In the currency markets, pegging refers to the creation of an exchange rate policy between different currencies, where one currency is set at a fixed rate against another to ensure stability.

We have a similar concept in the cryptocurrency markets, where a stablecoin’s value is linked to an external asset, typically a fiat currency. This is known as hard pegging and allows the value of the stablecoin to remain stable. 

In this guide, we’ll explore what hard pegging in crypto is, its advantages and disadvantages, and its importance in the crypto markets. 

What Is Hard Pegging in Crypto?

Crypto asset prices can get quite volatile, making cryptocurrency usage challenging for purposes such as borrowing, lending, and making payments. To close this gap, stablecoins were invented to offer a crypto asset that holds a stable value during market volatility.

A stablecoin is a cryptocurrency whose value is tied or pegged to a fiat currency like the US dollar or a commodity like gold. Thanks to price-pegging, stablecoins offer an alternative to volatile cryptocurrencies like Bitcoin (BTC), which is less favorable for day-to-day transactions.

The reserve assets used to provide stablecoins with stability act as collateral. This means stablecoins have a fixed 1:1 ratio to the asset backing it. For instance, Tether (USDT) is a popular stablecoin pegged to the US dollar on a 1:1 ratio. So, for every 1 USDT in circulation, there is $1 held in reserve in cash or near-cash US dollar-denominated assets.  

USDT’s backing with US dollars is an example of hard pegging in crypto, as it ensures the stablecoin’s value remains stable and doesn’t fluctuate. So, the cryptocurrency should always maintain the same value as the asset it’s pegged to. 

Hard Peg vs. Soft Peg: What’s the Difference?

Soft pegs work in a similar manner as hard pegs. However, a soft peg mechanism permits slight variations in the value of a pegged commodity or currency and its peg. The soft peg typically stabilizes the currency’s rate with respect to another asset, providing some flexibility, unlike a hard peg, where the rate is fixed. 

However, cryptocurrencies commonly start with a fixed rate and then fluctuate freely over time under market conditions. Soft pegs are, therefore, used to stabilize a cryptocurrency’s utility by offering a value with a given range against its reserve currency. As such, a soft peg in crypto has an exchange rate policy that accedes slight flexibility between the pegged cryptocurrency’s value and its peg. 

An example of a soft pegging of fiat currencies occurred between 1994 and 2005 between the Chinese Yuan and the US dollar. The Chinese Yuan was pegged to the US dollar for over a decade and was apprised to appreciate by 2.1% against the dollar after 2005.

In the crypto market, Tether is a good example of a cryptocurrency with both a hard and soft peg. While it is hard-pegged against the US dollar in theory, given its collateralization, in reality, it has a soft peg that moves slightly above or below one dollar, depending on market conditions and the investor community’s trust in the stablecoin.  

Advantages and Limitations of Hard Pegging In Crypto

Let’s take a look at the pros and cons of hard pegging in the crypto markets. 

Pros 

  • Eliminates volatility: Cryptocurrency tokens pegged to another asset don’t suffer from extreme price volatility, which is common with unpegged crypto assets. 
  • Stability: Hard pegging provides cryptocurrencies with stability depending on the kind of asset backing, eliminating price fluctuations.
  • Utility: Hard-pegged cryptocurrencies can be used to facilitate day-to-day borrowing, lending, payments, and remittances due to their price stability. 

Cons

  • Depegging: Pegged cryptocurrencies can depeg – an event that occurs when the reserves backing a cryptocurrency aren’t sufficient to back every token issued. This can lead to a loss of trust and confidence from the token holders.
  • PESTLE analysis: Hard pegging in crypto doesn’t consider political, economic, social, technological, legal, and environmental factors that may influence the utility of the pegged currency or asset, such as deflation, devaluation, inflation, political instability, or regulation. 
  • No price appreciation: Fiat-pegged cryptocurrencies don’t enjoy new price appreciation or discovery beyond their peg, which hinders their potential as a store of value or a meaningful investment vehicle. 

Why Is Hard Pegging in Crypto Necessary?

Hard pegging in crypto is very important as it helps eliminate price volatility, providing stablecoins with the ability to offer a price-stable digital currency that can be used for payments, remittances, and in the lending markets.