Peg Defense Mechanisms Often Accelerate Collapse

Algorithms that mint more stablecoins to buy back a falling peg create a death spiral. This was the core failure mode of Terra's UST.\n- Reflexive Minting: More debt is issued against a devaluing asset.\n- Liquidity Illusion: TVL appears high but is composed of the failing asset itself.\n- Guaranteed Dilution: The supply inflation required for defense destroys the peg's credibility.

Relying on a centralized entity to hold and manage off-chain reserves (e.g., USDC, treasury bills) reintroduces single points of failure and regulatory attack vectors.\n- Custodial Risk: Reserves are not on-chain or verifiable in real-time.\n- Regulatory Arbitrage: The peg is only as strong as the jurisdiction holding its assets.\n- Redemption Friction: Users cannot directly claim underlying assets, creating a 'paper promise'.

The only sustainable model is excessive, transparent collateral held in smart contracts, as pioneered by MakerDAO's DAI. Defense is passive, not active.\n- Capital Efficiency Sacrifice: Requires >100% collateralization ratios, limiting scalability.\n- Verifiable Solvency: Reserves are on-chain and auditable by anyone in real-time.\n- No Reflexive Loops: The peg is defended by liquidation auctions, not algorithmic minting.

The algorithmic design of the UST-Luna pair created a reflexive mint-and-burn mechanism. De-pegging UST triggered a hyperinflationary feedback loop.

• Mechanism: To mint $1 UST, burn $1 of Luna. To redeem $1 UST, mint $1 of Luna.
• Failure: A loss of peg confidence triggered massive redemptions, exponentially diluting Luna's supply and collapsing its value from $40B+ market cap to near zero.

A partial-collateralized stablecoin (IRON) used its governance token (TITAN) as the variable collateral component, directly linking its stability to market sentiment.

• Mechanism: IRON de-pegging triggered automatic arbitrage minting of TITAN, flooding the market.
• Failure: The sell pressure on TITAN lowered the protocol's collateral ratio, creating a reflexive death spiral that erased ~$2B TVL in days. A canonical example of a fragile peg.

Synthetix's early on-chain oracle for sKRW (Korean Won synth) was manipulated, but the protocol's debt pool mechanics turned a pricing error into a systemic risk.

• Mechanism: A faulty oracle price allowed arbitrageurs to mint overvalued synths, increasing the global debt pool. All SNX stakers became liable for the inflated debt.
• Lesson: Reflexive, shared liability in a debt pool system can amplify a single oracle failure into a protocol-wide solvency crisis, requiring a hard fork to resolve.

Curve's crvUSD stablecoin uses the LLAMMA (Lending-Liquidating AMM Algorithm) to avoid death spirals. It's a direct response to past failures.

• The Problem: Traditional liquidations in a crash create reflexive sell pressure on the collateral, worsening the depeg (see MakerDAO's 2020 Black Thursday).
• The Solution: LLAMMA continuously converts collateral to/from stablecoins within a price band, acting as a soft liquidation. This avoids mass, discrete liquidations that crash the collateral's price.

Rebasing tokens like Ampleforth or Terra Classic (UST) use supply changes to target price. This creates a reflexive death loop where selling pressure triggers dilution, punishing holders and accelerating the crash.

• Key Flaw: Punishes the exact users (holders) needed for stability.
• Anti-Fragile Alternative: Use exogenous collateral (e.g., MakerDAO's DAI) or non-dilutive yield to absorb volatility without harming loyal capital.

Systems like MakerDAO require >100% collateral, which is safe but capital-inefficient. In a crisis, this creates a massive, latent sell order for the collateral asset if positions are liquidated, exacerbating the market downturn.

• Key Flaw: Concentrates systemic risk on the collateral asset (e.g., ETH).
• Anti-Fragile Alternative: Diversify collateral types and implement soft liquidations (e.g., Aave's Gauntlet) or auction mechanisms to dampen market impact.

Pegs reliant on oracle prices (e.g., Iron Finance (TITAN)) are vulnerable to latency attacks. A slight price lag allows arbitrageurs to drain reserves, forcing a cascade of liquidations that the oracle then confirms, creating a self-fulfilling prophecy of failure.

• Key Flaw: Security is gated by external data latency (~10s blocks).
• Anti-Fragile Alternative: Use time-weighted average prices (TWAPs), multiple oracle feeds (Chainlink), or circuit breakers that halt operations during extreme volatility.

Models like Terra's Anchor yield reserve or Iron Finance's partial backing use new deposits to pay existing yields. This is a Ponzi-like structure that collapses the moment net deposits turn negative, as seen in the $40B UST implosion.

• Key Flaw: Stability depends on perpetual, exponential growth.
• Anti-Fragile Alternative: Pegs must be backed by verifiable, liquid assets with yields generated from real revenue (e.g., protocol fees, staking) not inflationary token emissions.

Allowing a DAO to vote on critical risk parameters (collateral ratios, fees) creates governance lag and attack vectors. A malicious proposal or voter apathy can cripple the system, as nearly happened with MakerDAO's 'Black Thursday'.

• Key Flaw: Human decision-making is too slow for sub-10-second market events.
• Anti-Fragile Alternative: Implement parameter hardening, emergency shutdowns with multi-sig safeguards, and delegate-based risk committees with skin in the game.

Pegs rely on arbitrage to correct deviations. But if the arbitrage requires holding the native token (e.g., LUNA for UST), a death spiral makes the arbitrage trade unprofitable and risky, removing the very force meant to restore balance.

• Key Flaw: The stabilization mechanism's token becomes toxic during a crisis.
• Anti-Fragile Alternative: Design arbitrage with exogenous incentives (e.g., fees paid in a stable asset) or use multi-asset reserve baskets that don't correlate with the failure mode.