All You Need To Know About Pegged Assets
We will examine what are pegged assets. You will find out why it is advantageous to use pegged assets, what are the pegging mechanism, the types of assets, and more.
Pegged assets are a kind of crypto derivative. They derive their price from an underlying asset, which can be another cryptocurrency, fiat currency, or, for example, a precious metal. Pegging is done usually to represent an asset in its non-native environment - like fiat currencies on a blockchain, which otherwise could not exist.
These representations can be used in a variety of ways and solve problems such as high volatility of most crypto assets or difficult transfer of liquidity between different asset classes.
- Pegged assets have a fixed price to an underlying asset (fiat, commodity, another crypto, etc.)
- Types of pegged assets include stablecoins, wrapped coins, commodity assets, and crypto derivatives.
- Stablecoins allow users to mitigate volatility without having to exchange crypto for fiat
- Assets maintain peg by backing, market interventions, or algorithms
- Depegging occurs when the price deviates from the underlying asset
Why peg an asset?
It is a fair question to ask ourselves as to why would one want to hold a non-native asset. Crypto is very different from traditional finance, but at a certain time, similar problems arise. The problem leading to the creation of stablecoins was volatility.
A coin representing the stable value of a centralized currency without the need to actually buy the currency itself. Stablecoins were a game changer for people wanting to escape volatility and at the same time, not exit crypto. With the rise of DEXs (decentralized exchanges) swapping a volatile currency for a stablecoin became much easier and more direct.
Types of pegged assets
Cryptocurrency assets designed to hold value 1:1 to a certain fiat currency, typically USD. There are various types of stablecoins with different peg sustainability.
Popular centralized stablecoins include USDT (Tether), USDC (Coinbase), and BUSD (Binance). These centralized options involve a third-party custodian, who is issuing the coins and holds an equal value in fiat reserves. A centralized entity (custodian) is usually an organization that is run by a single person/small group and manages assets on users' behalf. Easy solution, but still includes the risk of non-verifiability of the reserves and the need to trust the third party.
More decentralized options are available - the most prominent is DAI, issued by Maker protocol. DAI is generated from over-collateralized loans and backed by Ethereum-based assets. Other examples: Ampleforth, FRAX, USDD
Wrapped coins and tokens
Representation of an asset on its non-native chain. Let's say I have some BTC and want to trade it on an Ethereum-based DEX. I will need to use a wrapped version of BTC (wBTC) to operate with BTC on the Ethereum blockchain. Wrapped versions also track the price of an underlying asset, but the asset in this case is a cryptocurrency.
Most wrapped tokens are created in a similar way as centralized stablecoins. A custodian receives BTC and issues an equivalent of wBTC on the Ethereum blockchain. The problem is the same - requires authority, not permissionless.
Backed by a real-world commodity like a precious metal. The most popular choice are gold-backed tokens, acting as a hedge against the volatility of both crypto and fiat assets. Examples include Tether gold (XAUT) or PAXOS gold (PAXG).
Act as a representation of your assets in a staking pool. The user is issued an equal amount of staked derivative, which should be redeemable 1:1 at all times. This is done through a smart contract, so there is no need to put your trust in a custodian.
How do assets maintain their peg?
There are various mechanisms to ensure that the price of a pegged asset remains close to the reference:
Sufficient backing - refers to holding a certain amount of assets by a custodian, who then issues the same amount on a blockchain. The backing has to be 1:1 and the custodian must be fully transparent.
Market interventions - issuer may buy or sell the asset on an open market to influence the price. However, assets like this raise some reliability questions. Market interventions are usually done in case other peg mechanisms are failing.
Algorithmic stabilization - usually done by algorithmically adjusting the supply of the asset. When the price is below the peg, assets are burned. In the opposite situation, more tokens of the same asset are minted to reduce the price. Algorithmic stablecoins are somewhat controversial since only a small fraction of projects actually worked. Examples include Ampleforth, Empty set dollar, or the once-great UST.
Hard peg vs soft peg
A hard peg refers to a fixed exchange rate for the underlying asset. These assets should have minimal, or no price fluctuation whatsoever. Hard peg is usually achieved through 1:1 backing on a single asset type (USDT)
A soft peg allows for a bit more price fluctuation. It is subjected to open market conditions and should have control mechanisms in place to prevent high volatility. A CDP (collateralized debt position) stablecoin like DAI has a soft peg, also because it is backed by many types of assets instead of just one.
Depegging occurs when the market price of pegged asset differs from its designated price. This can happen for a variety of reasons, including a lack of liquidity in the market, a lack of trust in the issuer, or a change in the underlying economic conditions.
It's important to note that depegging can be a very disruptive event and it can affect not only the holders of the pegged asset but also the overall crypto market. A recent example of this was the depegging of the Terra Luna stablecoin UST in May 2022.
Where can I buy stablecoins?
What are the risks of using pegged assets?
The main risk is pegged assets becoming volatile and losing their peg. When involving a third-party custodian you are exposing yourself to a risk of rug-pull or bankruptcy of the said custodian. On the other hand with decentralized assets, you have to consider smart contract risks, such as bugs or hacks.
How can I minimize the risk of depegging?
When using a centralized option, look for a transparent and verifiable issuer. With decentralized assets, it is important to verify, if the platform you are using has regularly audited code and is battle-tested (new projects are much riskier). If depegging actually occurs there is not much you can do about it, so it is better to leave the asset altogether.
Which is better, centralized or decentralized stablecoin?
Both have their strengths and weaknesses. Centralized stablecoins are overall more used and easier to purchase, however, pose a risk of third-party custodian. Decentralized options are safer in the means of privacy and transparency, but are still in the early stages of development. That means the underlying algorithms could potentially prove unstable - as was the case with UST.
Where can I buy wrapped BTC?
On centralized exchanges such as Coinbase, Binance, or Kraken. But the main feature of wBTC is that it can be traded and used on the Ethereum blockchain - so decentralized exchanges are better suitable for this job.
Are staked derivatives safe?
Depends on the provider of the staking pool. Generally speaking, staked derivatives are safer than centralized stablecoins, but still contain smart contract and depegging risk.