Depegging

Published on :

21 Aug, 2024

Blog Author :

Edited by :

Reviewed by :

Depegging Meaning

Depegging in crypto refers to the phenomenon where the stablecoin's value fails to maintain its worth in connection to the underlying asset. The crypto event happens when developers do not keep enough reserves of the underlying asset, which affects the value of the pegged token.

There can be various reasons that may cause depegging to occur within the stablecoin. However, its significant impact distorts the crypto token's price stability, efficiency, and volatility. It also compromises the transparency and integrity of the users. Likewise, a similar effect is visible in the foreign exchange market. Therefore, this strategy can reduce inflation.

Depegging Meaning

Depegging refers to a point where the stablecoin fails to maintain its value with that of the underlying asset. Several factors cause this event to occur.
It leads to price instability, inefficiency, and volatility in the price of the pegged token.
Some factors include insufficient reserves, market manipulation, issues in coin mechanism, trust issues, and similar issues.
This situation creates havoc among the investors, which results in lower trade volume. However, the process of minting and burning minimizes the effect.

How Does Depegging Work?

Depegging of currency occurs when the value of the stablecoin or pegged token cannot match the value of reserves in the system. As a result, the prices of the former fall below the sustained level. It creates panic or havoc among crypto users and traders. Due to this, the pegged token loses the trust and utility of the stablecoins. However, if the situation remains the same, with time, even the regulated exchanges remove the stablecoin from their platform.

There are various ways to correct the depegging in the crypto market. However, it initiates with detecting and identifying the root cause itself. As a new developer announces the creation of a pegged token, an underlying asset is decided in advance. Based on this asset, the stablecoin will eventually survive in the market. This asset can be fiat currency like dollars, gold, or cryptocurrency. So, developers must maintain a certain number of reserves of the underlying asset to operate pegged tokens.

For instance, the reserves of $3000 will result in an equal number of stablecoins (that is 3000). But, if the team fails to maintain this reserve, the stablecoin's value will deteriorate. As a result, the demand and supply of these coins will also be impacted.

Within this transition period, if there is early detection, the chances of depegging of currency are still less. However, the coin developers must take appropriate steps to minimize this effect. They can burn or deposit more funds as reserves to balance the market fluctuations. Thus, countries peg their currency for various reasons, such as stabilizing trade, controlling inflation, or maintaining economic stability.

Reasons

Various factors and reasons cause the occurrence of the depegging in the crypto market. Let us look at them:

Insufficient Deposits: One of the prime reasons for the depegging is the insufficient funds within the reserves. Since the stablecoin's value depends on the underlying asset, the latter must be compatible enough to hold the former. If it fails to do so, the value of the pegged currency will fall compared to the reserves held. In addition, it may also lead to loss of tokens, fraudulent activity, malicious actors, and mismanagement of the existing supply.
Market Manipulation: The presence of stablecoins holds a certain amount of vulnerability with it. If there are any manipulative activities within the market, it can disrupt the token's price. Since it is a deliberate act by crypto whales, the chances of depegging rise, which creates a fake price movement.
Lack of Data Integrity: Another reason for a drop in the value of pegged tokens is the trust issues. Due to mismanagement of the coin or fraud, consumers lose trust in the token. As a result, the trading volume decreases, and its value reduces compared to other tokens.
Issues in The Coin Mechanism: Besides the market events, various factors like token architecture and the mechanism cause depegging. In short, if the coin's design is inappropriate, it will eventually lead to issues during the trading sessions. As a result, traders may resist investing in it. Thus, the value of the coin may drop to an extreme low.
Regulatory Changes: Even regulatory concerns impact the stablecoin's worth. If the coin is constantly under supervision by regulatory bodies, it negatively affects the investors. As a result, the impact will be visible in the crypto market.

Examples

Let us look at a few examples to understand the concept better.

Example #1

Suppose HITZ is a pegged token with a value equal to the USD (the United States dollars). Within three years, the coin was properly managed per the compliances suggested. However, in the later stages of development, a malicious hacker attacked the blockchain and stole over 1,500 private keys from the network. As a result, the value of the HITZ dropped by 15%, which caused a huge panic selling among the crypto community. Likewise, it resulted in depegging in the next few weeks.

When the founders and developers noticed this fall, they framed an objective to regain the HITZ's value. They resolved the security issues and created a new, updated token version per the plan. Hence, the stablecoin's price started improvising, and it entered the green zone. As a result, the trust among the investors was stabilized without liquidation issues.

Example #2

According to the recent crypto news article, as of March 2023, the stablecoin USDC witnessed a depegging in its value. The main reason was the decline of Silicon Valley Bank (SVB), where $3.3 billion was stored as reserves. In addition, the Circle also burned (or removed) 3.9 billion USDC from the circulating supply. However, the coins burnt were more than minting itself. As a result, the price of USDC fled the investors.

The daily trade volume reached an all-time high of $600 million during March 16, 2023, according to a report from the cryptocurrency analytics firm Kaiko. The trading pairs between the USDC and the US dollar on centralized exchanges (CEX), which provide real-time exchange rates into the dollar.

Significance

While depegging lowers the stablecoin's value, it benefits crypto investors in a big way. It reduces the dependence on a single stablecoin, which shifts the crowd towards other coins. As a result, it provides enough exposure to investors on different cryptocurrencies. Moreover, it also allows for reviewing the protocols for managing and securing the coins. Thus, if any coin's value decreases, it warns the community about the possible malicious elements. Thus, the developers can work on it and resolve the issue before the need arises.

Likewise, the depegging of cryptocurrency also indicates insufficient reserves in the vault. If it creates a shortage, the market might face a fall in the value and vice versa. As a result, the existing supply may be disrupted. Therefore, depegging is essential as it is an indicator for crypto users.

Frequently Asked Questions (FAQs)

1. How to prevent depegging in sudden situations?

Although mismatch reserves and outperformed algorithms cause depegging, certain ways exist to prevent them. Coin developers can fund their reserves and adhere to the compliances. However, the arbitrage mechanism can eventually bring back the peg. As the value falls, the arbitrageurs can purchase it at a lower price, exchange it for $1, and restore the original value. As a result, the traders can also earn profits out of it.

2. What is the difference between pegging and depegging?

Attaching a coin's value to another currency, asset, or commodity is pegging. However, depegging detaches the value from the coin temporarily. However, it is possible to restore its value.

3. What causes USDT to Depeg?

The main reason for the Tether's coin to depeg was the imbalance within the Curve's 3pool. A crypto whale address named CZSamSun borrowed 31.5 million USDT and swapped it for USDC. As a result, the value of USDT fell drastically.