Why can some stablecoins collapse?

Let's ask the question straight away and bluntly: But why are some stablecoins not sandable? Not as stable, at least as we would like them to be. Why do some stable coins collapse before our incredulous eyes? What are the causes and mechanisms behind stablecoin de-anchors?

That's all we invite you to discover in this ultimate guide dedicated to stablecoins.

Understanding how stablecoins work is essential because they form pillars of the crypto economy. In the word “stablecoin”, there is the word “stable”. They are therefore supposed to represent cryptocurrencies that do not experience volatility and have a relatively fixed price.

Generally, stable coins are cryptocurrencies that are backed by fiat currencies. For example, USDT stablecoins represent one US dollar, in a 1:1 ratio.

However, we can see that this "stability" is not always effective. We have even seen some stablecoins lose their anchor to the asset on which they are backed as with the fall of the UST, although ranked 3rd during its collapse.

This caused a real earthquake in the cryptocurrency markets with a domino effect that we still feel today, almost a year later….

So let's see in this ultimate guide to stablecoins, everything you need to know to protect yourself as best as possible with cryptocurrencies that are often "stable" only in name...

🎥 There is also a video version of this article that you can watch here.

What are stable coins used for? Why do they exist?

Stable coins are backed by real economy assets such as fiat currencies (euro or dollars, for example) or raw materials (like gold or silver). All assets can serve as collateral and support stablecoins. Thus, most of the stablecoins used in the crypto industry are cryptocurrencies backed by fiat currencies and in particular the US dollar. However, euro stablecoins are gaining popularity, even if they still remain in the minority.

Over time, stablecoins have become real pillars of the crypto economy, and this can be explained by the numerous advantages they bring to individual investors and institutions.

What are the advantages of using stablecoins?

There are several advantages to using stable coins, the main ones of which are:

✅ Have a reliable store of value: Traders can take positions more easily without being subject to cryptocurrency price fluctuations and volatility. This also allows them to have a reference for estimating the price of an asset. Above all, this allows you to have a small reserve of value to be able to manage and take a position. So, if a trader has $1000 in stablecoin and decides to leave it in his account. Theoretically, he will not have any surprises if he does not check his balance. However, if he owns this same amount in another cryptocurrency like ETH, its value could increase or decrease over time.

✅ Facilitating cross-border transactions : This is the biggest advantage of stablecoins when considering international payments. There is no need for an intermediary or need to wait for banks to open to make a payment. Everyone can make transfers too. Stablecoin payments are cheaper and faster. This radically minimizes sending costs because remittances are sent on the blockchain with the inherent costs of blockchains. For example, many individuals and businesses make payments in stablecoins like USDT on the TRON network which has very low fees (around less than $1 to make a transfer, currently).

✅ Enabling greater financial inclusion : Many businesses around the world do not have access to traditional financial services. They can then use stable coins to make payments without even having a bank account. In emerging countries, stablecoins represent an accessible opportunity to enter international trade.

The top 10 stablecoins today

As you can see on Coinmarketcap, the top 10 stable coins in terms of market capitalization essentially represent stable coins backed by the US dollar. In first place we find USDT, USDC, BUSD as well as DAI.

👉 TheUSDC is a stablecoin backed entirely by US dollar reserves. This means that the company has the same amount of USDC in circulation as dollars in reserve. More specifically, the consortium that issues USDC, namely Circle and Coinbase, own real cash as well as US Treasury bonds. The Circle company had more than 3 billion dollars of his assets in the now bankrupt Silicon Valley Bank. After experiencing a depeg of almost 10%, USDC finally regained its peg to the dollar.

👉 The DAI stablecoin is what we call an algorithmic stablecoin. It is issued by the protocol MakerDAO based on the Ethereum blockchain. During the fall of Silicon Valley Bank, the DAI also suffered a loss of value. This is explained by the fact that the reserve collateral for DAI is made up of more than 50% in USDC.

👉 Tether is the stablecoin issuing company USDT which is the first stablecoin in terms of market capitalization. However, USDT has experienced numerous upheavals and legal setbacks concerning precisely the amount of real reserves that the company claims to have. The company has several ongoing cases with the American justice system. (See Here is the incredible saga of USDT (Tether) and here is why the story is scary)

the top 10 stable coins — Source: https://coinmarketcap.com

The specific case of the collapse of the UST

The collapse of the UST stablecoin serves as the ultimate reference point when discussing the likely collapse of stablecoins. However, even though UST has made history, we must clarify that its case is somewhat “apart” in that it was a algorithmic stablecoin subject to very specific market conditions.

