In finance, a soft peg is a method of keeping the value of a currency within a certain range against a reserve currency by using an exchange rate regime.
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What Is a Soft Peg?
The soft peg method is an exchange rate regime applied to a currency that stabilizes its value against a pegged currency or reserve currency. The other peg approaches are hard peg and flexible peg. The primary difference between soft and hard peg is that soft peg allows for limited flexibility in the monetary policy. The goal is to enable governments to deal with fluctuations.
Peg is a monetary policy tool that allows a currency’s value to be fixed relative to another currency or a commodity. In cryptocurrency, pegging is used to maintain stability in the market against fluctuations. The soft peg method allows some fluctuation between the value of the pegged cryptocurrency and its peg. The hard peg method does not allow for any fluctuation and the value of the pegged cryptocurrency remains exactly equal to its peg at all times.
The most famous soft-pegged currency is the Chinese Yuan, which was pegged to the Dollar from 1994 until 2005. Under the soft-pegging system, Yuan’s value was allowed to move within a narrow band around its fixed target value. After 2005, China revalued its currency to appreciate 2.1% against the Dollar.
The soft peg system should not be confused with “free-floating,” where a currency is not tied to another currency.
Benefits of Using the Soft Peg Method
Soft pegging can bring stability and predictability to foreign exchange markets. It especially benefits countries with highly volatile currencies or currencies that have high inflation rates. For example, the Chinese government used soft pegging to stabilize its economy during periods of high inflation and prevent it from trading too far below its official exchange rate.
Tether is an example of a cryptocurrency that uses both hard and soft pegs. It has a hard peg of $1 USD and a soft peg that allows it to move up or down by 2%.
In modern-day cryptocurrency markets, soft pegs are common. Bitcoin has historically been relatively volatile compared to fiat currencies, such as the US dollar. This means that its value rose and fell dramatically at times. This suits traders who want to capitalize on short-term price movements, but it poses problems for those who want their cryptocurrency to be useful as an everyday tender: if you receive $100 worth of bitcoin today, what will it be worth tomorrow?
Soft pegs aim to solve this problem by tying cryptocurrencies closely to more stable fiat currencies, such as the US dollar or gold. By fixing its value in this way, it becomes possible for people to use their crypto tokens as their everyday currency.