Definition and Function of Stablecoins

Stablecoins are a type of cryptocurrency engineered to maintain price stability, commonly being pegged to the US dollar or other major fiat currencies. Their main applications include settling crypto trades, facilitating decentralized finance (DeFi) lending, and serving as a safe haven asset. In theory, stablecoins enable investors to hedge against crypto market volatility. However, in real-world use, risks remain.

Major Stablecoin Collapses in Recent Years

Stablecoin crashes have become increasingly common in recent years, with some of the most notable cases including:

• TerraUSD (UST) Crash (2022)
  UST was a flagship algorithmic stablecoin, maintaining its peg through the LUNA token mechanism. In May 2022, large-scale redemptions and algorithmic stablecoin failure caused UST to break its US dollar peg, plummeting in value to nearly zero. This triggered widespread market disruption and erased tens of billions of dollars in market capitalization.
• Iron Finance (IRON) Crash (2021)
  IRON was an algorithmic stablecoin aimed to maintain a 1:1 peg to the US dollar. In June 2021, a sharp loss of investor confidence drove a redemption wave, resulting in short-term liquidity constraints in the crypto market.
• Other Small Stablecoin Failures
  These cases, though less significant in scale than UST, underscore the inherent risks of stablecoins. Several smaller centralized and algorithmic stablecoins—including sUSD and DEI—have also faced price instability due to insufficient reserves or flawed design.

Key Drivers of Stablecoin Collapses

The main causes of stablecoin crashes include:

• Algorithmic stablecoin failure: Algorithmic stablecoins rely heavily on market confidence, and spikes in redemption pressure often cause cascading effects.
• Insufficient reserves or liquidity management: Centralized stablecoins with limited reserves or poor asset management may lose their peg during major market swings.
• Market panic and sentiment: Sudden drops in investor confidence lead to rapid redemptions and can spiral into crisis.

Impact of Stablecoin Collapses on the Crypto Market

Stablecoin crashes often lead to:

• Tighter market liquidity, disruption to trading pairs, and heightened price volatility.
• Decreased investor confidence, prompting capital outflows from the crypto market.
• Greater regulatory scrutiny, prompting governments to tighten stablecoin oversight.

Investor Strategies for Managing Stablecoin Risks

To mitigate stablecoin risks, investors should consider these approaches:

• Diversify holdings: Avoid concentrating funds in any single stablecoin.
• Prioritize reserve transparency: Select stablecoins with robust reserves and regular public audits.
• Monitor market conditions closely and adjust positions as needed to protect against sudden redemption events.