The violent price swings witnessed in the crypto market is part of the reason why virtual currencies haven’t found favor in the public’s eye. While the volatility can result in quick gains, unexpected losses are also inevitable. This explains why digital currencies are more speculative investments than a store of value. It’s even harder for merchants to accept cryptocurrencies as payment due to their dynamic prices.
However, the recent entry of pegged cryptocurrencies is proving to be a solution to the crypto market’s volatility. In fact, they have the potential to win more investors into the virtual currency space, making digital assets acceptable across the world. But what exactly is a pegged cryptocurrency?
Pegged Cryptocurrency Overview
Pegging is a financial concept whereby an unstable asset is tied to a more stable asset to mitigate volatility.
Similarly, when a digital currency’s value is tied to that of some other medium of exchange, it is said to be pegged. Usually, the coin is tied to a stable fiat currency such as the US dollar, gold, or any other bank-issued currency. Tether is an ideal example of a pegged cryptocurrency whose value is tied to the US dollar.
In addition to being an alternative store of value, pegged cryptocurrencies help compliment the typical cryptocurrency trading.
If, for instance, you made huge gains from trading volatile cryptocurrencies but fear that the gains might evaporate soon, you can safeguard your gains by trading them for Tether tokens, usually denoted as USDT. This way, even if the dollar loses its value, the price decline won’t be as huge as that experienced in the digital currency market.
Also, in a bearish market, pegged cryptocurrencies can be used to increase the number of tokens/coins in your portfolio. This is especially true because a pegged currency’s value isn’t affected when the market dips. But since it’s still available in the crypto market and has not been exchanged into fiat currency, you can leverage on the dip by making more purchases to increase your coin/token holdings.
How Crypto Pegging Works
Cryptocurrency developers wishing to peg their tokens to a stable asset must at all times have the actual asset in reserve as proof of pegging. This is to say that if a cryptocurrency is backed by gold or the US dollar, the project developers should have vast amounts of gold/dollars in vaults to guarantee the pegged value of their tokens.
In the case of Tether, each token of the coin is tied to the value of one US dollar. Should the coin fail for some reason, investors can then go to developers to claim a refund that is proportional to the number of tokens that they held.
Benefits of Pegged Cryptocurrencies
There is more to pegged cryptocurrencies than just being an alternative hedge against market volatility.
- Improved Liquidity
Compared to typical cryptocurrencies, pegged tokens can be liquidated easily and faster. This is especially true for coins pegged to a fiat currency. They serve as a liquidity vent through which other digital currencies can be swapped for more stable assets.
- Offer Affordable Remittance Transaction Cost
Sending remittances overseas is characterized by high transaction costs. If you are sending the funds in the form of digital currency, for instance, Bitcoin, the process is overly slow and sometimes expensive. It becomes even more expensive when you factor in the volatility of the coin, which may result in the recipient receiving less than the amount expected. At the same time, sending fiat currencies overseas has its own challenges, such as an amount limit which you can send at any given time, as well as accumulating transaction costs.
Pegged cryptos, on the other hand, offer the best of both worlds. First, they are less affected by the market movements, which helps minimize transaction fees. Also, since they are virtual currencies by nature, they aren’t affected by remittance transfer limits.
As such, they can be transferred to various jurisdictions in an affordable process compared to money transfers. Once you consider the foreign exchange-swapping hurdles that plague fiat currency transfers, it becomes even clearer as to why pegged cryptocurrencies are the most viable option.
Risks Associated with Pegged Cryptocurrencies
One of the biggest risks associated with pegged cryptocurrencies is investors can never be sure if a coin is backed up by real funds. For this reason, before investing in a pegged cryptocurrency, note that it is not enough for a developer to simply claim that their coin is pegged. They must be transparent with their reserves by providing physical proof that the backup funds are available. Ideally, the developers should be open to third-party audits of their financials to verify that indeed the coin is backed up by a stable medium of exchange.
Also, the fact that a coin is backed up by physical funds stored in large amounts is a problem in itself. It means that the funds are prone to theft and can even disappear for some other reason, causing a decline in the token’s value. Such cases mainly affect gold-pegged cryptocurrencies. Therefore, investors should examine the credibility of who stores the gold of a particular coin and where it is housed.
For coins pegged to a fiat currency, the government doesn’t take kindly to developers linking a product to the value of a central bank currency. To successfully peg their currency, the developers are required to obtain the necessary paperwork and license as well as maintain a public record of their holdings. So, be sure to check the whitepaper of a pegged crypto to ascertain whether it maintains compliance.
At the same time, it is pretty hard to make profits from a pegged cryptocurrency. This is because the buying and selling price of the digital coin has the same value as that of the fiat currency. It’s probably the reason why developers fail to convince investors to store their assets in digital tokens instead of fiat currency.
Unfortunately, there have been only a handful of successful pegged cryptocurrencies in the market. Nonetheless, it’s undeniable that they play a vital role in bridging the gap between the crypto-space and the traditional economy. With time, as more developers continue to launch pegged cryptos, their role will be appreciated and eventually bring in more investors in the market.