Important Aspects of Stablecoins: The Difference Between Pegging, Collateralization, and Redeemability

Stablecoins have been making the headlines in recent months, attracting big investors, tempted by the allure of a on ‘non-volatile’ cryptocurrency. At first, we usually pay attention to the backing connection, in other words, to the coin’s  stabilizing mechanism. Broadly speaking, this is broken down into 3 categories: asset-backed (including fiat), crypto-backed, and non-backed stablecoins (including algorithms and the Seigniorage shares’ approach).

This is a great way of introducing the concept of stablecoins and a good basis for providing an overview, but it doesn’t paint a full picture in terms of how the composition of stablecoins can ultimately affect its utility and usability. To do this, we need to include 3 additional, but equally important, aspects into stablecoin discussions, i.e. pegging, collateralization, and redeemability.

These 3 aspects provide a more rounded explanation of how stablecoins work, how they are constructed, and how their utility and usability ultimately depend on it.

Pegging

What is pegging?

Pegging is commonly associated with the world of foreign exchange, where the currency of one country is fixed or “pegged” to that of a country with a more stable economy. The main goal of currency pegs is to bring stability to more volatile economies, but it’s also a beneficial mechanism for trading partners to make exports more competitive while keeping import costs down.

Currency pegs stem from the Gold Standard that originated in early 18th century England, and the Bretton Woods agreement that was implemented after World War 2. Under this agreement, most Western European countries fixed (or pegged) their currencies to that of the United States, who in turn pegged the US Dollar to gold. Although the agreement was finally dissolved in 1973, it was very effective in the post-war era to stabilize economies and promote growth.

With cryptocurrencies today, we see the idea of stablecoins, such as USDVault, TrueUSD, Tether, Circle, Gemini, and Paxos Standard pegging 1:1 to a steady fiat currency like the US Dollar.

But the phenomenon is also still present in a traditional economy. Many countries use pegging to fix their currency, most commonly to either the USD or EUR. Very rarely though is it 1:1. Examples include the Hong Kong Dollar, pegged to the USD at a rate of 7.75 to 7.85, and the Danish Krone pegged to the EUR at 7.46.  

Different types of pegging

There are different types of pegging mechanisms and not all pegs are a 100% fixed.

Crawling peg

A crawling peg is a fixed exchange rate but one that is allowed to fluctuate between the par value of the pegged currency and a range of predetermined rates. The par value may be periodically adjusted to account for inflation and other market conditions to increase stability. This allows an exchange rate to adjust over a period of time instead of a sudden currency devaluation.

A commonly referenced example, refers to Mexico, which implemented a crawling peg against the USD in the 1990’s. This allowed it to gradually devalue its currency (hence the term crawl) over time, until it reached an acceptable exchange rate, thereby avoiding economic instability associated with dramatic currency devaluations.

Adjustable peg

An adjustable peg is also a fixed exchange rate, but one that that has a predetermined level of flexibility built into it (normally between one and two percent). If the rate moves beyond this range, the central bank will intervene to bring the rate back to the target peg. The goal is to allow a country to stay competitive in the export market.

Many developing Asian nations have been known to operate such an exchange rate regime in the past, including Indonesia, Malaysia, the Philippines, and South Korea, to restrict the degree of fluctuation towards the dollar and to allow for cheap exports.

Basket peg

With a basket peg, a currency will be pegged to more than one currency in a weighted mechanism, comprising currencies of its most important trading partners. The reason a country might use a basket peg is the same reason an investor would diversify their portfolio; to make the currency even more stable and hedge against the risks a single pegged currency might face when the anchor currency suddenly devalues, such as high inflation.

Examples here include the Chinese RMB, which is pegged against a basket of 24 different currencies, and the Fijian Dollar, which is pegged against five different currencies.

Commodity peg

A currency can also be pegged to a reliable commodity, such as gold. For many years, before WW2 and the Bretton Woods agreement, the Gold Standard was widely used to stabilize currencies. However, governments and economists believe the practice can actually stifle growth. Although central banks might still hold some gold as a form of backing, the last currency to decouple from gold was the Swiss Franc in early 2000.

Many cryptocurrencies have been designed with a Gold Standard style mechanism in mind, where one token would be backed by a specific quantity in gold, such as Digix and OneGram for example. That has mixed results, because for investors, prices of commodities are not a relevant unit of account. It doesn’t necessarily have to be gold. Venezuela launched the Petro, an oil-backed cryptocurrency pegged to the price of barrels of Venezuelan crude oil.

Collateralization

What is collateralization?

Collateral is defined as “To offer an asset as a surety that a debt will be repaid.” Basically, it’s the asset that the borrower leverages to secure a loan from the lender. The most common example we’ll all be familiar with is mortgages, where the bank customer is able to obtain a loan to buy a house based on the provision that the bank may repossess the house if the customer defaults on their repayments. The house serves as backing or security on the loan and reduces the lender’s risk.

The same principle can be applied to car financing, buying jewelry, or art. Businesses can also leverage their existing equipment to obtain financing. With stablecoins, the collateral refers to the commodity or fiat (i.e. USD, EUR). For every fiat collateralized token a platform issues, they should hold an equal amount of fiat currency as collateral, but this is not always the case, as we’ll see later. The same goes for commodity-backed assets, for every token a gold backed stablecoin platform issues, they should hold an equal value of physical gold as collateral, but, again, this does not always happen.

Difference between backing and collateral

When a currency is backed by another commodity or asset, it does not necessarily mean the holder of the currency has that surety to exchange it, or have a claim on, the backed commodity. If we look at the Venezuelan Petro, example above, a holder of Petro tokens cannot exchange it for a physical barr