Gold-Backed Crypto and USD-Backed Crypto: Everything You Should Know
Economies across the globe are on the path to recovery after the ravaging wrought by the coronavirus since early 2020. While economic recovery is welcome, it means that assets, such as cryptocurrencies that were all the rage for the better part of 2020 will take a step back from the limelight.
In 2020, cryptoverse experienced one of the largest influx of users in the history of the ecosystem. For instance, daily active ETH addresses doubled during the year to 400,000 while daily active Bitcoin addresses crossed the one million mark.
Figure 1: Bitcoin and Ethereum Addresses
The message here is clear – people are willing to transition from legacy financial systems at whatever cost. During the year, another type of cryptocurrencies grabbed headlines – they go by the name stablecoins. As the name suggests, a stablecoin has a less volatile price because its value is underwritten by a reserve asset. For example, a gold-backed stablecoin supposedly has a value equivalent to a given amount of gold, it could be one gram or a troy ounce.
Granted, traditional cryptocurrencies such as Ethereum and bitcoin have information on their nature easily available because of disproportionate coverage. Information on stablecoins is not as vast because of little attention. In this article, we seek to highlight the stablecoins – particularly USD and gold-backed cryptocurrencies.
Gold-Pegged Cryptocurrencies: What Are They?
Now that you have a slight idea concerning stablecoins, let us dig deeper into the stablecoins whose value is underwritten by gold. One token of this type of cryptocurrency defines gold of equivalent worth. As such, the idea is to have gold reserves somewhere in a company-owned vault or a custodian.
CoinMarketCap lists the top five gold-backed tokens as Paxos Gold (PAXG), Tether Gold (XAUT), Perth Mint Gold Token (PMGT), Meld Gold by Algorand, and Digix Global (DGX). Most of these digital assets are ERC-20 tokens except for PAXG.
Gold-pegged tokens enjoy price stability that is uncommon in the unbacked type of cryptocurrencies. Some providers allow holders to redeem their tokens for real gold. Others only support cash redemption but at par with the market price of gold. Gold-pegged tokens derive their value from the scarcity of gold, and the inflation-hedging capabilities of the yellow metal.
Cryptocurrencies pegged to the USD
On the other hand, there are cryptocurrencies whose value is underwritten by the value of the world’s most important currency, the US dollar. Different tokens maintain different natures of pegging – some have a one-to-one peg (where one token is worth one dollar), while others have a one-to-two, and so on.
USD-pegged stablecoins use the greenback as collateral and an anchor against price volatility. Similar to gold-backed tokens, providers of USD-backed cryptos must set up a reserve in which owners can redeem their tokens. Providers usually maintain accounts in legacy financial institutions to back up a similar number of units in circulation. USD Coin and Tether are the most popular USD-pegged digital tokens today. Tether launched in 2014, which makes it the oldest dollar-backed crypto.
Advantages of pegged cryptocurrencies
Pegged cryptos solve a problem that is endemic in cryptoverse – unsustainable price volatility. Because of the peg, the market value of the digital tokens tracks the value of the underlying assets. The US dollar and gold have for a long time proved to be stable and reliable assets.
Figure 2: Tether (USDT) vs. Bitcoin (BTC) price action
In figure 2 above, notice that Tether’s price (in terms of USD) has remained almost level since it launched. Conversely, Tether’s price in terms of BTC has declined substantially because of heightened volatility in the price of bitcoin. The difference between the two graphs is that Tether’s value is tied to the USD and not Bitcoin. Without a correlation between Tether and Bitcoin, a Tether holder cannot use bitcoin to hedge against risks and vice versa.
Another advantage of pegged cryptocurrencies is utility. Stablecoins are closer to the legacy financial system than, say, Bitcoin. Because of Tether’s association with the USD, you are more likely to get a merchant that accepts the token than Bitcoin. Additionally, stablecoins do not face challenges regular crypto would face when it comes to regulations.
Disadvantages of stablecoins
Despite the benefits of the dollar or gold peg, stablecoins face trouble with systemic issues, issues that plague the legacy financial structure. First, stablecoins are not popular. Cryptocurrencies such as Bitcoin are in high demand because of high price volatility. Risk-taking traders who wish to trade the price gyrations find bitcoin more attractive than lethargic Tether. This relative lack of interest in the pegged cryptocurrencies makes their liquidity to be very low.
Perhaps the biggest challenge for pegged currencies is centralized operations. When Satoshi Nakamoto released the Bitcoin whitepaper in 2009, the central theme was the decentralization of the financial system, which would be possible via enabling peer-to-peer (P2P) transactions. But stablecoins introduce third parties between the peers, which is the diametric opposite of cryptocurrencies’ original goal. For example, USDT providers have to keep dollar reserves in a traditional bank to facilitate transactions.
Lastly, a regular holder of a stablecoin cannot ascertain that the provider has sufficient reserves to support all tokens in circulation. If the reserves are unascertainable, this could trigger a run on the cryptocurrency.
Pegged cryptocurrencies are akin to the legacy financial system and the cryptocurrency ecosystem meeting halfway. They take the best of both worlds to offer users the prospect of enjoying innovative financial services without exposure to the full attendant risks. Perhaps the most critical of stablecoin benefits is price stability, which is lacking in the other cryptos.
Nonetheless, the convenience of stablecoins is not without its demerits. For example, you might want to forget everything about decentralization because third parties are an integral part of stablecoin-based transactions. You cannot buy or sell Tether without having to interact with a traditional bank. Whether the stablecoin is dollar or gold-pegged, it means you will suffer the risks of volatility in the underlying asset.