly evolving space with confidence.
FAQs
What are the warning signs that a stablecoin might lose its $1 peg?
A stablecoin teetering on the edge of losing its $1 peg often comes with telltale warning signs. One of the biggest indicators is price drifting away from $1 - even minor but consistent deviations can hint at trouble. Another red flag is low liquidity, which makes trading the stablecoin tricky without triggering noticeable price swings. Keep an eye on the reserves backing the stablecoin; unclear or insufficient reserves may mean it doesn’t have the assets needed to maintain its value.
Issues can also arise with restricted redemption options, like delays or limits on converting the stablecoin back to fiat currency, which might suggest deeper problems. And during times of market volatility or regulatory uncertainty, the risk of depegging tends to climb. Always stay alert to these signs to gauge the stability of a stablecoin.
How can you tell if a stablecoin doesn’t have enough reserves?
There are some clear warning signs that a stablecoin might not have enough reserves to keep its $1 peg intact. These include:
- Persistent trading below $1 or showing heightened price swings.
- Liquidity problems, like delays or failures when users try to redeem their stablecoins.
- Limited transparency or vague information about the assets backing the stablecoin.
Spotting these red flags could mean the stablecoin's reserves are insufficient, potentially putting users at risk.
How do regulations affect the stability of stablecoins?
Regulations are crucial for maintaining the stability of stablecoins. They set the ground rules for issuers and prioritize consumer protection. For example, clear policies around licensing, reserve asset management, and redemption rights help establish trust. These measures reduce the likelihood of a stablecoin losing its peg to its underlying currency.
That said, sudden shifts in regulatory policies - like stricter reserve requirements or restrictions on certain types of collateral - can create uncertainty. This uncertainty may lead to a wave of redemptions and could even result in a stablecoin depegging. On the flip side, regulations that are well-designed and transparent give users confidence in the stability and liquidity of their stablecoins.
For those in the U.S., buying stablecoins through compliant platforms like Kryptonim adds an extra layer of security. These platforms adhere to strong consumer protection and reserve standards, providing users with greater assurance in a constantly shifting regulatory environment.