What Does Pegging Mean in Crypto? Best Definition Out There

Pegging in the world of cryptocurrency refers to the practice of linking the value of a digital asset to an external reference, typically a stable currency like the US Dollar or Euro. The purpose of pegging is to establish stability, as cryptocurrencies are known for their price fluctuations. In this article, I will cover everything you need to know about pegging in crypto: how they work, why they are needed, and the different types.

What are Stablecoins?

Cryptocurrencies that tether their value to an external asset are called Stablecoins.

The most popular stablecoins are Tether (USDT) and USD Coin (USDC) where each equals $1 U.S. Dollar.

These two stablecoins are so popular that they are in the top 6 digital currencies by market capitalization (= price * volume).

For example, as of September 2023, there are $83Bn USDT and $26Bn in USDC circulation.

Considering there were about 2 trillion US dollars in circulation in 2022 in the US that’s 5% of the total supply.

Of course, stablecoins aren’t only used in the US. They are bought and traded internationally.

Benefits of Pegging: Why People Prefer Stablecoins

When Bitcoin, Ethereum, and the like first emerged their plan was to replace the existing monetary system.

Satoshi Nakamoto, the person or group who created Bitcoin, describes Bitcoin in their White paper as being a medium of exchange.

This means Satoshi envisioned us using Bitcoin instead of dollars to pay for our groceries, fuel, concert tickets, and the like.

Bitcoin in particular has created this narrative about being a store of value similar to gold.

However, things haven’t gone exactly to plan.

Neither Bitcoin nor any of its competitors is anywhere near becoming a medium of exchange in mainstream society.

And no cryptocurrency has managed to convince people that it will retain its value. At least in the short term. Cryptocurrencies are just way too volatile.

Stablecoin uses

Stablecoins emerged out of three needs

1. The first was the need to park your money between trades. Say I decide the price of Dogecoin is going to drop. Prior to stablecoins, I would need to sell my Dogecoin for US dollars. But if I wanted to move my dollars to another crypto exchange or wallet I couldn’t. I would need to withdraw the cash to my bank first and then from there move it to wherever I wanted. This added a lot of delays and frustrations. The other alternative would be to convert my Dogecoin to Bitcoin or some other cryptocoin. But Bitcoin is volatile. Who’s to say its value won’t drop while I sit on the sidelines waiting to see what happens to Dogecoin? Stablecoins emerged to address this problem.
2. The second reason is that many people wanted to test or take part in the crypto market but they didn’t want to be exposed to the volatility of cryptocurrencies. A popular way to make money in crypto is to lend your crypto assets to someone else and earn a yield on it. For example, Yearn Finance is an automated crypto platform that optimizes your stablecoin investments by finding you the lending opportunities with the highest interest rate.
3. The third is that you live in a country with high inflation such as Venezuela, Argentina, or Türkiye where it is hard to get your hands on dollars. These countries are seeing wide adoption of stablecoins for peer-to-peer transactions because they act like an inflation hedge.

Efforts to decouple from the dollar

So, ironically, the main medium of exchange in the crypto world is stablecoins which represent a fiat currency.

But the whole point of crypto was to get away from fiat.

There are a number of crypto projects that are trying to find a way to decouple crypto from the US dollar by pegging the value of their token to a basket of cryptocurrencies.

The most famous of these is Olympus DAO but the notion is complicated and hasn’t really caught on. Olympus has a small market cap of $15mn at the time of writing.

How pegging works in crypto

There are three main ways that stablecoins peg themselves to fiat currencies.

#1. Backed 1:1 by reserves

Tether (USDT) and Circle (USDC) both peg their value to the dollar by keeping reserves with equal amounts of dollars to the amount of the circulating stablecoin.

For example, when you buy 1 USDT token, Tether, the company issuing USDT, will take your dollar and keep it in cash or cash equivalents and short-term deposits in a bank account.

Cash equivalents are things like short-term US treasury bonds that you can easily sell for US dollars.

This way if everyone in the world decides to convert their USDT to dollars at the same time, Tether will be able to give them back their dollars.

The fact that all USDT is easy to convert to dollars is what ensures the currency peg doesn’t break.

However, if one day you were to find out that Tether has taken the dollars and done something else with them (trade them, spend them, bet them) then the value of USDT would decouple from the US dollar.

