Introduction
Stablecoins are crypto assets whose value is pegged to the value of another financial asset which can be a fiat currency, a commodity or another cryptocurrency among others. Designed to have a stable price relative to the reference asset, they are a necessary component of the crypto market. Stablecoins can be considered an equivalent of money for the crypto ecosystem because thanks to their less volatile nature, they play the role of medium of exchange and store of value for the crypto market. But are they truly stable? Another question is, if they are, how do they maintain the peg stability mechanism? In other words, how do they remain stable?
Deviation from the peg
Though designed to be stable in price, occasionally stablecoins can significantly deviate from their peg. That a stablecoin is trading below or above the peg depends on many factors. For example, the surge in Bitcoin price volatility has a positive relationship with USDT price. This is understandable: If the prices of Bitcoin or other cryptocurrencies fall considerably, investors will sell their crypto assets into stablecoins. For example, the Bitcoin price drop in 2018 January resulted in USDT trading at a premium of 5 cents. This implies that stablecoins are safe havens of the crypto market during volatile periods.
Below is the histogram of two-sided distribution of USDT deviations from the peg.
We can see that the deviations follow normal distribution, premiums over and discounts under the peg being almost equally likely. Why do stablecoins sometimes trade at a premium? The paper “What keeps stablecoins stable?” suggests three explanations. The first reason why the stablecoin price may be above the peg is what the authors of the paper refer to as “intermediation premium”. Some exchanges accept only stablecoins, not fiat currencies, for trading which makes stablecoins more valuable as a medium of exchange.
The second channel through which stablecoins trade at a premium is safety premium. During turbulent periods stablecoins play the role of safe havens for the crypto market. In late 2017 and early 2018, when BTC price crashed from $20,000 to $6,000, USDT premium above the peg increased.
USDT also traded at a premium during COVID-19 when Bitcoin lost 64% of its value. As BTC was falling, investors were selling their risky assets into stablecoins which resulted in USDT trading above the peg.
Finally, “latency premium” is the advantage of stablecoins over fiat currencies in that they take less time to make payments in crypto exchanges.
Sometimes a stablecoin can trade at a significant discount. One of the reasons may be a speculative attack on the stablecoin especially if investors think that the stablecoin is undercollateralized. This is what happened to USDT in 2018 October. Issuer of USDT, Tether Limited, came under scrutiny over if its reserves were adequate to the minted USDT tokens. An announcement from Bitfinex, a cryptocurrency exchange connected to USDT, exacerbated the situation. The exchange suspended deposits in fiat currencies, US dollars and euros, among others.
Following this, tether fell to $0.925. Other stablecoins, such as TrueUSD (TUSD) and Gemini Dollar (GUSD), and large market cap cryptocurrencies, BTC and XRP among others, appreciated because investors fearing of USDT depeg sold their tethers into other crypto assets.
Peg stability mechanisms
Now let’s look at peg stability mechanism of various stablecoins. In the case of USDT, when it departs from the peg, there’s arbitrage incentive for investors. If USDT is trading at a discount, investors can buy USDT cheaply making a risk-free gain. This is possible because every USDT is redeemable for USD through the stablecoin’s primary issue, Tether Limited Inc. On the other hand, if USDT is trading at a premium above parity, investors can buy USDT from Tether Treasury one-for-one rate and sell it in the secondary market (through crypto exchanges or decentralized exchanges) at profit.
There’s theoretically another way involving the issuer of USDT, Tether Limited which can play the role of a central bank if USDT price is above $1. We know that central banks intervene currency markets when their national currencies deviate from the peg by selling foreign reserves and buying their currencies. Similarly, Tether Limited also could sell its reserves decreasing USDT price if it is trading above the peg.
Another big player in the stablecoin industry is DAI, a decentralized stablecoin developed by MakerDAO. DAI differs from other large market cap stablecoins with many features. First, it has really achieved “an unprecedented degree of decentralization”. Unlike centralized stablecoins, which are issued by a single issuer (USDT and USDC are issued by Tether Limited and Circle respectively), DAI is not controlled by any single entity. An investor has to deposit collateral into Maker vaults if he wants to get DAI. The vaults are overcollateralized with the collateral rate of 150%. Which means that if to get DAI worth $1,000, you should you deposit ETH worth $1,500. These collaterals are employed to maintain the peg of DAI to the USD.
Furthermore, DAI is collateralized by not a single asset but by multiple assets, such as wrapped BTC, Ethereum, USDC, BAT, COMP, LINK among others.
Since it has a soft peg to USD, we can expect more variance in DAI price. Soft peg is the type of exchange rate control mechanism under which a currency is allowed to trade at a preset level of the peg.
This is exactly what the data shows us. While the average deviation of DAI from its peg during 2019 November – 2022 October was 30.3 basis points, the same figure for USDT was only -1.8 bps (basis points). That USDT was less volatile than its decentralized counterpart can be implied from the fact that standard deviation of its daily close prices during that period was 16 bps versus 77 bps that of DAI.
UST & LUNA death spiral
Speaking of stablecoins we should mention now infamous UST, the stablecoin of the Terra blockchain. UST started to lose its value on 10th May, now trading at $0.03. Even without the benefit of hindsight, the collapse of the stablecoin and LUNA, the token linked to it, was perfectly predictable. There were many analyses that showed inherent weaknesses of the system and how this interconnectedness of the 2 tokens could result in the crash of both.
For example, “TerraLuna & UST - Risk Assessment” by Swissborg written in April 2022, a month before the spectacular failure of the Terra blockchain, predicts how UST could lose its peg. To follow their reasoning, we should review how UST is created and redeemed. Investors can burn $1 of LUNA to mint 1 UST; or they could burn 1 UST to redeem $1 LUNA. When there’s a demand for UST, more LUNA tokens are burnt which decreases its supply and increases LUNA price.
But this is theory. In adverse market environments both LUNA and UST may fail due to their close ties. Let’s say, there’s a speculative attack on UST. The attack doesn’t have to be strong to cause anxiety for UST holders who begin to sell their UST fearing that the stablecoin will depeg. This will mint more LUNA (remember when UST is burnt, LUNA is minted) which will create a selling pressure on LUNA. LUNA price decrease, in its turn, will result in more investors selling their UST holdings which will result in more UST deviation from the peg. This is what how LUNA and UST failed in “death spiral”.
