The growing popularity of “pegged” cryptocurrencies is directly related to the active development of decentralized finance (DeFi). We will look at what binding is, how it works and what it is for.
“Peg” or otherwise “fixed rate” is a direct borrowing of experience from the traditional financial system. To simplify mutual settlements, the value of an asset or currency is fixed (pegged) to the value of another asset or currency in a certain proportion, and the pegging coefficient is fixed.
In particular, the stability of the currency was maintained in this way. To this end, the peg was used by some countries to attract investment and trade for themselves, since an unstable currency is inconvenient and unprofitable for commerce.
Binding in cryptography
In the process of linking, the cryptocurrency becomes the underlying asset, and its value is tied to some external asset: fiat currency, financial instrument, commodity, etc. Such coins are called stablecoins. The most famous and most capitalized stablecoins are pegged to the US dollar, the dominant global currency.
Initially, cryptocurrencies were almost the exact opposite of fiat currencies. Instead of rigid centralization and control, they offered the greatest possible freedom, which was achieved through decentralization. In the crypto community, fiat currency is often viewed as an adversary of digital assets and does not welcome attempts to centralize digital money.
Then why do you need a binding? Moreover, now it is technically easy to directly exchange LTC to BTC or dozens of other coins, bypassing the dollar? In fact, everything is quite simple and extremely pragmatic. Pegging to an external asset ensures the stability of the coin.
The past two years have provided an unprecedented example of extreme volatility. In the fall of 2021, Bitcoin hit an all-time high of $69,000. The example of the flagship was followed by altcoins and demonstrated an enchanting parade of highs. In 2022, the market also collapsed simultaneously, yesterday’s stars lost 50-60% of the value and more, the price of Bitcoin fell inexorably and now the #1 coin is trading below $17,000.
Pegging creates a stable environment for cryptocurrencies and the ability to protect capital in conditions of high volatility. In addition, stablecoins are much more convenient for everyday payments.
Types of stablecoins
There are several types of stablecoins in use today:
- Fiat backed stablecoins. Such coins must have a reserve of the fiat currency to which they are pegged. As a rule, the security ratio is 1:1. USDT, USDC, BUSD are pegged to the US dollar and 1 unit of each of these coins is equivalent to 1 US dollar.
- Commodity-backed stablecoins. This group includes coins backed by precious metals, crude oil and some other assets. Coin holders make a profit if the commodity rises in price.
- Cryptocurrency-backed stablecoins. Cryptocurrency stablecoins provide excess collateral for an existing digital asset in order to maintain a stable market price. To receive a coin of this type, the user makes a deposit. The coins are locked in a smart contract, and the user receives a certain amount of stablecoins. When the need for stablecoins disappears, they can be returned to the smart contract and the collateral asset returned.
- Algorithmic stablecoins. They are not tied to real-life external assets. The supply of tokens is controlled by smart contracts and algorithms. When the price of a coin falls, the algorithm reduces the issuance of stablecoins and vice versa.
What is depegging?
However, in practice, maintaining the ideal ratio is not always possible. Suppose the value of a dollar stablecoin falls below $1. In this case, a scenario with loss of binding is possible – depegging.
Unbinding is an extremely unpleasant event for a stablecoin. At the very least, this raises many questions about the effectiveness of the currency, and at the most, it turns into a disaster. Algorithmic stablecoins are more vulnerable to rapid market falls.
When the rate of market decline outstrips the algorithm, the peg is quickly lost, and then the fate of the coin is very sad. This is exactly what happened with the algorithmic stablecoin Terra UST. The coin rapidly depreciated, which provoked a panic on the exchanges. Against the backdrop of general panic, even the most liquid centralized stablecoin, USDT from Tether, deviated from the peg. It is noteworthy that its competitor – USDC – was almost unshakable.
Fiat-backed stablecoins also have their weaknesses. If the issuer for some reason cannot maintain the ratio of the stablecoin to the underlying asset, depegging the coin is possible. To prevent this from happening, up-to-date information on the state of reserves should be open, but issuers are extremely reluctant to make it public.