Every cryptocurrency enthusiast understands that price volatility is the bane of the crypto world. That’s why a careful investor demand more Stablecoins than other cryptocurrencies. These cryptos are usually free from price fluctuations due to pegging.

So, what does pegging mean in crypto, and how does a pegged cryptocurrency work? Pegging means a method of setting the value of a cryptocurrency to a real-world asset. The value of the pegged cryptocurrency will be the same as the underlying asset.

For instance, a USD-pegged cryptocurrencie is worth the same as 1 USD. Also, gold-backed digital currency draws its value from the underlying asset, gold. If the price of real-world assets increases, so will the pegged asset value and vice versa.

But how will a cryptocurrency developer implement a peg? What causes digital currency depegging? Find the answers to these questions and more below.

How Do Developers Implement Currency pegs?

Currencies are pegged to maintain stability. The stable cryptocurrency value will be fixed against the exchange rate of its peg. By so doing, the currency’s value will be controlled so that it rises and falls with the peg.

  • Currency pegs are usually carried out by a monetary authority, which in most cases is the Central Bank. For example, a country might peg its currency with the dollar. Whenever the dollar value decreases or increases, the effect will be reflected in the pegged currency.
  • For a country’s currency to be USD-pegged, it must have enough dollars in reserves as Treasury to maintain the peg.
  • Monitoring by Monetary Authority. The central bank monitors the currency's exchange rate relative to the dollar value. If the currency loses value below the dollar peg, then the issuing entity will raise the currency's value and lower the value of the dollar.

The central bank raises the value of its currency by selling the Treasury (dollar reserves) in the secondary market. When the supply of Treasury in the secondary market increases, its value falls alongside the dollar's value.

This mechanism ensures that the circulating supply of the currency is reduced, its value is raised, and the peg is re-established.

Understanding Pegged cryptocurrencies?

A pegged cryptocurrency is a crypto asset whose value is fixed on another physical asset. In most cases, cryptocurrencies are pegged to popular fiat currencies, gold, or other high-earned assets.

The popular pegged cryptocurrencies are Stablecoins such as Tether USDT, USD Coin (USDC), DAI, Trueusd (TUSD), etc.

A pegged cryptocurrency is more stable than the unpegged one. The pegging helps control the token's volatility and reduce the risk associated with loss of value.

When pegging a crypto asset to fiat, such as the Us dollar, the rate is 1:1. So, if the issuer has about one million tokens of a coin pegged to USD, he has an equivalent of one million USD. Users could buy, sell and trade the tokens like other digital assets such as Bitcoin or Ethereum. Also, they can easily know the money value of their coins whenever they want.

What makes a pegged currency special?

  • A reserve backs a pegged cryptocurrency. Usually, the reserve assets of a pegged currency must have an equal number of the stable currency to which it is pegged. So, if a crypto asset is pegged to the US dollar, an equivalent number of USD must be in the present reserve. This is the only method to maintain the stability of crypto and preserve its backing.
  • The pegged asset is auditable. While it could be difficult to generally audit digital assets, pegging breaks such limitations. Each existing token has a physical representation of its backed-up currency in reserve.
  • Pegged cryptocurrencies are transparent. Transparency is the key player for any pegged cryptocurrency. There is no ambiguity in its value and worth since every crypto coin has real-world cash as its value.
  • The pegged assets create stability during volatility. Pegged cryptocurrencies ensure stability in investment value even when there's a price fluctuation. The value of the pegged cryptocurrency remains the same despite changes in the crypto market.

How does A Pegged Cryptocurrency Work?

Cryptocurrencies are constantly fraught with incessant volatility. To solve this problem, cryptocurrency developers created ways to improve digital assets' stability. The crypto developers now created digital tokens with values pegged to reserve assets like the US dollar and gold. Developers eliminate value instability and payment privacy issues by linking them to fiat currencies.

Pegged cryptocurrencies, otherwise known as Stablecoins, obtain their stability through buying and selling algorithms of the reserve asset. There are two major types of pegged assets, gold-pegged digital currencies and USD-pegged cryptocurrencies.

Gold-pegged cryptocurrencies

Some cryptocurrencies are pegged to the physical gold and stored in gold reserves. The custodians of these reserves are usually banks or any other third-party company. The ratio of the pegging differs across the pegged currency.

Some cryptocurrencies peg in the ratio of 1:1 with tangible gold metal. Meaning 1 token is equal to 1 gram of gold. Others may peg by an ounce or a fraction.

Usd-pegged cryptocurrencies

Usd-pegged cryptocurrencies values mimic the United States dollar. For instance, usdc is pegged to USD. This means that 1USDC equals 1USD.

Some risks are attached to Usd-backed cryptocurrencies. But they remain the top choice for the majority of investors. This is because the USD has always been popular and stable, facilitating cross-border payments and e-commerce.

Hard peg Vs. Soft peg, What Are The Differences?

The major difference between a hard peg and a soft peg lies in the operating system. The market determines the value of a soft peg. So, it can either drop or appreciate according to the dictate of the market. On the other hand, a hard peg has a fixed exchange rate set by the central bank. As a result, its value neither grows nor drops.

But let's address these currencies in detail for a better understanding.

Soft pegging

Soft pegging refers to an exchange rate policy to sustain the value of a particular currency. The aim is stability, and the foreign exchange market sets the rates. But the government will intervene during fluctuations. In crypto, soft pegging sustains a token value to a reserve or pegged currency.

Hard pegging

Hard pegging is another exchange rate policy used by central banks or governments. The currency value is set at a fixed rate against a different currency. In hard pegging, there's a limit to how much change will occur relative to the other currency. This occurrence is known as a band. One notable advantage of a hard peg is its transparency and simplicity.

