What does pegging mean in crypto? How pegged crypto works and related risks

In cryptocurrency, especially in the decentralised finance or DEFI sub-sector, pegged crypto or pegging crypto assets are increasingly popular as a way to deal with cryptocurrency’s long-standing problem of volatility.

In this article, Learn Crypto examines several topics for discussion related to pegging in crypto. You will learn:

• What pegging refers to in a financial context, how the term was first used in traditional finance and why it was important.
• What pegging means in crypto and how it works
• Some examples of pegged crypto
• What are the risks of pegged crypto?

Introduction 

Before taking a look at what pegged crypto is and learning about how pegging works in the crypto context, it’s worth going back to basics to understand the main features of traditional pegging in economics. The expression “pegging” refers to the act of linking the value of a currency or an asset to the value of another currency or asset. thereby establishing a fixed rate of exchange. In other words, the economic expression of pegging is the practice of tying a state’s currency exchange rate to another state’s currency.

Many nations throughout history have used pegging to overcome problems of unpredictability in determining the value of a currency, particularly in times of high volatility. This is because, for trade and commerce to take place, a currency that keeps changing value makes it difficult to establish a stable price. Most countries that peg their currencies do so to promote trade and foreign investment – which is why goods and services are often priced against a pegged currency, usually one that is most accepted or recognised regionally or globally.

Currency pegging can be traced way back to the 18th century Gold Standard and the Bretton Woods agreement after the Second World War. Under the mentioned agreement, many Western states pegged their currencies to the United States dollar, and the United States pegged their national currency to gold. 

To learn more about the Gold Standard and its significance, read this Learn Crypto article: “What was Executive Order 6102 & why is it relevant to crypto?”. 

The practice is used by states’ central banks to provide stability to the state’s national currency by linking it to a currency with a higher degree of stability. For example, the United States dollar has been frequently used as a currency peg by many other nations, taking into account it is the world’s reserve currency. Hence, currencies such as the United Arab Emirates dirham (AED) and the Hong Kong dollar (HKD) are pegged to the US dollar (USD).

Even more “established” currencies like the Swiss franc (CHF) has gone down this route before, pegging itself to the euro (EUR) for a relatively brief period from 2011 to 2015. 

How does traditional pegging in economics work and why is it important for businesses?

In economics, it is generally understood that currency risks make it harder for businesses to manage finances, especially in the terms of conducting commerce internationally and extending to other countries. For instance, think of a US firm that wants to extend its business operations to Singapore. At some point in time, the company will have to convert US dollars into Singapore dollars. But if the value of the Singapore currency fluctuates too much in relation to the US dollar, the company could lose a lot of money when converting back to its national currency. 

Hence, pegging in the traditional sense specifically means that a state’s central bank buys and sells its currency on the open market to maintain the pegged ratio. 

We’ll now move on to learn about the meaning of pegging in the context of cryptocurrencies and how it actually works. We’ll also take a look at the differences between pegged and backed crypto, gold-pegged crypto, fiat-currency pegged crypto, and some other examples as well.  

What Does Pegging Mean in Crypto? 

A pegged cryptocurrency can be defined technically as an encryption-secured digital medium of exchange whose value is tied to another medium of exchange, such as a national currency or gold.

We now see here that the traditional economic expression of pegging has been just extended to a new environment. In simple terms, the notion of a pegged cryptocurrency refers to a token, coin, or asset issued on a blockchain that has been linked to a fiat currency issued by a bank. Furthermore, when the exchange rate is established between the currencies, such as the 1:1 ratio, the value of the cryptocurrency fluctuates to the same degree and in the same direction as the currency to which it is pegged.  

In most cases today, cryptocurrencies are pegged to the US dollar, following the longstanding trend in traditional economics of tying currencies to the American national currency to gain stability. Namely, it is a currency that has been a dominant factor in the entire financial sector worldwide.

We then dig deeper into what digital currencies, featured by blockchain technology and the characteristics of decentralization and independence, may have in common with the centralized traditional banking services. In other words, why it is beneficial to tie a digital currency to a recognised asset like the US dollar or gold. At first glance, it appears at odds with the tenets of cryptocurrency as fiat money has often been presented as being a nemesis to the crypto-community to now be naming the benefits of linking digital currencies to a state’s national currency.

There may be many other opinions such as Elon Musk expressing it in one of his Tweets on the issue of cryptocurrencies.

The answer could be linked to the same reasoning as to why many national currencies wanted to tie themselves to the US dollar in the first place. Unpegged cryptocurrencies are considered to be very volatile, due to typical marketplace perceptions of associated risks and similar factors. For example, the price of Bitcoin has been documented to vary at ten times the rate of the US dollar. 

Therefore, tying a digital currency to a more stable currency or asset is beneficial in safeguarding the cryptocurrency from rapid and broad fluctuations in value that could negatively impact anyone holding or trading in these cryptocurrencies.

