Sunday, December 26, 2021

Let’s Talk About ‘Pegged’ Crypto Assets

This past week has seen some of the most difficult fluctuations in the cryptocurrency markets, and investors are looking everywhere for answers. With the declining market, opportunities are great for purchasing assets at a discounted rate.

Like the stock market in certain ways, many similar lessons can also be learned from the crypto markets.

But not all investors are as enthusiastic and optimistic about the future of the cryptocurrency space, especially for those with large positions in altcoins that have taken major hits over the past weeks.

This leads a lot of “weak hands” to search for alternatives. What about a coin or ERC20 token that is directly pegged to another real-world asset like gold or a mainstream currency like the US dollar or euro?

Sure, I can see the appeal as easily as the next concerned investor, but are they really worth it in the long run? Doesn’t the concept go against everything the cryptocurrency revolution stands for? Let’s break it down and take a look at the theory behind the practice.

Fiat Currencies

Let’s Talk About ‘Pegged’ Crypto Assets

Much of the argument against Bitcoin and other cryptocurrencies from traditional investors and financial strategists comes from the point that “it isn’t worth anything,” but is that really the case?

In the case of a crypto asset like Bitcoin, the value attributed to the “coin” (remember the term “coin” is really only being used metaphorically as a placeholder anyway, Bitcoin is just a series of transactions, no actual “Bitcoin.png” or any other file is digitally transferred between individuals on the network) is only valid so long as the community recognizes it. In that sense, Bitcoin is another fiat currency, and really not much different from other popular fiat currencies like the US dollar or euro, except for the reason why the community accepts it.

Unlike a commodity, fiat currencies have no inherent value in and of themselves outside of cultural context. In contrast, a commodity has a value regardless of where you are (think things like food crops, cotton, copper, etc.). Yes, even gold is really another fiat currency nowadays for the most part (outside of some utility used for electronic manufacturing—but that’s a conversation for another post).

The biggest difference when it comes to assets like Bitcoin and traditional fiat currency is the reason why the asset is accepted. In the case of the US dollar, and other major currencies, communities accept and use the currency (backed by nothing) as a means of exchange because the currency and entire system are supported by (some may say “enforced” by, depending on the level of cynicism and crypto-anarchist opinions) a federal government which ensures the value of the dollar is recognized by the nation.

Conversely, cryptocurrencies are not ensured value by any centralized governing authority. Instead, the crypto assets are granted value from a far more organic source: the global community.

Cryptocurrencies are only worth what they’re valued at based on what others are willing to pay for them. Unlike traditional, centralized fiat currencies, cryptocurrencies do not have an unlimited amount of coins (note: XRP need not apply, seeing as it’s not exactly a cryptocurrency and is controlled by a central authority).

So we know that cryptocurrencies are similar to many other fiat currencies, but why does that matter in the context of “pegged” cryptocurrencies?

We’ll unpack some of the reasoning behind those pegged assets. Still, it’s important to note that cryptocurrencies were created specifically to give people an alternative to traditional fiat controlled by one centralized source.

‘Pegging’ an Asset to Another Fiat

The new trend of taking a cryptocurrency, the antithesis of traditional fiat, and ‘pegging’ it to the same thing it was designed to replace is becoming increasingly common. There are a lot of new cryptocurrencies on the block looking to take advantage of novice investors and, to be fair, some experienced investors who are actually excited about the new assets and want to see them succeed. But there are some problems. Let’s talk about them.

What is a ‘Pegged’ Asset?

Before considering some concerns, let’s clarify what exactly a ‘pegged’ crypto asset is. This new crypto asset class is either a coin or token with a value directly related to another asset most investors are familiar with, like a well-known currency (US dollar, euro) or another asset like gold.

You’ve likely heard of many of these before, especially with perhaps the single largest one making news recently: Tether. Tether (USDT) was a cryptocurrency created to allow investors an opportunity to pull money out of the crypto markets and store their funds in a cryptocurrency-related to the US dollar with a 1:1 ratio. Each USDT token is set to be worth $1 USD.

Similar types of assets are being developed to do the same thing with gold-backed cryptocurrencies, which you may have heard of. The idea is that investors can take their cryptocurrency and directly exchange the token with the issuer for the exact amount of whatever the token was backed by.

What’s the Problem?

Let’s Talk About ‘Pegged’ Crypto Assets

Besides the obvious irony of using the very same currency cryptocurrencies were created to circumvent to attribute value to the asset in the first place, there are other concerns with the legitimate use of such crypto assets.

Who is Backing the Pegged Asset?

