What is a Cryptocurrency Depeg?
Cryptocurrencies are volatile and can often see sharp swings in price. Stablecoins were created as a hedge against this volatility. Stablecoins are cryptocurrencies designed to withstand volatility and serve as a store of value or means of exchange. To achieve this, they are collateralized by assets such as fiat currencies, gold, silver, or other valuable assets that experience minimal volatility.
Stablecoins and stable assets can also be pegged algorithmically via smart contracts and code. In this case, an on-chain algorithm maintains the pegged value of the stablecoin by managing volatility of the coin. The code adjusts the supply of the coin to match the value of the asset it is pegged to. Despite these stabilizing models, however, sometimes a stablecoin’s value can deviate from that of the asset it is pegged to, and this is known as a ‘depeg’.
A depeg occurs when the value of a stable asset strays exponentially from its pegged value. There are several reasons why this can happen, including liquidity problems, unfavorable market conditions, and regulatory crackdowns. It can be temporary and cause minimal losses, or it can be permanent and cause significant losses for investors.
Why do Stablecoins Depeg?
Stablecoins can depeg for a variety of reasons. The most frequent factor is market conditions. A sudden spike or drop in the demand for a stablecoin can cause it to depeg, especially if there is not enough liquidity to fill orders. Poor collateralization ratios can also lead to a depeg. Ideally, a stablecoin is supposed to be backed by a ratio of 1:1 to the underlying asset it is pegged to. For example, every supply of the USDC stablecoin issued is typically backed by its equivalent in USD or bonds. Stablecoins that are not adequately backed are more likely to depeg during adverse market conditions.
Other factors that can cause a stablecoin to depeg include regulatory crackdowns, a bug in the stablecoin’s code, and network congestion. The most recent example of depegging occurred in May 2023 with UST. The stablecoin on the LUNA blockchain was the third largest stablecoin by market capitalization at the time of its crash. The algorithmic stablecoin worked with its sister token, LUNA, to maintain a value pegged to 1 USD through a set of mint and burn mechanisms. However, the UST depegged due to market conditions and lost over 97% of its value.