This has happened a few times in the past when markets have been very turbulent and investors start doubting who to trust.

In the past Tether had been accused of not being very transparent. However, they seem to have tidied this up because when you visit their site today an independent auditing firm shows what they invest their reserves in.

Note that it is preferable for reserve-backed stablecoins to have a sizeable portion of non-cash holdings as part of their treasury management. Holding cash in a bank is risky because banks go bankrupt from time to time. When they do they are allowed to use the use cash. They aren’t allowed to use your treasury bills though.

In his interview with Anthony Pompliano, the CTO of Tether, Paolo Ardoino says that they also hold a large volume of reverse repos collateralized by US T-bills. This allows them to have access to liquidity overnight. Say if you suddenly need $10Bn or so.

#2. Collateralized pegging

Collateralized stablecoins are backed by a collateral asset, such as another cryptocurrency or a basket of assets.

The value of the collateral is used to maintain the stability of the stablecoin.

In the event of a price fluctuation, they can liquidate the collateral to stabilize the stablecoin’s value.

This is best understood through an example.

The largest crypto that uses collateralized pegging is MakerDAO and its DAI stablecoin which is a protocol built on top of the Ethereum blockchain.

Here is how it works.

Say you have $1,000 worth of bitcoin and you need someone to lend you money. On MakerDAO you can post your bitcoin as collateral and take out a proportion of its value as a loan, say $500.

If the value of Bitcoin drops you need to top up your collateral otherwise a smart contract will kick in and sell your Bitcoin to get the $500 back.

When they give you $500 they issue it in the form of DAI where 1 DAI = 1 USD.

Because the value of DAI in existence will always be backed by cryptocurrencies that are worth more than the aggregate value of DAI in circulation, DAI will hold its peg.

The cool thing about stablecoins like DAI is that they are automated. They use a core functionality of blockchains called smart contracts to allow them to do this.

My tutorial on MakerDAO and DAI is part of my core module on understanding crypto. I highly recommend you study it in order to grasp how revolutionary this is.

#3. Algorithmic stablecoins pegging

Unlike traditional asset-backed stablecoins that use reserves, algorithmic stablecoins use algorithms to maintain their stability.

These algorithms adjust the supply of the stablecoin based on market demand, ensuring that the price remains pegged to the external asset.

So far Algorithmic stablecoins haven’t worked. The most famous debacle is that of the Terra LUNA collapse.

If you really want to understand algorithmic stablecoins read my post titled What is Terra LUNA.

Pegging is not unique to crypto

The concept of tethering the value of a currency to that of a more dominant one is not new. In fact, it has been used in traditional financial systems for centuries. For example, the Bretton Woods system, established the gold standard after World War II which pegged various currencies to the U.S. Dollar which in turn pegged itself to gold.

For example, there are more than 10 countries today whose central banks peg the value of their currency to the US dollar.

And there have been many failed pegs as well. For example, Argentina has tried to peg its currency to the US dollar multiple times and eventually failed.

How Does Pegging Work in Crypto

Pegging works when there is trust in the system. If I know that reserves back a crypto stablecoin then I can make money from people who don’t believe that.

The biggest stakeholders who help a digital currency maintain its peg are market makers.

Market Makers manage large flows of money and ensure liquidity in the market by buying and selling the stablecoin at the pegged price.

When the stablecoin’s price deviates from the peg, market makers step in to stabilize the price by adjusting the supply and demand of the stablecoin. This helps to maintain the stability of the pegged asset

Stablecoin issuers also use Oracles.

Oracles play a crucial role in pegging mechanisms by providing external data to the blockchain.

They act as trusted sources of information, such as exchange rates or asset prices, which are necessary for maintaining the peg.

Oracles fetch this data from various sources and feed it into the smart contracts that govern the pegging mechanism.

Hard Pegs vs. Soft Pegs

• Hard peg: is when you peg the value of your assets to an external reference like the US dollar at a fixed exchange rate with no room for flexibility. Your aim is for your crypto to always equal a dollar. USDT, USDC, and DAI are hard pegs.
• Soft peg: when you need some flexibility. The Chinese yuan, Venezuelan Bolivar, and Hong Kong Dollar have a soft peg to the US dollar. This means that even though their currency is backed by US reserves they want to have the flexibility to manage the amount of money available in the economy depending on inflation. So they might allow the peg to vary between 1-2%.

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