Depegging

Depegging refers to the deviation of a Stablecoin from its original pegged currency. For instance, if Tether drops below 1 USD, then depegging is said to have occurred as what happened in May 2022. Tether USDT depegged from USD and crashed.

Depegging happens in both fiat currencies and cryptocurrencies.

What Causes A Sudden depegging?

Sudden depegging occurs due to market moves and broken ratios.

Broken ratio

Once the reserve fails to match the coin with the ratio of 1:1, depegging occurs. For instance, Stablecoins will automatically lose their peg. Some Stablecoin companies do not expose such information to prevent panic in the market.

When the market beats the algorithm

A currency peg is secured using smart contracts for algorithm-based coins. If the market makes sharp price turns or movements, the currency will begin to depegg. A recent example is the Terra UST stable coin, which led to financial chaos.

Problems Of Pegged Currencies

Pegging makes currencies more stable. However, it does not exempt them from the market forces and price movements. Here are some challenges that can be encountered:

  • The central bank of the pegging country must watch the demand and supply of currency. A sudden spike can cause a depeg. So, the bank must have a large amount of fiat currencies in reserve to maintain balance.
  • A peg set too high can force the country to spend foreign reserves; once they are exhausted, the peg is broken.
  • A pegged currency can also bring about high import rates and general inflation.
  • It can encourage the creation of a black market. If a pegged currency is scarce, the black market will thrive with unofficial exchange rates.

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Margex offers a lot of cryptocurrency pairs and pegged cryptocurrencies. Here are the three most popular ones.

Us dollar Tether (USDT)

This cryptocurrency is pegged to the Us dollar. Launched in July 2015, it has since grown into a popular Stablecoin. Tether is the largest Stablecoin project, with a market capitalization of close to $83 billion.

Steem Backed Dollar (SBD)

These are liquid, and stable crypto tokens also pegged to the US dollar. They operate on the steem, a social blockchain that functions as a community.

Users of the sbd network are rewarded with steem tokens when they share their content on steemit. The steem dollar can be traded for steem and then used for commercial purposes.

Trueusd (TUSD)

This asset is a multichain Stablecoin that works with escrow accounts, traditional banks, and third-party financial frameworks. It is pegged to the Us dollar and exchanges at a 1:1 ratio.

Trueusd operates on the Ethereum blockchain and uses smart contracts for its transactions.

Margex offers a reliable platform to trade any of these assets and more. When you fund your account, you are on your way to making a profit.

Pros And Cons of Pegging Currencies

Currency pegging has its shares of pros and cons, as we will find below.

Pros

The credibility of Monetary Policy

Pegged assets are important in countries experiencing hyperinflation. The strategy helps maintain these countries' economies and sustain the credibility of its monetary policies.

Good Planning Basis

Governments that implement currency pegging enjoys a stable basis for their financial planning. By implementing currency pegging, these governments can plan their expenditures and revenues without fear of price volatility, especially when purchasing foreign currencies.

Low Volatility

Pegging reduces the volatility of currencies. Even though soft pegs are usually affected by market moves, they're better managed than floating currencies. The low volatility advantage of currency pegging also enables businesses to avoid possible losses in the market.

Cons

Speculative Attacks

Currency pegging can result in speculative attacks, particularly when there's a high deviation in the currency value. But the chances of deviation are rare for free-floating currencies. There's an instantaneous correction from the market mechanism each time a deviation takes place, unlike in currency pegs.

Automatic Adjustment Difficulty

Unlike the floating currency system with automatic deficit adjustment, pegged currencies don't support this feature. The pegged currency system is known to elevate the possibility of disequilibrium in the currencies.

Increased Foreign Influence

Often, currency pegging leads to a greater foreign influence. The reason is that the monetary policy of the pegging country depends on that of the other nation. It is quite a drawback considering that it sometimes leads to conflict between both nations.

What Does Pegging Mean In Crypto, Frequently Asked Question

If you’re confused about Stablecoins and how they remain stable or depeg and lose value, the answers below will be helpful.

What is crypto pegging?

Pegging simply means hinging the value of an asset to another one in a 1:1 ratio. The purpose of this is to imitate the price movement of the more stable asset.

The crypto market often displays massive volatility, hence the need for pegging. Pegged cryptocurrencies are known as Stablecoins. A good example is the USDT which is a Usd-pegged digital currency.

How does a crypto peg work?

Usually, pegging of cryptocurrencies is done using reserve assets which are the Us dollar and gold held in reserve. For gold-backed cryptocurrencies, the number of coins in circulation should be backed by the equivalent gram of gold. However, some cryptocurrencies are put on risker pegs by linking them to another coin or a group of coins.

What is pegged to the dollar?

Being pegged to the dollar means fixing the value of an asset to the dollar in the ratio of 1:1. It means that as long as the dollar remains stable, the asset will maintain the same status.

How do developers peg a currency?

There are two methods for pegging a digital currency, keeping reserves and algorithms. In the first method, the value of the pegged cryptocurrency depends on what is in reserve.

Algorithmic stablecoins maintain pegging using smart contracts and collateralization to increase the supply. Algorithms are used to sustain the peg by manipulating the demand and supply algorithmically.

What are dollar-backed cryptocurrencies?

The Us dollar coin (USDC) is successful usd-pegged digital currency. The coin is pegged to the dollar's value in the ratio of 1:1. Other cryptocurrencies backed by the dollar include Tether (USDT) and Trueusd (TUSD).