The masterful fall of the UST remains a special case and should not serve as a generalization for other stablecoins.

UST was the algorithmic stablecoin of the Terra blockchain. This blockchain had developed two complementary native cryptocurrencies: Luna and TerraUST (which was therefore the stablecoin). We are talking about relatively complex algorithmic stablecoins implying that for each UST that was created, a 1 dollar of LUNA was destroyed. The arbitrage mechanism ensured that if the price of UST decreased, then it was possible to exchange 1 UST for 1 dollar of LUNA, thereby reducing the total supply.

It is a mechanism that works "well" as long as the market is rising and there is no speculative attack.

Before the crash of the Terra blockchain as a whole occurred, you should know that LUNA was among the 10 largest cryptocurrencies in terms of market capitalization. It was one of the most promising and popular cryptocurrencies (especially in Asia). A project that had everything to succeed (with partnerships, protocol development, developers, etc.) and which imploded itself.

👋 There are several intertwined reasons why UST fell on May 9, 2022. However, one of the biggest reasons is known to come from a lending protocol called Anchor that promised around 20% returns to depositors. Obviously, this was the highest rate of return on a stablecoin that existed on the market. This excessive return has attracted many investors and in particular companies on the lookout for profit. More than 50% of the UST in circulation was on the Anchor protocol... The yields collected were then disproportionate and some wanted to take advantage of the arbitrage caused. Even more, the economic announcements (particularly in connection with the war in Ukraine) marked investors' fear. This pushed many depositors to sell the UST token on a massive scale...No collateral to justify the offer, which led to a radical fall in the price of the stablecoin.

The token then fell to no longer be worth anything at all, in the space of a few days, bringing with it the fall of an ecosystem valued at more than 20 billion dollars...

It is since that fateful day that we know that stablecoins can be risky and are not as "stable" as we might think.

To find out more, you can consult the article which summarizes the fall of Terra Blockchain: https://www.richmondfed.org/publications/research/economic_brief/2022/eb_22-24

How stablecoins can lose their values?

When a stablecoin loses its peg, it typically happens in a few steps that will vary depending on the stablecoin and the circumstances of the situation.

If for a long time we thought that stablecoins were risk-free, today we know that they have a risk of losing their anchor. This happens when the value of the stablecoin deviates significantly and dangerously from the reference value.

Several reasons can explain this disanchoring for various reasons, and often a combination of micro and macroeconomic factors. A collapse of a stablecoin can be explained by economic conditions (inflation, rise in interest rates), liquidity problems, a sudden decrease or increase in demand (or supply), technical problems or by regulatory changes for example.

We must not forget that stablecoins are assets that are subject to law of supply and demand. Thus, on exchange platforms, if demand increases, then the stablecoin can see its value increased. Conversely, its value can fall if liquidity is not sufficient relative to demand.

When it comes to macroeconomic reasons, the inflation rate can influence the underlying asset that backs the stablecoin.

Regulatory changes can also have an impact on the price of a stablecoin. If a government decides to ban their use, this could lead to a massive sale among investors, for example, and lead to a drop in its value.

A stablecoin is technically a token hosted on a blockchain. It is then subject to various hacking attacks, network congestion or smart contract bugs. For example, a flaw can lead to an incorrect calculation of the value of the stablecoin and jeopardize its anchoring and its so-called stable value.

How does the collapse of a stablecoin take place?

Here are the steps that we have observed very often during a depeg of a stablecoin. This is a general scenario in which you can find a certain pattern during stablecoin collapses.

1/ The value of the stablecoin is experiencing a decline in its value

Market turbulence, liquidity problems or even problems can affect the price of the stablecoin. We can then observe a slight depreciation of the stablecoin.

2/ Traders and investors react and anticipate

Even a small depreciation can cause a powerful wave of panic in the markets. It is enough for the media to be more alarmist, for example, to in turn lead to outright panic among traders and investors. Depending on the severity of the situation, this small depreciation can lead to a real feeling of FUD (fear, uncertainty, doubt) spreads on social networks so that sales are greater.

