What If USDT Loses Its Peg? Part II: DeFi and Self-Custody

Not long ago, the Bank for International Settlements (BIS) published a report warning that a major stablecoin might not survive a wave of redemption requests. The name of the stablecoin and its issuer weren’t disclosed. The warning itself was also phrased carefully — the BIS wasn’t predicting the collapse of a stablecoin outright, but rather the risks of a sharp sell-off in the short-term U.S. Treasuries that could follow a “bank run” on one of the big ones.

BIS researchers point out that capital flight from stablecoins puts upward pressure on Treasury yields — and that under conditions of “severe stress,” those yields might spike nonlinearly. That kind of scenario — a full-on stampede out of one of the top stablecoins — is something we’ve never seen before.

They didn’t name names. But we do know which stablecoin issuer holds the largest share of U.S. Treasuries — and that’s Tether. And we also know that Tether has one of the most questionable reputations in the entire industry. No one outside the company knows whether it can truly honor all of its obligations. The hint from BIS seems clear enough: the risk of 1 USDT falling significantly below 1 USD is real — and should not be ignored.

In Part I of this article, I explored how a serious USDT depeg could devastate crypto exchanges. The outlook was grim: many of them would likely collapse. And the pain wouldn’t just hit USDT holders — even users who steer clear of USDT and trade other assets could suffer. If you haven’t read the first part and want to know why, here’s the link.

But now let’s take a look at how a potential USDT collapse might affect those who avoid centralized exchanges altogether. I’ll explore the impact on DeFi protocols, users holding USDT in self-custody wallets, and even those who don’t touch USDT at all.

DeFi

So, centralized exchanges are vulnerable — that part’s clear. Human error, greed, pooled reserves. But we’ve still got DeFi, right? Unbiased smart contracts where code is law. The problem, though, isn’t with the code. In the case of a USDT collapse, the code will work perfectly. That’s precisely the issue — it will do exactly what it’s supposed to, and that’s what could cause everything to fall apart.

Take a lending protocol like Aave. It’s basically a digital pawnshop. You deposit something valuable (your collateral) and borrow the asset you actually need. Simple enough.

Many seasoned crypto users aren’t betting on the price of coins going up — they’re betting on it going down. That’s the long-term fate of most altcoins anyway: dust and ashes. Almost everything bleeds out eventually.

So, a savvy user deposits 10,000 USDT into Aave as collateral. The smart contract checks the price feed — 1 USDT ≈ 1 dollar — and says, “Okay, your collateral is worth $10,000. You can borrow up to $7,000 in the crypto of your choice.” You take out the loan, sell the borrowed crypto, wait for it to drop, buy it back cheaper, repay the loan, and recover your USDT. Everything’s smooth. You feel like a genius.

Then the depeg begins. USDT starts to slide: $0.90… $0.80… At $0.75, your 10,000 USDT is now worth only $7,500 — uncomfortably close to the $7,000 you owe.

What does the smart contract do? It doesn’t panic. It calmly follows the rules: if collateral becomes too risky, it must be sold to repay the debt. That’s called liquidation. It’s not a bug — it’s a feature. It protects the protocol.

But this isn’t just happening to you — it’s happening to everyone. Thousands of users are liquidated at once. We’re now in full-blown cascade mode — the biggest forced-selling event in DeFi history.

And now our perfect code meets reality. The liquidation bot repays your $7,000 worth loan and grabs your 10,000 USDT as collateral. But USDT is falling so fast that by the time the transaction clears, those 10,000 USDT are worth just $6,500.

There’s a shortfall. The protocol recovered the loan but came up $500 short. That’s called bad debt. A loss. But the protocol doesn’t have its own money to cover that. So who pays?

Everyone else.

That loss gets absorbed by users who simply parked funds in the protocol. If you were holding USDC, for example, now every $1,000 you thought you had is backed by slightly less — because the protocol’s shared liquidity pool just shrank. And in Aave’s case, bad debt triggers the use of the Safety Module — a reserve fund filled with staked $AAVE tokens.

This Safety Module consists of tokens that users voluntarily locked for rewards. When bad debt appears, the protocol automatically seizes a portion of those staked AAVE tokens and sells them on the open market to cover the hole. Stakers lose part of their assets directly — and the large-scale sale also tanks the market price of AAVE, causing indirect losses for all other holders.

And now for the cherry on top. There’s a protocol called Curve, home to the legendary 3pool — a stablecoin pool with USDT, USDC, and DAI. It’s considered the safest place in DeFi to park your stablecoins. You add liquidity, and because the prices of these assets stay close to $1, you don’t suffer impermanent loss — plus you earn fees from other users.

So what happens when USDT becomes toxic? Especially when you can no longer sell it on exchanges (remember from Part I why centralized trading might be halted)?

Everyone holding USDT will go looking for alternatives. And experienced DeFi users will rush into Curve’s 3pool — hoping to swap USDT for safer USDC or DAI.

Imagine a giant tank with three faucets. Panicked users show up, open the USDC and DAI taps full blast, and pour buckets of dirty USDT into the same tank.

Very quickly, all the USDC and DAI will be drained. The pool will end up 99.9% filled with depegged USDT. Anyone who added USDC or DAI to the pool won’t be able to get them back. And the economic function of the pool will be destroyed. The core liquidity layer of DeFi will become a radioactive wasteland.

That’s the final result. The code did everything right. Liquidations went by the book. Swaps followed the formula. But the entire financial system — built on the assumption that USDT would remain stable — has collapsed, leaving behind losses and a paralyzed infrastructure.

