Breaking Peg

In 1992, The Quantum Group, a hedge fund led by George Soros, made a legendary trade on a bet that the GBP could not maintain its peg to the Deutsche Mark in the European Exchange Rate Mechanism, ERM.  The Bank of England spent, in vain, over $3 billion attempting to defend the peg while Quantum pocketed $1.5 billion profit when the central bank finally abandoned the ERM. More recently, the Nigerian central bank capitulated struggling to maintain its peg to the US Dollar, dropping over a third of its value in a single day.

The motivation for some central banks to embark on the tricky task of maintaining a
rigid exchange rate, is to draw some desirable traits from the peg currency. Proponents for the UK to enter the ERM were impressed by the low inflation record of the then West Germany. Nigeria, during the time the peg lasted, was able to internally absorb volatility while outwardly display a stable looking currency.
Cryptocurrencies notorious for high price instability are also resorting to pegging to a harder currency or assets as a path to stability. Two such cryptocurrencies are NuBits and bitUSD, both pegged 1:1 to the US Dollar.

New tricks, same challenge
Whereas central banks enforce the peg by directly buying or selling the peg currency against their own, cryptopegs lacking a central controller, use other techniques with the same aim. NuBits utilize a set of ‘custodians‘ acting as market makers incentivized to provide buy side liquidity, i.e to step in to purchase nubits when it deviates from parity,
bitUSD, takes a more decentralized approach, using collateral locked on a blockchain to back issued bitUSD and automatically triggering margin calls when insufficient harder assets are backing the peg. Cryptopegs however, are not immune to peg breaks. This month, NuBits broke the peg causing an implosion on the cryptocurrency.

Screenshot 2016-06-24 05.27.03

As of this writing bitUSD is still trading at near parity, while nubits are exchanging for about 20 cents.

The way of the DAO
On the Ethereum side, Dai, a cryptopeg project targets to peg 1:1 to the SDR, Special Drawing Rights, a low volatility basket of major reserve currencies maintained by the IMF.
Dai, borrows some concepts from NuBits; Market makers as source of liquidity, and from bitUSD, in-chain collateral backing of the Dai. The rules of engagement to maintain the peg are encoded in special smart contracts and controlled by Maker, a Distributed Autonomous Organization (DAO), existing exclusively on the Ethereum blockchain. Unlike central banks, Maker is owned publicly by shareholders, albeit without the latitude to change or even influence monetary policy, unambiguously encoded in the mentioned smart contracts.
An additional innovation in the Dai, is an insurance like mechanism to enable a bail-in when margin calls are not sufficient to cover divergence from the peg. This ensures that shareholders of the DAO get hit first, before any impact flows to holders of Dai. In compensation for this, Maker shareholders receive ‘stability fees’ implicitly paid by holders of the cryptopeg.

In search for the permanent fix
Earlier this year, the three decade peg of the Saudi Riyal to the US Dollar, came under threat forcing Saudi authorities in panic, to take drastic measures aimed at any trading activity that could undermine central bank efforts to defend the peg. Weather the Dai experiment will find the magic formula for stable pegs remains to be seen. In the meantime, holders of cryptopegs can only be assured that the peg will work, until it stops working.

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