In the world of finance, pegging refers to the establishment of a fixed rate of exchange between currencies, ensuring stability. When rates are set with preset ratios, they are referred to as fixed rates. In the crypto market, the idea is similar; instead of a fixed rate of fiat currency between countries, a fixed value of a stablecoin is attached to an external asset. With hard pegging, this value doesn’t fluctuate.
But what is the significance of hard pegging in crypto? This article reviews the differences in pegging, including hard and soft pegging. Plus, we explore which stablecoins are most popular among crypto investors in 2023.
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What is hard pegging in crypto?
To understand what hard pegging in crypto means, you must understand how pegging works in the first place. In the cryptocurrency market, extreme price volatility often makes it hard for businesses and investors to rely on crypto for various tasks like purchases or cross-border payments. Stablecoins were created to provide a crypto asset that maintains a stable value within a volatile market. These coins are pegged to real-world assets such as a fiat currency, another crypto, or a commodity.
The assets backing the stablecoin are securely stored and act as collateral in the form of reserves. This gives stablecoins a 1:1 ratio to the asset, so one USDT stablecoin can be exchanged for one currency unit, like $1.
This 1:1 ratio is an example of a hard pegging in crypto because it does not allow for any fluctuation in the value. Note that the value of the crypto will always remain the same value as the asset it is pegged to. Essentially, hard pegs offer a more trusted and transparent trading environment.
Hard peg vs. soft peg
Often, currencies start out with a fixed rate but, over time, begin to fluctuate more freely in accordance with market conditions. Since fluctuations are so common, a method to stabilize the cryptocurrency value is to provide a value with a certain range against the reserve currency. This is referred to as a soft peg.
Contrary to a hard peg, soft pegging in crypto represents an exchange rate regime that allows for limited flexibility between the pegged crypto’s value and its peg. The most common example of this in world currencies is the Chinese Yuan. It was pegged to the U.S. dollar from 1994 to 2005, after which it was revalued to appreciate 2.1% against the dollar.
Fun fact: Did you know that Tether (USDT) is considered both a hard and soft peg? It has a hard peg of $1 and the soft peg permits it to go up or down by 2%.
What is depegging in crypto?
One challenge in crypto pegging exists in cases where the reserves backing the crypto are not enough to back every issued token.
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If, for example, a large number of people sell their USD-backed stablecoin for dollars, it would make it harder to maintain the peg if there’s a shortage of the USD to back them all. This is an example of depegging in crypto.
The most known depegging event happened in 2022 with Terra (UST). The stablecoin was intended to retain a $1 value, using LUNA to back the peg. Both coins then collapsed, and due to supply and demand, Luna’s increased supply, coupled with Terra’s depegging, eventually made Luna worthless.
In the chart below, you can see the fall in the stablecoin’s price since the depegging. It is now being traded at $0.014.
Some causes that can result in depegging include:
- Unmatched reserves — When the issuing entity fails to maintain enough backed reserves to keep the peg, a depegging will ensue as we went over. However, this is an issue that is not always open to the public, and markets must be aware of this imbalance.
- Market outperformance — Another scenario that can cause depegging to occur is if the market outperforms the algorithm. Supply and demand can secure an asset’s currency peg by smart contracts but only up to a certain extent. The market can crash quickly or even outperform the smart contract algorithms, leading to a currency’s depegging. This is what happened to Terra UST.
What types of stablecoins are there?
Many people think of common stablecoins pegged to real-world currencies like USD. However, cryptocurrencies can be backed by other means. The most common stablecoins are coins backed by fiat, crypto, commodities, or are algorithmic.
Fiat-backed stablecoins
As the name suggests, fiat-backed stablecoins are backed by a fiat currency. And in most cases, it is the U.S. dollar. Fiat-equivalent reserves collateralize them with a 1:1 ratio. Note that this means one stablecoin can be exchanged for one fiat currency unit that it’s pegged to. Fiat-backed stablecoins are the simplest and also the most centralized types in the market. The most popular are Tether (USDT), Binance USD (BUSD), and USD Coin (USDC).
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Crypto-backed stablecoins
Some stablecoins are backed by other cryptocurrencies, which are referred to as being crypto-backed. They are often issued to launch their underlying crypto asset on other blockchains. One thing to note is that these stablecoins are often over-collateralized. This means that there’s a surplus of reserves that greatly outnumber the value of the stablecoin. One good example of a crypto-backed stablecoin is MakerDAO’s (DAI), which is pegged to USD but backed by ETH and other cryptocurrencies.
Commodity-backed stablecoins
Not all stablecoins are backed by other types of currencies; commodity-backed coins derive their value from another tangible asset. These commodities can be in the form of precious metals such as gold or silver. Another tangible asset that a stablecoin can be backed by is crude oil. Paxos Gold (PAXG) is a stablecoin pegged to real gold reserves.
Algorithmic stablecoins
Rather than being backed to other assets, algorithmic stablecoins remain stable due to a preset formula run on a computer program. Essentially the computer algorithm controls the coin’s supply and demand via smart contract. As a result, this affects the coin’s overall market value. Centralized reserves do not always back algorithmic stablecoins. And because of that, they can be considered decentralized. TerraUSD (UST) was an example of an algorithmic stablecoin before it lost its peg.
This chart tracks the aggregate supplies of the following major stablecoins:
The future for stablecoins
Amid significant market chaos — from centralized exchanges like FTX collapsing, stablecoins depegging, and banks shutting down, stablecoins are facing increased regulation. As of May 2023, multiple bills in the U.S. Senate and House of Representatives are proposing to set more regulatory standards for stablecoins.
With Paxos potentially facing an SEC lawsuit and issues surrounding Circle’s USDC under scrutiny, stability in the stablecoin market is not guaranteed. In addition, depegging also poses a threat to DeFi protocols that depend on the stable value that these coins bring to the platform. Chief technology officer of Tether and Bitfinex Paolo Ardoino claims that 90% of DeFi relies on USDC alone.
“I think regulators should give a bit more guidance on how stablecoins operate and what should have in its reserves. That, to me, is extremely important because right now there is no big jurisdiction that provides guidance on stablecoin reserves,”
Paolo Ardoino, Tether CTO: BeInCrypto
Why hard-pegging crypto is necessary
Whether it’s a soft peg or a hard pegging in crypto, it’s clear that the cryptocurrency market — and DeFi in general — depends on the value stablecoins bring to the space. By removing some of the market volatility that is so rampant in crypto, stablecoins help investors and institutions establish a degree of trust and guarantee. With hard pegging, trading environments become more secure and easier to decipher.
It’s crucial that any stablecoin must live up to the promise of stability in order to succeed. And many speculate that the emergence of Central Bank Digital Currencies (CBDCs) — cryptos backed by central banks — will be the spark that ignites a new era of stablecoin adoption for the digital asset world.
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Frequently asked questions
Are stablecoins always backed by fiat currency?
What are the most popular stablecoins in the market?
How does stablecoin regulation affect the crypto market?
What is soft peg vs. hard peg crypto?
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