Most pegged cryptocurrencies active in the present day are linked to the US dollar due to its dominant position in the global financial sector. For example, Tether (USDT) mostly managed to maintain the same value as 1 US dollar. As mentioned above, digital currencies can be linked to other assets, such as gold or other states’ currencies. 

How Does Pegging Crypto Work? 

The term stablecoin is one of the main terms we may encounter when examining crypto pegging. A stablecoin can be defined as a digital currency that is pegged to a stable reserve asset such as gold or the United States dollar to decrease volatility and value variations associated with unpegged digital currencies such as Bitcoin.

Consequently, when discussing stablecoins, you should keep in mind that there are different types of stablecoins. There are fiat-collateralized stablecoins, commodity-backed stablecoins, crypto-backed stablecoins, and algorithmic stablecoins. So far, we have explained only fiat-collateralized stablecoins and commodity-backed stablecoins (for example, gold-backed stablecoins) since the combination of digital currency flexibility and traditional asset stability has proven to be a widely popular and proven idea. This is evidenced by the fact that billions of dollars in value have flowed into stablecoins such as USD Coin (USDC). 

It is important to note that one cannot plainly claim a token or a coin is linked to the value of, for example, 1 US dollar (although there are many crypto assets out there that claim as such). Specifically, digital currency project owners generally need to have a particular amount of United States dollars in reserves at all times to be able to guarantee the pegged value of their digital currency.

This is even more significant when such a cryptocurrency can be openly traded across multiple exchanges allowing numerous financial transactions. Holding broad amounts of dollars in reserve is one of the main challenges when pegging a cryptocurrency. Even though they are initial ways to achieve this objective rapidly such as through fundraising or investors, it also means that project owners won’t gain any profits from selling or purchasing the cryptocurrency as it will always have the same value as the fiat currency. 

For example, let’s take a look at Tether and the USDT stablecoin. The USDT stablecoin is pegged to the US dollar with a 1:1 ratio and has been extensively used for crypto financial transactions and getting American dollars in and out. Even though it has been praised widely in the crypto community, Tether’s peg became at one point no longer credible because it admitted that Tethers have not been 100 percent backed by actual US dollars. That’s the importance of holding broad reserves when pegging a cryptocurrency. It is also significant for the value and stability of the digital currency to see what the reserves are made of.

Tether’s original claim referred to being 100% backed, namely that every Tether coin is always backed 1-to-1 by traditional currency held in reserves, but there has never been a transparent professional audit of these reserves (there have been audits more recently that apparently satisfies some requirements of financial regulators). Tether has now changed their claim, stating that the digital currency is backed by traditional fiat currency and cash equivalents, presumably other cryptocurrencies, and corporate debt. Reserves made of partly other cryptocurrencies and loans are something that change the entire picture regarding stability and foreseeable value variations. 

Pegged vs Backed Crypto 

As explained above, a stablecoin is merely a digital currency token pegged to another stable asset that encompasses a value at a 1:1 ratio. The most significant feature of a stablecoin is to hold the stability of its pegged value while being a cryptocurrency. It takes the best from both worlds as it is a cryptocurrency without associated negative characteristics such as volatility. 

Backed cryptocurrencies are a new generation of digital currencies that majorly differ from first-generation cryptocurrencies since they are characterized by liquidy, security, and stability. For the sake of comparison, first-generation cryptocurrencies have been accused of lacking built-in value, and thereby, most people were skeptical about using them. 

Just as the term suggests, asset-backed cryptocurrencies are crypto tokens or coins with a deep-rooted value due to being linked to a tangible object with a determined economic value. Asset-backed digital currencies are used to digitize a particular type of asset, along with the record of it being stored on the blockchain.  

Backed crypto is linked to tangible assets such as fiat money, real estate, or gold. Blockchain is a good medium for the development of asset-backed crypto due to its main perks such as proof of ownership and transparency. Being tied to external and longstanding markets means that if the tokens’ value drops below the real value of such underpinned assets, investors are still able to cash out the tangible asset.  

Examples of Asset-Backed Crypto 

To illustrate the possibilities pegging brings to the world of cryptocurrencies as a mixture of traditional economics and a novel digital environment, below you may find a list of the most popular (or notorious) examples of pegged and backed crypto.  

1. Tether (USDT) 

As explained above in the text, USDT is the most traded digital currency out there grounded on its levels of liquidity. In the last couple of quarters, Tether managed to outcompete even Bitcoin. The fiat-backed digital currency in circulation is pegged to the US dollar and backed by dollar funds and assets in reserves. As examined above, the total supply is not entirely fixed, yet it increases or decreases periodically founded on the amount of withdrawals and deposits. However, the main goal is to keep the exchange rate as close as possible to 1 US dollar at all times. 

