Why Peg Stability Mechanisms Are Incompatible with Volatile AMM Pools

AMMs like Uniswap V3 rely on arbitrageurs to correct price deviations. A stablecoin's peg mechanism (e.g., MakerDAO's PSM) actively resists these corrections, creating a permanent arbitrage opportunity that drains reserves.\n- AMM Goal: Converge to market price via arbitrage.\n- Peg Goal: Defy market price to maintain $1.00.\n- Result: The peg mechanism subsidizes arbitrage bots, bleeding collateral.

Protocols like MakerDAO and Aave's GHO isolate peg stability mechanisms from general AMM liquidity. The Peg Stability Module (PSM) holds off-chain price feeds and a dedicated, non-volatile reserve (e.g., USDC).\n- Mechanism: Direct 1:1 mint/redeem against stable collateral.\n- Isolation: Volatile pool arbitrage cannot touch core reserves.\n- Trade-off: Introduces centralized collateral dependency.

Providing liquidity for a stablecoin in a volatile pool (e.g., ETH/DAI) subjects LPs to double-sided risk. The pool's external price drifts and the peg may break, leading to non-correlated losses.\n- Normal IL: Loss from ETH price movement.\n- Peg Break IL: Catastrophic loss from DAI de-pegging.\n- Result: Risk-adjusted returns are often negative, requiring unsustainable >100% APY incentives.

Curve Finance designed its AMM specifically for like-valued assets, using a combined invariant that approximates a constant sum (peg) near equilibrium and a constant product (Uniswap) during large trades.\n- Mechanism: Low-slippage swaps while $0.99 < price < $1.01.\n- Defense: Volatile arbitrage is minimized within the band.\n- Limit: Fails during a black swan de-peg, as seen with UST.

Hybrid systems that use AMM prices for peg corrections (e.g., Frax Finance's AMO) create a circular dependency. The oracle reading the AMM price can be manipulated, triggering faulty monetary policy.\n- Vulnerability: Flash loan to skew pool price.\n- Response: Protocol incorrectly mints/burns stablecoin.\n- Result: Reflexivity loop that destabilizes the very peg it's meant to defend.

New architectures like Ethena's USDe or Lybra's eUSD sidestep the conflict by decoupling from AMMs entirely. They use delta-neutral derivatives (staking ETH, shorting futures) or LSD collateral to generate yield that subsidizes stability.\n- Mechanism: Stability funded by endogenous yield, not arbitrage.\n- Isolation: No direct AMM pool for peg defense.\n- New Risk: Counterparty and basis risk in derivatives markets.

Volatile AMM pools like Uniswap V2/V3 provide a price based on internal reserves, not external market data. This creates a fatal lag.

• Arbitrage is reactive, not preventative. AMM price only corrects after the external peg is broken, creating a profitable one-way bet for attackers.
• Oracle attacks are trivial. A large swap can temporarily skew the pool price, triggering faulty liquidations or mint/burn mechanisms in the stablecoin protocol.

High Total Value Locked (TVL) in an AMM pool creates a false sense of security. Peg stability requires always-available, low-slippage exit liquidity, which volatile pools cannot guarantee.

• Concentrated Liquidity (e.g., Uniswap V3) exacerbates fragility. Liquidity is concentrated around a narrow price band; a depeg event quickly moves price out of range, vaporizing all active defense.
• Defense liquidity is borrowed. Liquidity Providers (LPs) are profit-seeking, not protocol allies. They will withdraw or adjust ranges at the first sign of stress, abandoning the peg.

In a volatile AMM, the pool's price is the peg. This creates a deadly feedback loop absent in oracle-based systems like MakerDAO.

• Price drop → LP losses → Liquidity flight → Worse slippage → Further price drop. The AMM's own mechanics accelerate the death spiral.
• Contrast with PSM/OTC models. Protocols like MakerDAO's PSM or Curve's stableswap use direct, low-slippage redemption, breaking this reflexivity. They don't rely on AMMs for primary price stability.

A volatile AMM pool (e.g., ETH/USDC) demands liquidity to absorb price swings, while a peg mechanism (e.g., algorithmic mint/burn) demands liquidity for arbitrage. During a market shock, both systems compete for the same collateral, causing a liquidity death spiral.\n- AMM Impermanent Loss drains LP capital needed for peg defense.\n- Arbitrageurs extract value from the pool, not the protocol.

Decouple the stablecoin's stability mechanism from the volatile trading pool. Use a dedicated, over-collateralized vault (like MakerDAO) or an external liquidity pool (like Curve's 3pool) solely for minting/redemption. The volatile AMM becomes a secondary market, not the primary peg anchor.\n- Vaults provide a non-volatile collateral base.\n- Curve-style stableswaps offer low-slippage exits without IL.

UST's peg relied entirely on arbitrage between the UST/LUNA pool on Terraswap and the mint/burn mechanism. When LUNA price fell, the pool's liquidity evaporated, destroying the arbitrage pathway. The result was a negative feedback loop where selling UST crashed LUNA, which further de-pegged UST.\n- Single point of failure: The volatile asset (LUNA) was the sole collateral.\n- Reflexivity: Price action directly weakened the peg mechanism.

Design a system where users mint/ redeem stablecoins against a basket of non-correlated assets in a dedicated module, not a volatile AMM. Frax Finance's AMO and Maker's PSM are canonical examples. The volatile pool (e.g., on Uniswap) exists for price discovery and leverage, with its imbalances corrected by flows through the primary module.\n- PSM: Direct 1:1 swap with off-chain collateral (USDC).\n- AMO: Algorithmically manages protocol-owned liquidity across venues.