Stablecoins are a type of cryptocurrency designed to have a stable value relative to a specific asset or a basket of assets, typically a fiat currency such as the U.S. dollar, euro or Japanese yen.

Stablecoins are designed to offer a “stable” store of value and medium of exchange compared with more traditional cryptocurrencies like Bitcoin (BTC) and Ether (ETH), which can be highly volatile.

Fiat money, cryptocurrencies, and commodities like gold and silver are examples of assets used to collateralize or “back” stablecoins. Tether (USDT), USD Coin (USDC) and Dai (DAI) are a few examples of stablecoins pegged to the U.S. dollar.

Stablecoins can also be algorithmically stabilized through smart contracts and other mechanisms that automatically adjust the supply of the stablecoin to maintain its peg to the underlying asset.

Despite the potential benefits, stablecoins are not without risks. The most significant risk with any stablecoin is the potential for its peg to break, causing it to lose its value relative to the underlying asset.

Depegging is where the value of a stablecoin deviates significantly from its pegged value. This can happen for various reasons, including market conditions, liquidity issues and regulatory changes.

USDC is a fully reserved-backed stablecoin, meaning every USD Coin is backed by actual cash and short-dated United States treasuries. Despite this, USDC issuers, Circle, announced on March 10 that USDC had depegged from the U.S. dollar, with around $3.3 billion of its $40 billion in USDC reserves stuck in the now defunct Silicon Valley Bank. The bank — the 16th-largest in the U.S. — collapsed on March 10, and is one of the biggest bank failures in U.S. history. Given USDC’s collateral influence, other stablecoins followed suit in depegging from the U.S. dollar.

Related: USDC depegs as Circle confirms $3.3B stuck with Silicon Valley Bank

MakerDAO — a protocol based on the Ethereum blockchain — issues DAI, an algorithmic stablecoin designed to preserve a precise 1:1 ratio with the U.S. dollar. However, DAI also fell off its peg amid the Silicon Valley Bank’s collapse, mainly due to a contagion effect from USDC’s depegging. Over 50% of the reserves backing DAI are held in USDC.

Tether issues USDT, with every USDT token equivalent to a corresponding fiat currency at a 1:1 ratio and fully backed by Tether’s reserves. However, USDT also experienced a depegging in 2018, which raises concerns about the overall stability mechanism of stablecoins.

Importance of stablecoin pegs

The importance of stablecoin pegs is in providing a stable and predictable value relative to an underlying asset or basket of assets — typically a fiat currency like the U.S. dollar. Stablecoins are a desirable alternative for various use cases, including cryptocurrency trading, payments and remittances, due to their stability and predictability.

With stablecoin pegs, traders may enter and exit positions without being subjected to the price fluctuations of cryptocurrencies like BTC or ETH. This is important for institutional investors and companies that depend on a reliable store of value and a medium of exchange to run their operations.

Cross-border transactions can also be made more accessible using stablecoin pegs, especially in nations with volatile currencies or restricted access to conventional financial services. Compared with more traditional methods like wire transfers or remittance services, stablecoins can offer a more effective and affordable way to make payments and transfer value across borders.

Stablecoin pegs can also increase financial inclusion, especially for people and enterprises without access to traditional financial services. Stablecoins can be used to make payments and transact in digital assets without requiring a bank account or credit card, which can be crucial in developing and emerging markets.

Why do stablecoins depeg?

Stablecoins can depeg due to a combination of micro and macroeconomic factors. Micro factors include shifts in market conditions, such as an abrupt increase or decrease in stablecoin demand, problems with liquidity and modifications to the underlying collateral. Macro variables involve changes in the overall economic landscape, such as inflation or interest rate increases.

For instance, a stablecoin’s price can momentarily exceed its pegged value if demand spikes due to increased cryptocurrency trading activity. Yet, the stablecoin’s price could drop below its fixed value if insufficient liquidity matches heightened demand.

On the macroeconomic front, if there is high inflation, the purchasing power of the underlying assets that support the stablecoin may drop, leading to a depeg event. Similarly, adjustments to interest rates or other macroeconomic measures may impact stablecoin demand.

Regulatory changes or legal issues can also cause a stablecoin to depeg. For example, if a government were to ban the use of stablecoins, demand for the stablecoin would drop, causing its value to fall. A depegging event can also be caused by technical problems like smart contract bugs, hacking attacks and network congestion. For instance, a smart contract flaw could result in the stablecoin’s value being computed improperly, causing a sizable departure from its peg.

How do stablecoins depeg?

Stablecoin depegging typically occurs in a few steps, which may vary depending on the specific stablecoin and the circumstances that lead to the depegging event. The following are some general features of a depegging event:

The stablecoin’s value deviates from its peg

As noted, many factors, such as market turbulence, technological problems, a lack of liquidity and regulatory problems, may result in a stablecoin depeg. The value of the stablecoin may change dramatically relative to the pegged asset or basket of assets.

Traders and investors react to the depegging event

Whether they think the stablecoin’s value will eventually return to its peg or continue to diverge from it, traders and investors may respond by purchasing or selling the stablecoin when it dramatically departs from its peg.

Arbitrage opportunities arise

Arbitrage opportunities could materialize if the stablecoin’s value drifts away from its peg. For instance, traders may sell the stablecoin and purchase the underlying asset to benefit if the stablecoin’s value is higher than its peg.

The stablecoin issuer takes action

The stablecoin issuer may take action to rectify the problem if the stablecoin’s value continues to stray from its peg. This may entail changing the stablecoin’s supply, the collateralization ratio and other actions to boost trust in the stablecoin.

The stablecoin’s value stabilizes

If traders and investors adjust their positions and the stablecoin issuer responds to the depegging event, the value of the stablecoin may stabilize. The stablecoin’s value might return to its peg if the stablecoin issuer successfully wins back public trust.

Risks and challenges associated with stablecoins depegging

Depegging stablecoins can present several risks and difficulties for investors, traders and the larger cryptocurrency ecosystem:

  • Market volatility: When stablecoins depeg, the market may experience severe turbulence as traders and investors alter holdings in response to the depegging event. This could lead to market uncertainty and raise the possibility of losses.
  • Reputation risk: Depegging stablecoins risks the issuers’ and the larger cryptocurrency ecosystem’s reputation. This may make it harder for stablecoin issuers to draw in new users and investors and decrease the market’s total value.
  • Liquidity risk: Liquidity issues may arise if a stablecoin depegs because traders and investors sell the stablecoin in significant quantities. As a result, the value of the stablecoin may decrease, making it challenging for traders and investors to liquidate their holdings.
  • Counterparty risk: Traders and investors may be exposed to the risk of default by the stablecoin issuer or other parties participating in the stablecoin’s operation due to the depeg event.
  • Regulatory risk: Stablecoins depegging can also bring about regulatory problems. Governments and authorities may impose restrictions on stablecoins if they believe that the assets threaten the stability of the broader financial system.

Related: Circle’s USDC instability causes domino effect on DAI, USDD stablecoins

Considering the above risks, investors and traders alike should keep a close eye on the performance of stablecoins in their portfolios. Research the stablecoin issuer and its collateralization, and be on the lookout for any indications of depegging or other problems that might impact the stablecoin’s value. They can also think about diversifying their holdings by using a variety of stablecoins or other assets. This can lessen the chance of suffering losses in a stablecoin depegging event.