After getting past the initial irony and absurdity of backing a cryptocurrency with traditional fiat, the first major issue we run into is the question of who exactly is “backing” this asset.

At least with traditional fiat currency in the US, you’ve got Uncle Sam and all of his authority on your side when you spend USD, but where is the backing for these crypto assets?

If there were widespread adoption, users would theoretically be able to use something like Tether when out at a store or restaurant to pay for goods or services or ask to get cash back when checking out and paying via USDT, but that’s not the case.

The only way for a cryptocurrency to be backed by another asset is for the issuer to hold the exact amount of that asset in reserves. For example, if Tether were to issue 200 USDT tokens, the company would need to have $200, at least, in reserves set aside that are to be used for users looking to redeem their US dollars at all times, but that’s not the case.

Do They Actually Have Reserves?

To continue with the Tether example, there are questions regarding whether the company even has the reserves of US dollars they claim to have. Especially after cutting ties with Friedman LLP, an independent company that was adding legitimacy to the operation by assisting in conducting an internal audit and confirming reserve funds in possession, investors are concerned that it may not be the case.

To add to the questions, Tether won’t find official release information about where their reserves are held and with what banked the funds are stored after cutting ties with Wells Fargo. On top of the ambiguity, there are accounts of investors attempting to do just what the Tether token was designed for: trading a 1:1 ratio back into the US dollar.

Oguz Serdar, a Turkish investor, used Tether to “park gains” after successful cryptocurrency trading and accumulated a significant amount of the ‘pegged’ asset. When he tried to go directly to the source to trade his USDT token back into traditional fiat currency, Tether “refused his request.” If issuers can’t deliver on the one claim to legitimacy they have for a use case, then what is the point?

Don’t Similar Options Already Exist?

Let’s Talk About ‘Pegged’ Crypto Assets

Setting aside the case for investors to temporarily take their money out of the volatile crypto markets, many enthusiasts see pegged assets as a way to get traditional investors into the crypto world.

I grant that this is probably the most convincing argument in favor of pegged assets. By more investors bringing new money into the markets, we’re going to see total market capitalization rise as a whole, giving the traditional investors. They are skeptical of cryptocurrency trading an easy entrance to the new economy.

Unfortunately, problems persist with this case for pegged assets as well, mainly: what reason do investors have to use it? Investors already have the ability to purchase “paper gold” and other representations of ownership that establish ownership of the asset without requiring one to store gold bullion, bars, or coins physically. What makes the cryptocurrency pegged to gold any better for those who are already skeptical?

On top of that, the cryptocurrency markets require a bit more knowledge and tech-savviness that many older investors don’t have. The theory behind it is reasonable, and I certainly understand the case to be made here, but the outcome is just not realistic.

Likewise, gold certificates can typically be sold to anyone with strong confidence that it actually represents what it represents (opinions on “if you don’t hold it, it’s not actually yours” aside here, kind of like not owning your private key with crypto). In contrast, these new asset classes don’t have that kind of confidence. Ultimately, there just isn’t a pragmatic case for old investors to switch over.

Other Difficulties and Concluding Thoughts

Let’s Talk About ‘Pegged’ Crypto Assets

The concept itself is interesting at face value, but there are too many variables left unanswered by the industry. Sure, these could be remedied in the future, though the core idea behind the asset is still at fault, in my opinion. There’s a reason younger generations are not investing in gold at the same rate as older generations, and Millenials are opting to look at Bitcoin and Ethereum as better alternatives for a store of value for the long term.

I’ve reduced much of my skepticism to keep this particular piece to an easily digestible length, but more questions must be asked. For example, what are the plans for mining the new assets? Obviously, things will be different if proof-of-stake (PoS) really takes over and becomes the new standard over proof-of-work (PoW), but even that is a highly contested point of discussion in the crypto world.

Will the issuer need to hold a reserve amount of gold or another asset to fund payouts to miners? Are the institutions going to be handling keeping up with transactions on their own? What if the markets aren’t too fond of the idea and liquidity is limited because the issuer doesn’t actually have the number of assets pegged to the currency in reserve available (as we’ve seen with so many in the past)?

The result is that the open market dictates the price of the asset, not the issuer (as was intended), and holders of the asset start selling them off for less than the artificially designated “market value” in order to mitigate risk.

In the end, unless you’re a centralized federal government with authority and a standing legal structure to defend your assertions, there is no such thing as a truly ‘pegged’ asset in the cryptocurrency markets, and there never will be. Next up on the list of troublesome, scammy coins: “formula pegged assets.” Again, that’s a topic for another time. Thanks for giving this a read, and feel free to comment below if you have anything you’d like to add or take issue with.

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