USDT in Self-Custody Wallets

So what about those who don’t keep their stablecoins on exchanges or in DeFi protocols, but simply store them in regular self-custody wallets? For this group, the risks of a USDT depeg are actually the most straightforward. The key question they’ll face is simple: should I sell now, or wait and hope the peg recovers?

But where do you sell when proper trading isn’t available on exchanges or DeFi platforms? Most likely, two options will remain:

• P2P marketplaces to trade USDT for national currencies
• Over-the-counter crypto swaps

Once the big platforms start to collapse, all the activity will shift to places where you can trade directly from your own wallet. These will become the lifeboats — the escape routes from a sinking Titanic.

And I’m sure there will be plenty of buyers looking to pick up USDT at a discount. We’ve seen this before — during the Terra-Luna collapse. When UST fell to 90 cents, people thought it was a great deal. Then 80 — even better. And even when it hit 30 cents, there were still believers buying the dip. USDT will likely find buyers too. But let’s be honest: selling at a discount is never fun.

What about swapping USDT from your wallet into other cryptocurrencies? That’s where things might get more interesting. USDT won’t fall alone — it will drag the entire crypto market down with it. We’ve already seen, using Aave as an example, how dependent some tokens are on USDT stability. But even beyond that, the collapse of UST showed us how fear and uncertainty can spread across all of crypto. People start panic-selling everything — even Bitcoin took a hit during the UST crisis.

If centralized exchanges stop functioning properly, they’ll no longer serve as reliable price references. Market prices will shift chaotically. And if you can catch offers with unusually favorable rates for certain coins, there may be real profit opportunities. And yes — those offers will appear. You just need a way to find them.

That’s why I want to remind you: every time you create an exchange request on rabbit.io, we automatically scan the entire market for the best available offer, and use it as the source of liquidity for your swap. So if chaos breaks loose and you’re still holding USDT in your wallet:

• Don’t panic
• Choose a few cryptocurrencies you believe can survive the storm
• Go to rabbit.io and swap your USDT for those assets

Just one tip: in times like those, use the fixed-rate option. Otherwise, by the time your transaction gets confirmed on-chain, the price could shift dramatically. But with a fixed rate, you’re protected — no surprises.

What Happens to Those Who Don’t Hold USDT

USDT has depegged from the dollar more than once. And every time, it bounced back. But during those times, the crypto economy wasn’t nearly as dependent on USDT as it is today. These days, USDT underpins everything: centralized exchanges, decentralized finance, crypto debit cards, entire businesses — even users who refuse to touch USDT and proudly hold “real” crypto instead.

Let’s say you don’t have a single USDT in your wallet. You saw the risks a mile away, laughed at the idea of this so-called “safe haven,” and kept your savings in the “right” assets: good old BTC, privacy-focused XMR, maybe even that market-sweeping HYPE token that’s always getting bought up. You feel bulletproof. If your neighbor’s house is on fire — not your problem, right?

But in crypto, all the houses are connected to the same gas line.

Even the most cautious crypto investor on the planet — cold wallet, self-custody, no exposure to anything shady — will still feel the heat. You might hold the keys to your shiny car… but what good are they if the roads are gone and no one’s making gasoline? Your Bitcoin is intact. But its value, like always, is set by the market. And in this case, the market will be partly destroyed and partly panicking.

The price discovery mechanism will break down. People and institutions will dump anything that someone is still willing to buy. And that wave of panic will drag down the price of your supposedly safe Bitcoin, hard. In a systemic meltdown like this, there are no safe harbors.

Then again… maybe this would be the perfect moment to buy more?

What Comes After: Ashes and New Growth

When the smoke clears and the echoes of the last liquidations fade, what will remain of the crypto economy as we know it? If the industry enters a USDT collapse with the same level of dependence it shows today, the fallout will be on par with an extinction-level event. Think: the meteor that wiped out the dinosaurs. After that, nothing is ever the same.

First, we’ll enter a long, painful crypto winter. The trust this industry has spent years building could evaporate overnight. Global regulators — who once merely wagged fingers — will suddenly have the perfect excuse to roll out harsh, suffocating rules in the name of investor protection. For years, we’ll witness an endless stream of bankruptcies and court battles as people try to recover even a fraction of what they lost. And to institutional investors, “crypto” will once again sound like a dirty word.

But like any wildfire, no matter how destructive, the blaze will clear out the underbrush — and make room for something new to grow.

The first green shoots will appear in the stablecoin sector. A mass exodus toward quality is inevitable. The era of the black-box stablecoin running on trust alone will be over. Users will demand not just flashy promises, but audited reports, full transparency, and 100% on-chain collateral. The projects that can deliver this will become the new giants of the industry.

More than that, the fall of a centralized stablecoin like USDT could become the best advertisement for truly decentralized alternatives. After learning hard lessons from both UST and USDT, the crypto world will pour its energy into building a new kind of stablecoin — one that is resilient, transparent, and free from the control of any single company. That push could unleash a new wave of real innovation.

And maybe the most important silver lining of all is this: the survivors — you and me — will come out of the crisis with a lifelong immunity to blind trust. The age of “just trust us” will be over. We’ll all learn to ask the hard questions:
Why is this worth what it’s worth? What guarantees that it’ll hold its value tomorrow? What are the risks?

It will be painful. Brutal, even. But it may be the single most important lesson this ecosystem ever learns — and the one that makes it stronger than ever.