Special Report Stablecoins: Why can they 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 which you can watch here.

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

Stablecoins are backed by real-economy assets such as fiat currencies (like the euro or the dollar) or commodities (like gold or silver). Any asset can serve as collateral and back stablecoins. Thus, most stablecoins used in the crypto industry are cryptocurrencies pegged to fiat currencies, particularly the US dollar. However, euro-backed stablecoins are gaining popularity, although they still represent a 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:

✅ Having a reliable store of value: Traders can take positions more easily without being subject to the fluctuations and volatility of cryptocurrency prices. This also gives them a benchmark for estimating an asset's price. Most importantly, it allows them to maintain a low store of value for managing and taking positions. For example, if a trader holds $1000 in stablecoins and decides to leave them in their account, they theoretically won't encounter any surprises if they don't check their balance. However, if they hold the same amount in another cryptocurrency like ETH, its value could rise or fall over time.

✅ Facilitating cross-border transactions : This is the biggest advantage of stablecoins when it comes to international payments. There's no need for intermediaries or waiting for banks to open to make a payment. Anyone can make transfers. Stablecoin payments are cheaper and faster . This drastically minimizes sending fees because money transfers are done on the blockchain, with the inherent blockchain fees. For example, many individuals and businesses make payments in stablecoins like USDT on the TRON network, which has very low fees (currently less than $1 per transfer).

✅ Enabling greater financial inclusion : Many businesses worldwide lack access to traditional financial services. They can then use stablecoins to make payments without even having a bank account. In emerging countries, stablecoins represent an accessible opportunity to participate in 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.

USDC is a stablecoin fully backed by US dollar reserves. This means the company holds the same amount of USDC in circulation as it does dollars in reserve. More specifically, the consortium that issues USDC—Circle and Coinbase—holds both physical cash and US Treasury bonds. Circle had over $ 3 billion of its assets in the now-bankrupt Silicon Valley Bank. After experiencing a depreciation of nearly 10%, USDC has finally re-pegged to the dollar.

The DAI stablecoin is what's known as an algorithmic stablecoin. It's issued by the MakerDAO protocol , which is based on the Ethereum blockchain. During the collapse of Silicon Valley Bank , DAI also suffered a loss in value. This is because over 50% of DAI's reserve collateral is USDC.

Tether is the company that issued the USDT stablecoin , which is the leading stablecoin in terms of market capitalization . However, USDT has experienced numerous upheavals and legal setbacks, specifically concerning the amount of actual reserves the company claims to hold. The company has several ongoing cases with the US justice system. (See: Here is the incredible saga of USDT (Tether) and here is why the story is frightening )

The specific case of the collapse of the UST

The collapse of the UST stablecoin now serves as the ultimate benchmark when discussing the potential collapse of stablecoins. However, even though UST has made history, we must clarify that its case is somewhat unique, as it was an 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 that explain the fall of the UST on May 9, 2022. However, we know that one of the biggest reasons comes from a lending protocol called Anchor which promised around 20% return to depositors. Obviously, this was the highest rate of return on a stablecoin that existed on the market. This excessive return attracted many investors, particularly companies looking 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 resulting arbitrage. Moreover, economic announcements (particularly in connection with the war in Ukraine) marked a fear among investors. This pushed many depositors to sell the UST token massively… No collateral to justify the offer, which led to a radical drop 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.

It's important to remember that stablecoins are assets subject to the laws of supply and demand . Therefore, on exchange platforms, if demand increases, the value of the stablecoin can rise. Conversely, its value can fall if liquidity is insufficient to meet 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 trigger a powerful wave of panic in the markets. For example, if the media becomes more alarmist, it can in turn trigger outright panic among traders and investors. Depending on the severity of the situation, this small depreciation can lead to a genuine sense of FUD (fear, uncertainty, doubt) spreading on social media, causing a surge in selling.

3/ The presence of arbitrage opportunities

If a stablecoin loses value, arbitrage opportunities may arise. Arbitrage involves buying a token and selling it at a higher price. This can be done on various platforms or by manipulating the value of other stablecoins on different trading pairs, for example. It's worth noting that traders can use trading bots to perform automated arbitrage, such as the Cryptohopper bot . Considerable sums of money can then be involved.

4/ The stablecoin issuer takes action

The recent collapse of Silicon Valley Bank led to a depreciation of USDC of over 10%. The issuing company, Circle, temporarily suspended USDC:USD conversions, and some exchanges halted withdrawals. These measures by issuing companies help regulate supply and influence demand while a solution is sought, as was the case with the rescue plan implemented 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 can jeopardize the reputation and investor trust of the issuing company. For example, the fall of UST definitively ruined the reputation of Terra Labs, the issuer of UST. Furthermore, Do Kwon , the founder of the Terra Blockchain, completely lost the trust and goodwill of the crypto community.

Even if entrepreneur Do Kwon wanted to launch a new project, it wouldn't be easy… Once trust is lost, it's difficult to regain. This is true in personal life, but also and especially in professional life.

⚠️ Risk of stricter 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've seen that some experiments in creating stablecoins using methods other than collateral have proven unsuccessful. Indeed, stablecoins aren't as stable as we'd like. It turns out that, in general, algorithmic stablecoins are the riskiest. We've also seen that the collapse of even the most popular stablecoin (see UST) can occur and trigger a devastating domino effect on the entire ecosystem (see the "Luna cryptocurrency debacle ").

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 issues attestations to substantiate its holdings. This is not the case for USDT, even though 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 stablecoin holdings and consider synthetic assets, which can be an attractive alternative. You can also choose to hold stablecoins pegged to the Euro or those backed by commodities, such as gold-backed cryptocurrencies.

Watch the video about stablecoins on YouTube:

Read other articles:

• The 5 best cryptocurrencies that are worth Gold (seriously)
• Algorithmic stablecoins are not as “stable” as they claim…
• What are the stablecoins backed by the euro? 
• USDT and USDC: What you need to know about the two largest stablecoins
• How the Silicon Valley Bank contagion is affecting the crypto industry