Why Do Stablecoins Lose Their Pegs?

Stablecoins are designed to bring stability to the volatile world of cryptocurrencies by maintaining a fixed value, usually pegged to a fiat currency like the U.S. dollar. However, despite this promise of price consistency, stablecoins can lose their peg, sometimes with catastrophic consequences. In this article, we’ll examine what can cause a stablecoin to lose its peg, analyze notable examples, the fallout from such events, and discuss how projects are working to prevent future instability.

What Are the 4 Types of Stablecoins?

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ALT TXT: Types of Stablecoins. Source: AI-generated image

Understanding what keeps stablecoins stable begins with understanding the underlying mechanisms that govern their value. Stablecoins are categorized based on how they maintain their 1:1 peg, and each type comes with its own benefits and vulnerabilities that influence what can cause a stablecoin to lose its peg.

Fiat-backed stablecoins

These stablecoins are backed by reserves of traditional fiat currencies like the U.S. dollar, held in banks or trusted custodians. For every token issued, there’s an equivalent amount of cash or cash-equivalent assets stored somewhere off-chain. Regular audits and transparency reports are key to maintaining user trust. Examples include USDC and USDT, two of the most widely used stablecoins in circulation.

Commodity-backed stablecoins

Commodity-backed stablecoins are a sub-category of fiat-backed stablecoins; these tokens are pegged to physical assets like gold, silver, or oil. Their value depends on the market price of the underlying commodity, offering a crypto version of hard-asset exposure. These assets are typically stored by custodians, and in some cases, holders may redeem tokens for physical delivery. Tether Gold (XAUt) is a leading example in this category.

Crypto-collateralized stablecoins

Backed by digital assets such as ETH, these stablecoins are typically over-collateralized to compensate for the volatility of their reserves. For instance, issuing $1 worth of stablecoin may require $1.50–$2.00 worth of crypto collateral. These systems rely on smart contracts to manage collateral ratios and liquidations. A notable example is DAI, which maintains its peg through dynamic collateralization models.

Algorithmic stablecoins

Rather than being backed by fiat or crypto, these stablecoins maintain their value through mathematical formulas and on-chain supply control. The protocol automatically mints or burns tokens to counteract price fluctuations. However, because they lack hard reserves, they can be highly vulnerable in market crashes. TerraUSD (UST) is a cautionary tale of this model’s risk, having lost its peg dramatically in 2022.

Each stablecoin type answers the question “What keeps stablecoins stable?” in different ways, but also reveals why stablecoins fail when those mechanisms break down. Understanding these differences is crucial for evaluating what happens when a stablecoin depegs and how to mitigate that risk as an investor.

What Does It Mean for a Stablecoin to “Lose Its Peg”?

When a stablecoin is said to “lose its peg,” it means the asset no longer holds a 1:1 value with the fiat currency it\’s supposed to track, usually the U.S. dollar. For example, if a stablecoin drops to $0.90 instead of holding steady at $1, it has depegged.

While small, short-term price swings are often expected due to market supply and demand, a significant or sustained drop signals trouble. This can trigger panic selling, drain liquidity, and seriously damage user confidence. Can stablecoins lose all their value? Yes, in severe cases, as seen with TerraUSD, a stablecoin can collapse entirely, resulting in billions of dollars in losses.

Common Causes of Stablecoins Depegging

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Stablecoins are only as strong as the systems that uphold them. When any part of that system fails, whether it’s external financial infrastructure, internal smart contract logic, or broader market sentiment, a stablecoin can lose its peg. Let’s break down the key factors that commonly lead to depegging.

1. Bank failures and custodial risk

For fiat-backed stablecoins, trust in the system hinges on the security and accessibility of the underlying reserves. When a partner bank fails or becomes insolvent, it can trigger fear and uncertainty among investors. A notable example occurred in 2023 when Circle revealed that $3.3 billion of USDC’s backing was trapped in the collapsed Silicon Valley Bank. The result? A sharp drop in USDC’s price to $0.88 sparked widespread concern about whether the reserves could be recovered. Events like this can cause a stablecoin to lose its peg, exposing the risks associated with overly relying on traditional financial institutions.

2. Liquidity shortages during market stress

Liquidity is the lifeblood of stablecoin stability. In normal conditions, healthy trading volumes help keep the price close to $1. But in periods of market panic or extreme volatility, liquidity can dry up, leading to wider spreads and slippage. With fewer buyers or sellers available, stablecoins may rapidly depeg as users scramble to exit their positions. This isn’t just a technical issue; it’s a psychological one. Once trust begins to erode, it becomes a self-fulfilling spiral. What happens when a stablecoin depegs? Panic sets in, and without liquidity, recovery becomes difficult.

