What is a Stablecoin?
A stablecoin is a type of cryptocurrency that retains a fixed value at all times. Stablecoins are pegged to a reserve asset such as fiat currency, commodities, or cryptocurrencies. There are also algorithmic stablecoins that maintain their value by balancing their demand and supply dynamics using smart contracts.
Stablecoins are popular on account of its utility as a store of value and liquidity. Crypto investors find it easier to convert their portfolio reserves to and from stablecoins in comparison to fiat currencies.
What is Stablecoin Depegging?
As mentioned above, stablecoins are usually backed by a reserve asset such as cryptocurrencies, cash equivalents, bonds, fiat currencies, commodities etc. In this manner, stablecoins are allowed to retain their fixed value.
In most cases, one unit of a stablecoins retains the value of 1 USD. Stablecoins are usually issued by private companies. However, stablecoin reserves are managed by private firm rather than automated as a blockchain network or decentralized protocol.
Therefore, there have been some cases where the backing reserves supporting stablecoins can lose their value or be affected by mismanagement. Such an event can lead to the loss of unit price of a stablecoin.
This is called stablecoin depegging. Stablecoin depegging means a scenario where a stablecoin loses its pegged value and drops to near zero or zero. There are many different reasons and causes that can lead to stablecoin depegging.
How to Check Stablecoin Stability?
Cryptocurrency investors usually use stablecoins to convert their crypto reserves from one coin to another. At the same time, stablecoins are used as token trading pairs listed on different cryptocurrency exchanges.
Therefore, it is important for investors to check for the following factors that can affect the depegging of a given stablecoin namely micro and macroeconomic factors. Stablecoin value is affected by micro-economic factors such as a sudden increase or decrease in the demand for the given digital currency.
Other factors in this section include influences such as liquidity constraints, and changes in the collateral reserves. At the same time, stablecoin value is also affected by macro-economic factors such as inflation and interest rates etc.
There are also some instances where, the fixed value of a stablecoin rises above its pegged value on account of added demand or reduced supply. In case of inflation, the fiat reserves backing stablecoin drop in value leading to depeg. In the same manner, possible changes in interest rates can also lead to same problem.
Another factor that can lead to issues with stablecoin peg is regulatory uncertainty. If a government agency bans a stablecoin it can lead to decline of its demand resulting in loss of value.
How does Stablecoin Depegging Work?
Stablecoin depegging is a complex and technical process. Some of the baseline stages of stablecoin de-pegging are mentioned as under:
The unit value or fixed price of a stablecoin starts to decline on account of various factors such as technical issues, absence of liquidity, and regulatory issues.
Traders and investors who have the depegging stablecoin in their portfolio start to exchange their reserves to avoid losses. Some opt to purchase while other sell the stablecoin depending on their invested interests and market exposure.
At the same time, arbitrage traders become active and start conducting high value trades with the given stablecoins in order to generate quick profits from the rapidly changing value.
Stablecoin issuers start to look for the root cause of depeg and work on rectifying the issue. At the same time, the stablecoin issuers also establish communication channels with investors to keep them updated regarding the latest development and remove FUD.
The Stablecoin peg was eventually restored after the preventive measures went into effect. At the same time, it is imperative that the confidence of retail and commercial investors is restored in the product to retain its value.
Stablecoin depegs can lead to risks such as increasing market volatility, drainage of liquidity, counterparty default, and loss of reputation. At the same time, such events pave the way for traditional financial regulators to introduce stricter policies on DeFi and stablecoin issuers.