Don’t peg your hopes on stablecoins! Here is all that you need to know to make sense of USDC’s depegging.
On March 10, 2023, shortly after the closure of Silicon Valley Bank (SVB), the stablecoin USDC lost its value of US$1 and fell to US$0.91 by the very next day. Unlike other cryptocurrencies, stablecoins are designed to maintain their value at a fixed value, usually pegged one-to-one with a fiat currency like the US Dollar. Typically, a third-party custodian maintains a store of the currency/crypto that it has been valued against to ensure that the token can be readily exchanged. Unfortunately, USDC’s issuer company Circle held US$3.3 billion of its US$40 billion reserves in SVB. With the bank’s closure, the funds have been temporarily locked away.
But it wasn’t just USDC that lost its value. Its depegging led to a domino effect, and other stablecoins, such as DAI, USDD and USDP also ended up falling to US$0.93, US$0.95, and US$0.96 respectively. To put the fall in the value of these coins into context, let’s first learn about what pegging and depegging mean.
What is pegging?
In the crypto world, pegging refers to the practice of anchoring a cryptocurrency’s value to another asset. There are two types of pegged stablecoins—fiat-collateralized stablecoins (backed by fiat currency) and crypto-collateralized stablecoins (backed by cryptocurrency tokens).
Then mechanism of pegging comes in two forms—hard peg and soft peg. Hard pegging is when the value of a token or a fiat currency can never change from that of what it has been anchored to. A good example of this is the Chinese Yuan (CNY) between 1994 and 2005. At the time, the value of CNY1 was maintained at US$8.28.
Whereas, when a stablecoin is soft-pegged, it means that there is room for minor variations in the value of the stablecoin. Soft-pegging has become commonplace in the modern cryptocurrency market. One notable example is the stablecoin DAI. DAI’s value is pegged at US$1. For instance, as of March 23, DAI has a value of US$0.99 and in the past three months, it has fallen to a value of as low as US$0.92.
It is also important to note here that since cryptocurrencies trade on the open market, it is impossible for them to have a completely hard or soft peg. The trading of crypto on the open market makes it impossible for the price pendulum to not swing up and down.
Common reasons for stablecoin depegging
Depegging is what happens when the peg breaks, and the stablecoin cannot maintain its value. It can happen for a multitude of reasons, which could lead to catastrophic consequences for investors. Some of these reasons are:
- a fall in the value of the underlying asset;
- the issuer of the stablecoin went bankrupt;
- changes in the market demand of the stablecoin (if the demand is high, the value would exceed the amount it has been pegged to and vice versa);
- regulatory changes like government bans;
- technical errors like smart contract bugs, hacks and network failures; and
- sudden market shocks (like the closure of SVB).
The aftermath of USDC depegging
In the wake of USDC’s depegging, crypto exchanges Binance and Coinbase halted the conversion of USDC to Binance USD (Binance’s native stablecoin) and USD respectively. On the other hand, those who held USDC were trying to cut their losses and sell USDC in exchange for other stablecoins such as Tether (USDT). Naturally, in doing so, they lost a lot of money.
One of the most alarming stories of people selling off their USDC was discovered by Twitter user BowTiedPickle. In a Twitter thread, they highlighted a transaction where a USDC holder paid over US$2 million (albeit by mistake) to receive US$0.05 of USDT.
Attempting to calm down the investors, USDC’s issuer Circle made a blog post saying that liquidity will remain unaffected despite the depegging. The company clarified that even if SVB is unable to return 100% of its deposits, Circle will replenish its reserves through corporate recourses and external capital.
What USDC’s depegging tells us about stablecoins?
USDC’s depegging highlights the fragility of stablecoins, which are too dependent on a small group of financial institutions. According to a report by the financial services company Moody Analytics, stablecoins could be in a tough spot after USDC’s depegging, as it showed how a single bank’s liquidation can severely impact a stablecoin’s value. Of course, the failure of crypto-friendly banks, Signature and Silvergate, recently also didn’t help the situation.
The recent “instability” (pun intended) we are seeing in the stablecoin market reinforces the pre-existing issues within stablecoins. In December 2021, the International Monetary Fund (IMF) expressed concern about stablecoins, calling for better standards of disclosure of stablecoins. Soon after, in May 2022, Terra’s stablecoin LUNA was hit by the crypto market crash which made it lose its peg to the US Dollar.
Luckily, as of March 21, USDC has recovered its value at US$0.99, which is fairly close to the value it had been pegged at. Experts believe that USDC will continue to head in this direction, given that Circle was in the process of transferring its reserves out of SVB even before the liquidation occurred. Although USDC is safe for now, all of this should be a lesson for the stablecoin market as a whole. It should encourage stablecoin issuers to improve transparency and reduce dependence on a small group of financial institutions to better manage risks associated with market volatility.
Also read:
- Why Is the IMF Concerned about Cryptocurrency?
- Is Terra Luna Dead? 3 Lessons for Other Cryptocurrencies
- The Benefits of Cryptocurrency without the Risk: Stablecoins
Header image courtesy of Envato