3. Smart contract vulnerabilities

Collateralized and algorithmic stablecoins rely heavily on code-based mechanisms to function, meaning any flaw in the logic can have devastating consequences. Bugs in smart contracts, oracle failures, or improperly set collateral parameters can break the mechanisms that keep the peg in place. In the infamous case of TerraUSD (UST), the algorithmic design failed under pressure, and its sister token LUNA couldn’t absorb the shock, resulting in a total collapse. These flaws show that the reason why stablecoins fail often comes down to unchecked risks baked into the system architecture.

RELATED: Algorithmic vs Collateralized Stablecoins: Key Differences, Mechanisms, and Risks Explained

4. Supply and demand imbalances

Stablecoins rely on equilibrium. When supply expands too quickly without adequate backing or demand surges unexpectedly, without the system adjusting, the peg can slip. Over-issuance, under-collateralization, or sudden sell-offs can all disrupt this balance. Some algorithmic models attempt to stabilize through minting and burning mechanisms, but these are only effective when confidence remains intact. When belief in the system breaks, even small imbalances can spiral into full-scale depegging events.

5. Governance failures and policy missteps

Whether centralized or decentralized, stablecoin projects rely on decision-makers to update parameters, manage reserves, and implement crisis responses. Poor governance, such as delayed actions, lack of transparency, or controversial protocol upgrades, can severely undermine confidence. When stakeholders disagree or when decisions are made without clear communication, the result can be market uncertainty and instability. Governance failures don’t just weaken the peg; they weaken the project’s credibility, making users question: Can stablecoins lose all their value? The answer becomes more likely when leadership is lacking.

6. Macroeconomic and regulatory shocks

Wider economic forces can also destabilize stablecoins. Events such as inflation, interest rate hikes, or geopolitical tensions may increase demand for stable assets or place stress on reserve management. Meanwhile, sudden regulatory crackdowns or legal actions against issuing entities can cause fear-driven selloffs. These external pressures may not originate from within the crypto ecosystem, but their impact on sentiment and trust can still lead to depegging.

These causes, individually or in combination, underscore the fragility of maintaining a consistent peg. Whether it’s a flaw in the code, a gap in liquidity, or a bank failure, each point of failure has the potential to ripple across the entire ecosystem. That’s why knowing what can cause a stablecoin to lose its peg is critical not just for developers, but for anyone interacting with the crypto economy.

Notable Examples of Depegging

TerraUSD (UST)

In May 2022, TerraUSD collapsed from its $1 peg to mere cents. It was an algorithmic stablecoin that relied on its sister token, LUNA, to balance supply and demand. When LUNA’s value crashed during market stress, the system could no longer stabilize UST. This event is often cited as a catastrophic answer to why stablecoins fail.

USD Coin (USDC) during the SVB crisis

March 2023 saw USDC fall to $0.88 following the collapse of Silicon Valley Bank, which held a portion of Circle’s reserves. This sparked widespread fear, prompting questions like what happens when a stablecoin depegs? Though USDC recovered after regulatory intervention, it exposed the risk of banking dependencies.

DAI and Over-Collateralization Stress

DAI, a decentralized stablecoin, is backed by over-collateralized assets like ETH. On “Black Thursday” in March 2020, a massive ETH price drop led to liquidations that caused DAI to briefly trade above $1. This anomaly shows that even “safe” systems can depeg in extreme market conditions.

How Projects Are Improving Peg Stability

Given the high stakes, developers and issuers have introduced various tools and frameworks to prevent depegging. The following are what keep stablecoins stable.

Real-time reserve transparency: Issuers like Circle now publish reports and on-chain proof-of-reserves to assure users that their tokens are fully backed.
Over-collateralization & dynamic risk controls: Projects now maintain collateral far above the value of the issued stablecoins, with automated liquidation systems to protect against price crashes.
Smart contract audits & oracle improvements: Relying on decentralized and reliable oracles (like Chainlink) reduces the risk of pricing errors that could depeg a coin.
Automated stabilizing mechanisms: Algorithmic models, though controversial, are still evolving to include circuit breakers and hybrid collateral strategies that adjust based on market behaviour.
Emergency backstop funds & insurance pools: Some protocols maintain reserves specifically designed to respond to abnormal events, preventing spirals of depegging.

What Investors Should Watch Out For

For users and investors, the stability of a stablecoin should never be taken for granted. Here are key signs and questions to ask:

Reserve transparency: Are the reserves audited and verifiable?
Collateralization levels: Is the coin over-collateralized or under-collateralized?
Exposure to bank risk: Is the issuer dependent on vulnerable banks?
Smart contract security: Has the code been audited? Are upgrades handled responsibly?
Market liquidity: Is there enough volume on major exchanges to exit during volatility?

So, can stablecoins lose all their value? History has shown the answer is yes. Events like the TerraUSD crash proved that even top-10 coins are not immune.

Disclaimer: This article is intended solely for informational purposes and should not be considered trading or investment advice. Nothing herein should be construed as financial, legal, or tax advice. Trading or investing in cryptocurrencies carries a considerable risk of financial loss. Always conduct due diligence.

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