Hard Peg vs Soft Peg Mechanisms: Maintaining Price Points in Crypto

Have you ever thought of how global currency rates work? Why the exchange rate of some currencies remains at a steady level while the graphics of others follow some crazy unknown formulas?

The point is, the exchange rate regime applied to a currency strongly depends on the pegging mechanism that the authorities of the given region apply.

At this, hard peg vs soft peg mechanisms define how volatile the currency will be.

In this article, we are going to investigate how hard and soft peg systems work, how they correlate with overall economic stability, and how these mechanisms apply to cryptocurrencies.

What Is a Peg Mechanism?

A currency peg refers to a fixed exchange rate of a currency versus foreign currency or a basket of assets. 

Defined by local authorities and central banks, it represents an important part of national policies aiming to stabilize the economy and improve the nation’s wealth. 

At this, countries tend to peg their local currencies to larger and stronger economies. This helps local businesses access global markets at lower risks, reduces inflation rates, and contributes to the economic growth of the region.

The US Dollar as the world’s most dominant means of transferring value, represents the most popular asset that other currencies peg to. 

For example, in 1967, Australia abandoned the sterling standard that it’s been using for years before that. Instead, it implemented Australian Dollar (AUD) pegged to the USD at the rate of 1 AUD = 1.12 USD. The rate has significantly changed since then as AUD turned into a free floating currency in 1983.

Similarly, the Hong Kong dollar is pegged to the US dollar. The initial pegging ratio implemented in 1985 equaled 7.8 HKD per 1 USD. Though the currency has been through ups and downs over the years, today the rate remains practically the same.

It’s important to add that the rate does not have to be neatly fixed. At this, a currency can come with a hard or soft peg.

Hard Pegs for Currencies

With a hard peg method, it’s up to the government to define the exchange rate for a local currency. Thus, a hard-pegged currency’s value remains the same in comparison with other currencies.

Yet, the exchange rate remains fixed only while the economy is stable. If the market conditions result in high inflation or the governments can no longer maintain the peg, currencies may start to float.

The advantages of this approach are as follows:

• Simplicity. As authorities control the exchange rate, they know how large the supply of the currency is. Thus, the implementation process becomes much easier.
• International trade. Hard pegging makes trading easier for countries that have mutually fixed the exchange rate for their local currencies. As a result, both parties prosper.
• Economy boost. Finally, both businesses and individuals can freely exchange goods and services without any fear of the local economy’s decline. At the same time, this stability attracts foreign investors. This helps to boost economic growth and contributes to the state of the overall wealth.

There are disadvantages to this approach, too:

• Dependence on foreign currency reserves. In order to control the exchange rate and avoid its spikes, authorities have to hold large amounts of foreign currency. Obviously, this is not always possible, especially in unstable market conditions.
• The lack of stability in extreme situations. If the peg is too low, the purchasing power of the local citizens will go down as they won’t be able to afford to buy imported goods. In the opposite situation, the flow of imports will increase. Authorities, in turn, will have to sell their foreign currency reserves to protect the peg. If the reserve currency is not sufficient, the peg will collapse.

Soft Pegs for Currencies

In a similar fashion, the soft peg serves to stabilize the rate of the currency with respect to another asset. 

Yet, the soft peg provides some level of flexibility. The exchange rate may float to a limited extent helping governments deal with economical challenges. Typically, the rate may fluctuate between 1% and 25%.

Chinese yuan is, perhaps, the most famous historical example of a soft-pegged currency. In the period between 1994 and 2005, it was pegged to the value of USD at a rate of 8.28 yuan per US dollar with a narrow band of fluctuation allowed.

Under specific conditions, the soft pegging mechanism may be really advantageous:

• Higher stability. Soft peg currency can help to reduce volatility in the regions where it is particularly high and thus reduce the inflation rate.
• Higher usability for cryptocurrencies. Stablecoins mostly rely on the soft-peg method to maintain their rates. This method makes cryptocurrencies more applicable for daily use.

The risks include the following:

• Lower protection against abrupt market movements. With unstable economies, soft-pegged currencies may drop in value resulting in the worsening of the whole situation.
• Higher vulnerability to financial crises. The risks of soft-pegged currencies’ devaluation are much higher than those of hard-pegged ones.

Fundamental Difference: Hard Peg vs Soft Peg

In a nutshell, the key differences between soft-pegged and hard-pegged currencies are represented in the table below:

Peg Mechanisms in Crypto

In the context of cryptocurrency, a "peg mechanism" refers to a mechanism or system that maintains a stable value relationship between a cryptocurrency and another asset, usually a fiat currency like the US dollar or a commodity like gold. The purpose of a peg mechanism is to reduce price volatility and provide stability to the cryptocurrency.

There are different approaches to implementing peg mechanisms in cryptocurrencies. One common method is through the use of stablecoins, which are cryptocurrencies designed to maintain a stable value. Stablecoins are typically pegged to a specific asset or a basket of assets, and their value is often backed or collateralized by reserves held by a centralized entity or through smart contract mechanisms.

For example, a popular type of stablecoin is the "USD-pegged stablecoin," which aims to maintain a 1:1 value ratio with the US dollar. When the price of the stablecoin deviates from the peg, various mechanisms such as issuing or redeeming additional tokens, adjusting the collateral ratio, or market interventions may be employed to restore the pegged value.

Hard Peg vs Soft Peg for Stablecoins

In crypto, the essential mechanics of pegging are the same.

Here this process implies linking the value of a digital asset to another currency or a basket of currencies.

Just like with traditional fiat currencies, the majority of stablecoins are pegged to the USD. Other variations exist as well, though. For example, some cryptocurrencies such as Pax Gold or Perth Mint derive their value from gold

Some of the key mechanics that stablecoins use to maintain their peg include the following options:

• Via fiat collateral. Centralized stablecoins such as USDC or USDT mint new coins whenever someone sends fiat dollars to their vault.
• Via crypto collateral. Similarly, crypto-collateralized stablecoins rely on collateral in the form of digital assets.
• Via algorithms. Finally, algorithmic stablecoins such as USDL rely on redemption mechanics to maintain a stable rate.

Regardless of the stabilizing mechanics, the majority of stablecoins represent soft-pegged digital assets. 

At this, even the value of the most popular stablecoins may fluctuate. Whenever some black swan events occur, its rate may experience a sharp decline. 

For example, in March 2023, one of the most popular fiat-collateralized assets USDC lost its peg for a few days after the collapse of its major lender Silicon Valley Bank.

Is there a way to eliminate such risks? How can a digital asset maintain a hard peg and provide the needed level of stability regardless of any external events?

How Does the Pegging Mechanism Work for USDL?

The Liquid Loans protocol features a decentralized algorithmic stablecoin which is fully-backed and redeemable for PLS.

USDL has both hard peg and soft peg mechanisms.

USDL has a hard peg at $1. Anytime the price of USDL drops below $1, users are incentivized to buy it back at a discount and redeem it for $1 worth of PLS.

By doing this, they earn profits for themselves in the form of crypto arbitrage meanwhile pushing the price back to $1.

USDL also has a hard peg under $1.10. If the price of USDL were to go above $1.10, users are incentivized to open a vault, mint USDL and sell it on the market. This way they can make a quick profit, without necessarily ever having to pay back their loan. 

USDL has a soft peg towards $1 as well. When redemptions increase, meaning the price of USDL is likely under $1, the borrowing fees increase. This discourages borrowing and decreases the total supply of USDL.