What Is Peg in Crypto? The Mechanism Behind Stablecoins

Stability becomes a matter of utmost importance in the world of crypto, where volatility can rock the market. For major cryptocurrencies like Bitcoin and Ethereum, the price is determined by forces such as supply and demand. This is a major reason why the crypto market is susceptible to high price swings.

While volatility can be leveraged by opportunistic traders, it remains a huge barrier for these crypto assets to be adopted for mainstream applications. It is here that the concept of peg comes into play. In cryptocurrency, a peg is a mechanism used to anchor a digital asset’s price to a more stable real-world asset like a fiat currency or precious metals like gold and platinum.

It is on this stable bedrock that the entire stablecoin segment is built. This bedrock, in essence, provides the necessary stability for these digital assets to be made useful in practical applications like everyday transactions and global cross-border finances. In this article, we will look in detail into the nuances of what a peg is in crypto.

Why Pegging Matters in Cryptocurrency

The purpose of pegging a cryptocurrency to a more stable asset is to introduce predictability into an otherwise volatile asset. It is impractical to employ a currency that will drop or rise in value within a matter of days. The real-world transactions do not play by the rules of cryptocurrencies. It is here that the concept of pegging gains value.

For instance, pegging an asset to a fiat currency like the US dollar can stabilize its value while enjoying the benefits offered by the underlying blockchain of that cryptocurrency. This is what creates and applies practicality to stablecoins like USDT and PAXG. In more detailed terms, by pegging a crypto asset with a real-world asset without much volatility or having practical application like fiat currency, the process achieves a practical medium of exchange, a reliable unit of account, and a store of value within the crypto ecosystem.

When we look at peg in crypto, the use cases are far beyond that of simple transaction practicality. For DeFi (Decentralized Finance) ecosystems to exist and function, pegged cryptocurrencies are a necessity. These pegged assets provide the DeFi ecosystem with the option to be devoid of centralized assets like fiat for trading, staking, lending, and borrowing. In addition to this, since DeFi ecosystems are deployed all over the world, stablecoins ensure that transactions do not carry the delay and costs of traditional fiat currencies or other assets.

In essence, pegged stablecoins eliminate market volatility while enabling faster and cheaper cross-border transactions, which are essential to the DeFi ecosystem. In addition to this, countries with fiat currencies that face high inflation rates, a stablecoin pegged to something like the US dollar can offer a safe hedge against this inflation. This protects the purchasing power of the people in such countries, and crypto assets get more exposure in such countries.

How Stablecoins Maintain Their Peg

There are several distinct methods used to maintain a stablecoin’s peg. Each of these distinct methods carries its own risks and benefits. We will go through each of these in this section in detail.

Fiat-Backed Stablecoins Explained

One of the most straightforward and common methods used to peg a stablecoin is by fiat collateralization. Some examples of stablecoins thus issued are USDT, USDC, BUSD, etc. These are backed by respective reserves of fiat currency and cash equivalents like the U.S. Treasury bills.

The underlying assets, like fiat, cash, or Treasury bills, are issued by a central authority. For every stablecoin issued that is pegged to such an asset, a reserve is opened where an equal value of the underlying asset is stored safely.

The peg is enforced through a redemption mechanism and market arbitrage. We will now look at its workings with an example. We will use USDT, which is pegged to the US dollar, as an example.

When USDT’s price drops below the $1 peg (for example, to $0.98), arbitrageurs are encouraged to buy the undervalued USDT. These arbitrageurs can then sell the USDT on the open market and redeem the full $1 from the issuer. This buying pressure drives the price back up. When prices increase above $1, the issuers can mint more USDT and sell them on the open market to create selling pressure and bring the price back to $1.

This model of pegging relies on the trust and transparency of the centralized issuer to hold the promised reserves and undergo regular audits. To cite an example of the risks associated with this type of pegging, we can take a look at the 2023 Silicon Valley Bank collapse, where a portion of USDC’s reserves were held. This led to a temporary depeg. However, since there was enough transparency and audits, the matter did not affect the credibility of USDC.

Collateralized Crypto Pegs and How They Work

Unlike the case of USDT and USDC, this is a more decentralized approach to building a stablecoin pegged to a basket of other, more volatile cryptocurrencies. These are then locked in smart contracts. To account for the volatility of the assets inside the basket, these stablecoins are often overcollateralized. For instance, if $100 worth of stablecoin needs to be minted, a total of $150 worth of Ethereum or Bitcoin, or any other volatile crypto asset, may be required. This is to help offset the price volatility of the collateralized crypto asset from crashing the stablecoin’s value.

As an example, MakerDAO’s DAI is the most popular stablecoin, which is pegged to crypto collaterals.

The Risks Of DePegging

A depeg is a situation where the stablecoin loses its link to the underlying or collateralized asset. A situation of stablecoin depeg can be triggered by multiple reasons.

Insufficient reserves remain the most prominent cause of a depeg. For collateralized stablecoins, a lack of transparent and sufficient reserves can quickly lead to a loss of trust. This case becomes extremely amplified in a bank run case, where mass redemptions can worsen the situation quickly. 

Market manipulation in the case of smaller and low-liquidity projects often causes depegs. This is commonly found with crypto collateralized stablecoins. This happens when large market makers purposefully manipulate the market to raise or lower the value of the stablecoin to their liking.

Market volatility is the third most likely reason that can cause a depeg. Extreme volatility in the broader crypto market can stress even well-designed systems. This causes temporary depeg as arbitrage mechanisms struggle to keep up with sudden price movements.

Conclusion

The concept of peg is a vital innovation in the world of crypto assets. This has transformed the stablecoin ecosystem from a niche trading tool into a central component of the global financial ecosystem. Today, stablecoins power remittances, online payments, and corporate treasury management.

It is obvious that in the future, pegging will witness continued experimentation and refinement. The peg in its various forms will continue to be the essential link between the world of cryptocurrency and the stability required for broader financial integration.

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