3/ The presence of arbitrage opportunities

If the stablecoin loses value, then arbitrage opportunities may arise. The arbitration method consists of buying a token and reselling it at a significant price. This can be done on different platforms or by playing with the value of other stablecoins on other trading pairs, for example. You should know that traders can use trading bots to carry out automatic arbitrage as with the bot Cryptohopp is. Considerable sums can then be incurred.

4/ The stablecoin issuer takes action

Recently with the bankruptcy of Silicon Valley Bank, we could observe a depreciation of theUSDC by more than 10%. The issuing company Circle then temporarily suspended USDC:USD conversions as well as some exchange platforms stopped the withdrawals. The measures of the issuing companies then make it possible to regulate supply and influence demand, until a solution is found as was done with the safety plan decided for Silicon Valley Bank.

Companies may decide to increase collateral or consider other actions. The goal is always the same: to restore confidence in the stablecoin as much as possible. The faster the company reacts and chooses the right decisions, the more likely the sandcoin is to stabilize.

5/ The value of the stablecoin stabilizes or collapses…

From there, in general, the outcome is double-edged. Either the stablecoin collapses or it stabilizes. Everything then depends on the level of confidence in the stablecoin by investors. The more confident they are about the future of the company, the more they will want to maintain their position and not sell their assets.

What are the challenges associated with the depreciation of stablecoins?

The depreciation of a stablecoin can have serious repercussions on the entire ecosystem in which it is used. As we have unfortunately seen with the collapse of the UST, this has had enormous repercussions on multiple protocols and societies. The domino effect is the major risk that risks spreading to other cryptocurrencies…

Thus, the fall of a stablecoin is a major event that does not act as an isolated case. This can have dramatic repercussions for all of decentralized finance.

The repercussions can be observed at several scales within the industry:

⚠️ Extreme market volatility:

When tokens collapse, the market inevitably experiences turbulence. Traders are indeed looking to sell to limit losses. This creates panic on the markets with decisions sometimes taken hastily. Then, generally, investors record losses, even greater if they were unable to sell their assets in time.

Worse still, liquidity may be lacking to the extent that it may be difficult for investors and traders to liquidate their assets as the sale has been carried out in large quantities. They can very quickly find themselves with a bag of worthless tokens, without being able to sell them due to lack of demand.

⚠️ Loss of trust and damage to the company's reputation:

The collapse of a stablecoin may jeopardize the reputation and trust investors have in the issuing company. For example, the fall of the UST permanently ruined the reputation of TerraLabs, which issued the UST. Moreover, do kwon, the founder of Terra Blockchain has completely lost the trust and sympathy of the crypto community.

Even if the entrepreneur do kwon wanted to launch a new project, it would not be easy…Once trust is lost, it is difficult to regain it. This is true in private life but also and especially in professional life.

⚠️ Risk of tougher regulations:

As stablecoins are pillars of the crypto industry, this may have legal consequences. Governments may decide to impose regulatory restrictions or establish frameworks limiting the practice of certain companies. The authorities may consider that these assets threaten the stability of the financial system and decide to ban them. This may be an outcome, not beneficial for industry players….

Final word on the theoretical stability of stablecoins

As we have just seen, stablecoins are essential parts of the cryptocurrency industry. They prove useful in several respects and have allowed the ecosystem to expand and become ever more accessible to the general public.

On the other hand, we have seen that some experiments in creating stablecoins other than working on collateral have proven unsuccessful. Yes, stablecoins are not as stable than what we would like. It turns out that in general, algorithmic stablecoins are the riskiest. We have also seen that the collapse of a stablecoin, however popular it may be (cf UST), can occur and cause a devastating domino effect on the entire ecosystem. (Cf « the slaughter of the Luna cryptocurrency").

It is not easy to choose the best stablecoin. The largest stablecoins can unravel as we saw with the case of USDC during the Silicon Valley Bank affair. However, USDC showed its resilience and was able to regain its footing as quickly as it had lost it.

It can be reassuring to know that Circle regularly produces certificates to justify its assets. This is not the caseUSDT although it remains the most widely used stablecoin.

So, finally, we can only advise you to stay on your guard and keep your stablecoins on hand in case you need to get rid of them quickly…

You can also diversify your holdings in stablecoins and prefer synthetic assets which can be an interesting alternative. You can also choose to have stablecoins backed by the Euro or those backed by raw materials for example, such as gold-backed cryptocurrencies.

View video about stablecoins on Youtube: