In the decentralized finance (DeFi) space, pegged cryptocurrencies are becoming increasingly popular. But, before we start discussing how pegging works in crypto, let’s talk about traditional pegging in economics. “Pegging” represents the linking of the value of an asset or a currency to the value of another asset or currency.
It is also known as a “fixed rate” because the peg ratios are always fixed and provide stability to a country’s currency. Several countries in the past have leveraged pegs to direct trade and foreign investment toward themselves, as a constantly fluctuating currency isn’t beneficial for trade and commerce. With this, you might be thinking, “what is peg in crypto”?
Let’s take a closer look at what pegging means in crypto.
What Does Pegging Mean In Crypto?
When a cryptocurrency is pegged, it becomes an underlying asset, and its value is anchored to an external asset such as a bank-issued currency, a tradable commodity, or a financial instrument. In short, a digital asset issued on a blockchain is tied to a bank-issued fiat currency.
With crypto pegging, the conventional meaning of pegging has been taken to a new level. Today, the majority of stablecoins are pegged to the US dollar because it dominates the global financial sector.
Digital currencies represent independence and decentralization, so why are they pegged to gold or the US dollar? Fiat currency is often seen as an adversary to cryptocurrencies by the crypto-community, so what are the benefits of this peg?
The simple answer to this question is that pegging a cryptocurrency to fiat currency brings stability to the pegged coin or token in an otherwise volatile crypto space. The last couple of years are a great example of volatility in the crypto market. Bitcoin reached an all-time high (around $69,000) in 2021, and the price of Bitcoin at the time of writing this piece hovers around $16,700.
Crypto pegging creates a stable environment for a cryptocurrency and safeguards investors from broad and rapid fluctuations. This is why pegged cryptocurrencies are also called ‘stablecoins.’
Learn more about cryptocurrencies: What Is Cryptocurrency and How Does It Work
Types of Stablecoins
There are mainly four types of stablecoins:
- Fiat-backed stablecoins
- Crypto-backed stablecoins
- Commodity-backed stablecoins
- Algorithmic stablecoins
Let’s discuss them in detail.
Fiat-backed Stablecoins
These are also called fiat-backed stablecoins and they have to maintain a reserve of fiat currency. Generally, the collateralization ratio is 1:1 which reduces the volatility of the pegged asset. For instance, both USDT and USDC are pegged to the US dollar. So, 1 unit of these stablecoins is similar to 1 US dollar.
However, it is not just fiat currency that these assets can be pegged to. They can also be pegged to precious metals such as silver or gold and commodities such as crude oil. Fiat-backed stablecoins are most commonly pegged to the US dollar and have to maintain a reserve in the same currency.
Crypto-backed Stablecoins
As the name suggests, these are crypto-backed stablecoins. Crypto-collateralized stablecoins over-collateralize an existing digital asset to maintain a consistent market price. This gives the stablecoin a buffer against price fluctuations.
To get these types of coins, you have to put down your tokens as collateral, which are locked in a smart contract. You can retrieve this collateral at a later date by paying the stablecoins back into the smart contract.
Commodity-Backed Stablecoins
These stablecoins are backed by assets such as gold and silver. When these commodities increase in value, the owners of these stablecoins benefit from the increase.
Algorithmic Stablecoins
These types of stablecoins are not pegged to fiat, crypto, or a commodity. The stability of the coins comes from algorithms and smart contracts that manage the supply of these tokens. When the price of the coin falls, the algorithm will reduce the number of tokens in circulation. Similarly, if the prices increase, more tokens are issued.
Next in our discussion of what is pegged in crypto, let’s talk about soft and hard pegging.
What Is Depegging?
When a stablecoin deviates from its intended peg, this is referred to as depegging. Let’s say a fiat-backed USD-pegged stablecoin’s value tanks and drops under $1 then the coin can be referred to as crypto-depegged.
Depegging always raises questions about the currency’s effectiveness and it is usually troublesome for a stablecoin, especially for algorithmic stablecoins. When the market crashes too fast and outperforms the algorithm, the currency loses its peg and it all goes downhill from that point. Terra UST stablecoin is a great example of algorithmic stablecoin depegging.
If the issuing entity fails to maintain the 1:1 ratio of the pegged cryptocurrency to the underlying asset, the stablecoin can be depegged. For this to happen, stablecoins have to disclose the reserve information to the market, which stablecoins usually never do.
Examples of Stablecoins
- Tether (USDT): Tether is a stablecoin giant and is pegged to the US dollar. It is one of the first stablecoins, has achieved widespread usage, and is one of the most traded digital currencies in the crypto market.
- Digix (DGX): DGX is pegged to gold and one token of DGX is pegged to 1 gram of gold. DGX maintains only top-quality 100-gram Swiss-made gold bars in its reserves.
- TrueUSD (TUSD): It is an ERC-20-based token. It is the first asset that is built on top of the TrustToken Platform. Also, it provides real-time proof of funds.
Final Thoughts on What Does Pegging Mean in Crypto
Stablecoins are known for being less volatile as compared to other cryptocurrencies. And because their value stays the same as their peg, they are very popular among long-term crypto investors. With this article, we hope we answered the question, what is peg in crypto?
Disclaimer: This material has been prepared for informational purposes only and should not be interpreted as professional advice. Please seek independent legal, financial, tax, or other advice specific to your particular situation.