2. Digix Gold (DGX) 

The Digix Gold token (DGX) is an Ethereum-based token with its price and value pegged to gold. One token equals specifically one gram of gold. Digix was not the first crypto project aiming to tie crypto to gold, but it was the first that successfully pulled it off and became one of the most popular gold tokenization projects in the market. DGX tokens are backed up by tangible gold, kept in a secure vault in Singapore. 

3. Propy (PRO) 

As a tiny detour from the growing world of fiat and gold-backed crypto, tokenizing tangible and digital real-estate assets is on its way to becoming a popular way to create decentralized title entries for the real estate market. For example, blockchain companies such as Propy offers tokenization services for tangible real estate assets and enable smaller investors to get a portion of tinier assets. Hence, owners get to profit from real estate faster, along with decreasing monopoly in the real estate business due to the possibility of housing being distributed in a decentralized manner. 

4. Petro 

It’s important to note first that Petro is not a real cryptocurrency. It doesn’t have an operating blockchain and is highly manipulated. Nevertheless, it makes an interesting case study as one of the earliest attempts at a state-owned pegged cryptocurrency.

Regardless of its reputation today, Petro is an interesting example of how governments seek a way to monetize digital currency. In 2017, Venezuelan president Nicolas Maduro announced the first oil-backed cryptocurrency. The cryptocurrency was supposed to be backed by Venezuela’s physical reserves. Petro was intended to solve the country’s problem of hyperinflation which led to the emergence of a novel currency, namely the Sovereign Bolivar, that was tied to Petro. Specifically, one Petro equalled one barrel of oil. Even though it did not appeal to the masses and was, at worst, a fraudulent attempt at blockchain assets, Petro is considered to be the pioneering cryptocurrency backed up by a tangible asset and government as well, paving the way for more government-backed crypto. 

5. Security-backed cryptocurrencies 

Blockchain companies, especially startups, are now on the path of tokenizing securities by creating digital tokens that present ownership and generate passive income for its holders, bringing up liquidity to the securities industry. It quickly gained popularity among many bankers and investors due to proving safe transactions while being cost-effective at the same time.

In contrast to many aspects of crypto that exist in a legal vacuum, digital securities are highly regulated. Hence, investors are more likely to trust and embrace them, and that’s how the popularity boom happened in the first place. 

To lay down a few examples of security-backed digital currencies, we may single out Polymath and Gibraltar. Polymath, a blockchain startup that tokenizes securities, encompasses a platform grounded on smart contracts that provide developers with a secure place to launch their security token offering. Gibraltar (the nation), on the other hand, provides an ICO and token sale platform founded on blockchain working on the world’s first regulated tokenized security exchange. 

Pegged Crypto Risks 

While the main characteristic of stablecoins is the fact that they are taking away the risk usually associated with cryptocurrencies, there have been some ongoing issues regarding stablecoins as well. Some observers note that regulators have been blamed for pegged crypto risks since the area remained broadly unregulated, and the issue of regulation was put on the table only after the emergence of pegged crypto scandals.

Read about how the collapse of the Terra stablecoin and pegged crypto led to different reactions from regulators around the world in this Learn Crypto article: “Stablecoins and regulatory developments post-Terra”.

Stablecoins operate on the assumption that the reserves they are backed with are easily redeemable and liquid as the amount held in reserve should be equal to the amount of currency in circulation. The above-mentioned Tether affair, along with another start-up named Circle, didn’t provide a detailed explanation of where their reserves are invested and possible risks clients could encounter, nor was there an audit conducted. The affairs revealed finally that the companies have invested the reserves in commercial paper, corporate debt, and cash equivalents without disclosing this accurately to clients.  

The lack of regulation and obligation to disclose information and conduct audits, along with appropriate legal measures and punishments, led to such projects going south. Even though stablecoins have been introduced to minimize risk as much as possible, the main pegged crypto risks are again associated with uncertainty, owing partly to the lackadaisical attitudes of regulators and project owners. 

Conclusion 

Decentralized finance or DEFI opens up many opportunities that may not have otherwise been available in traditional finance. Thanks to the ease of DEFI access, crypto investors can earn money and access financial services in many ways.

However, cryptocurrencies were avoided for a long time by more conservative and/or skeptical investors due to the recognised downsides such as uncertainty and market volatility. Crypto pegging is the result of the market seeking solutions from traditional economic tools, yet without the oversight and regulation that accompany conventional finance.

As it stands, there are still plenty of risks associated with the space in relation to pegged crypto. On the other hand, the blockchain ecosystem continues to develop and it is highly likely that we’ll see more and more pegged value cryptocurrencies emerge.

No doubt, many will go down the route of Terra, but those that practise better safeguards may yet weather the test of maturity and provide secure and efficient solutions for users and investors to trade more reliably on a market characterized by a high degree of instability and uncertainty.