The Cost of Composability When Algorithmic Pegs Break

The canonical case study. The $40B+ collapse of UST's peg triggered a cascade of liquidations across Anchor, Mirror, and the broader Cosmos ecosystem. It demonstrated that a single broken peg can vaporize a top-10 token's market cap in days.

• Contagion Path: UST depeg → LUNA hyperinflation → Anchor TVL collapse → Cross-chain bridge outflows.
• Key Flaw: Reliance on reflexive, on-chain arbitrage without a hard asset backstop.

The $2B+ TVL Curve 3pool (DAI/USDC/USDT) is the primary liquidity nexus for stablecoins. A depeg event causes immediate, measurable capital flight, draining the vulnerable asset and stressing the entire pool.

• Contagion Path: Depeg → 3pool imbalance → DEX arbitrage fails → LP losses → Protocol insolvency risk.
• Systemic Role: Acts as the real-time canary for peg health; its composition is a leading risk indicator.

Wrapped assets (e.g., wUST, stETH) propagate failure across chains via bridges like Wormhole and LayerZero. A depeg on one chain instantly devalues its wrapped representation on all others, breaking money legos in foreign ecosystems.

• Contagion Path: Ethereum depeg → Bridge oracle reports bad price → Liquidations on Avalanche/Solana.
• Amplifier: Bridged assets create synthetic systemic risk, making local crises global.

Price oracles (Chainlink, Pyth) updating for a depegging asset create a predictable liquidation cascade. MEV bots front-run these updates, exacerbating price drops and triggering more liquidations than the fundamental depeg would cause.

• Contagion Path: Initial depeg → Oracle update tx in mempool → MEV sandwich attack → Depeg worsens.
• Result: Algorithmic acceleration of the crisis, turning a slow bleed into a flash crash.

Depegged collateral (e.g., MIM, FRAX during stress) becomes undercollateralized on platforms like Aave and Compound. This creates bad debt that must be socialized or covered by reserves, threatening protocol solvency and freezing markets.

• Contagion Path: Collateral depeg → Loan health check fails → Bad debt accrues → Reserve depletion → Governance token sell-off.
• Critical Flaw: Over-collateralization is meaningless if the collateral's value mechanism fails.

Modern protocols are adopting risk segmentation. Examples: Aave's isolation mode, Maker's collateral vault types, and Curve's gauge weights. The solution is not to prevent pegs from breaking, but to firewall the blast radius.

• Key Tactic: Asset-specific debt ceilings and oracle delay circuits to slow contagion.
• Goal: Transform a systemic crisis into a localized, manageable failure.

The canonical case study of a reflexive, composable peg destroying ~$40B in market cap. The Anchor Protocol's ~20% yield created unsustainable demand for UST, while the arbitrage mechanism linking LUNA minting to UST redemptions became a one-way death spiral under stress.

• Contagion Vector: Protocol integrations (e.g., Abracadabra.money) instantly transmitted insolvency.
• Key Lesson: Reflexive, two-token pegs are inherently fragile under bank-run conditions.

A prelude to Terra, demonstrating how composable leverage and panic selling create irreversible collapse. The partial-collateralized model (USDC + TITAN) relied on arbitrageurs to maintain peg, but a coordinated sell-off triggered a negative feedback loop.

• Composability Failure: The protocol's own token as collateral made the system reflexively insolvent.
• Key Lesson: Over-collateralization is non-negotiable; algorithmic stability during a crisis is a myth.

A counterfactual on how to survive extreme stress. Frax's hybrid model (algorithmic + collateralized) and AMO (Algorithmic Market Operations) controllers allowed it to weather the Terra collapse and 3AC insolvency.

• Defensive Composability: AMOs can be paused, and the protocol can fall back to its USDC collateral base.
• Key Lesson: Successful algorithmic systems require circuit breakers and a non-reflexive asset base.

A stress test of a novel LLAMMA (Lending-Liquidating AMM) design during the $100M+ Curve pool exploit. Instead of triggering a death spiral, the mechanism allowed positions to be liquidated gradually through AMM swaps, preventing a cascading sell-off of CRV.

• Composability Win: The stablecoin's design absorbed the shock without spilling over to its governance token.
• Key Lesson: Decoupling liquidation from reflexive token minting/burning is critical for stability.

A broken peg creates a recursive feedback loop. Chainlink or Pyth feeds reflect the depeg, causing liquidations in Aave and Compound. This sells more of the asset, deepening the depeg. The system's informational dependency becomes its primary failure mode.

• Key Risk: Price feed latency vs. on-chain DEX price divergence.
• Key Impact: Cascading, protocol-enforced liquidations of still-solvent positions.

Depegs are a predictable, high-value MEV opportunity. Bots front-run oracle updates and liquidation calls, extracting value that should go to protocol reserves or LPs. This turns a stability mechanism into a wealth transfer to searchers.

• Key Entity: Flashbots ecosystem and generalized intent solvers like UniswapX.
• Key Cost: Protocol security subsidies extracted as MEV, weakening the system's capital base.

A depeg on one chain doesn't stay there. Bridging protocols like LayerZero and Wormhole transmit the instability. Arbitrage lags and bridge security models (Stargate pools, Across RFQ) can freeze, stranding canonical bridged assets at multiple price points across the ecosystem.

• Key Failure: Loss of canonical bridge 1:1 redeemability.
• Key Consequence: Fragmented liquidity and broken composability across all integrated chains.

Architect for failure by containing peg-dependent logic. Use Euler's segregated risk modules or Maker's distinct vault types. Treat algorithmic assets as a separate, higher-risk asset class with isolated debt ceilings, oracle delay parameters, and no cross-collateralization.

• Key Benefit: Limits contagion to a designated risk silo.
• Key Trade-off: Reduces capital efficiency for the risky asset, which is the point.

Implement non-consensus-upgrade pauses. Trigger a cooling-off period after a large price deviation before allowing liquidations or new borrows. This breaks the oracle/liquidation feedback loop and allows for human intervention or off-chain resolution.

• Key Mechanism: Time-weighted average price (TWAP) guards or governance-triggered pauses.
• Key Benefit: Neutralizes flash crash exploitation and provides crisis response time.

Abstain from pure algorithmic designs. Instead, fund direct liquidity provider (LP) incentives for deep, stable pools on Curve or Balancer. Pay for stability with yield, not with complex, fragile tokenomics. This turns a systemic risk into a measurable operational cost.

• Key Entity: Curve's crvUSD and its LLAMMA design for soft liquidations.
• Key Benefit: Predictable cost, eliminates reflexive token death spirals.