Peg Band

A seigniorage-style algorithmic stablecoin that maintained its peg to the US Dollar by minting and burning its sister token, LUNA. When UST traded above $1, users could burn $1 of LUNA to mint 1 UST, creating arbitrage.

• Collapse: The mechanism failed in May 2022 during a loss of confidence, leading to a death spiral where minting LUNA to redeem UST caused hyperinflation.
• Legacy: A critical case study in the risks of reflexive, non-collateralized pegs.

All peg band mechanisms face the impossible trinity of stablecoins: achieving decentralization, capital efficiency, and price stability simultaneously.

• Collateralized models (e.g., MakerDAO's DAI) sacrifice capital efficiency.
• Algorithmic models (e.g., ESD) sacrifice stability for decentralization.
• Hybrid models (e.g., Frax) attempt a balance but add complexity. The reflexivity between the stablecoin and its governance/backing asset remains the core engineering challenge.

A peg band is the permissible deviation range from a target price peg, such as $1.00 ± $0.01. Its primary purpose is to define the bounds of acceptable price stability before the protocol's stabilization mechanisms (like minting/burning) are triggered. This creates a buffer zone, preventing excessive and costly protocol intervention for minor price fluctuations.

The band is defined by two key parameters:

• Upper Band: The maximum price (e.g., $1.01) before the protocol acts to increase supply or reduce demand.
• Lower Band: The minimum price (e.g., $0.99) before the protocol acts to decrease supply or increase demand.
• Band Width: The total spread between the upper and lower bands. A narrow band (e.g., ±0.3%) signals a tighter peg but requires more frequent intervention.

When the market price exits the peg band, it triggers specific protocol actions:

• Above Band: The asset is overvalued. Protocols may mint and sell new tokens or offer arbitrage incentives to increase supply, pushing the price down.
• Below Band: The asset is undervalued. Protocols may buy back and burn tokens or offer incentives to reduce supply, pulling the price up. This creates a feedback loop aimed at returning the price to within the band.

Choosing the band width involves a fundamental trade-off between stability and capital efficiency.

• Narrow Band (e.g., ±0.1%): Provides a tighter peg, enhancing its use as a medium of exchange, but requires highly liquid markets and frequent, potentially costly, interventions.
• Wide Band (e.g., ±5%): Reduces protocol intervention frequency and cost, but results in higher price volatility, making the asset less suitable for payments.

Frax Protocol's stablecoin, FRAX, historically employed a narrow peg band as part of its hybrid algorithmic design. The protocol used an Algorithmic Market Operations Controller (AMO) to dynamically manage collateral and algorithmic supply. If FRAX traded above its band, the protocol would mint and sell FRAX. If it traded below, it would buy and burn FRAX, utilizing its partial collateral reserves to support the peg.

A dead band (or hysteresis band) is a sub-range within the peg band where no protocol action is taken, even if the price deviates from the exact peg. For example, with a peg band of $1.00 ± $0.01, the dead band might be $1.00 ± $0.005. This prevents the protocol from reacting to negligible noise and reduces operational costs, a concept used in control system engineering applied to economics.

The peg band width is the maximum allowed deviation from the target price (e.g., $1.00 ± $0.01). A narrow band signals strong stability but requires highly responsive arbitrage and liquidity. A wider band provides more buffer against volatility but may erode user trust if the price lingers at the edges.

• Example: DAI's Stability Fee adjustments help keep it within its band.
• Risk: Persistent de-pegging outside the band can trigger a bank run on collateral.

The peg band's integrity relies on arbitrageurs profitably correcting deviations. When the price falls below the band, mechanisms like discounted redemption or burning create buy pressure. When above, minting at a discount creates sell pressure.

• Critical Dependency: Requires sufficient on-chain liquidity depth.
• Failure Mode: If arbitrage is unprofitable (high gas, low liquidity), the band becomes ineffective.

The observed market price determining band breaches comes from an oracle (e.g., Chainlink, Uniswap TWAP). This creates a critical trust dependency.

• Oracle Attack: A manipulated price feed can falsely trigger stabilization mechanisms, draining reserves.
• Defense: Use decentralized oracle networks and time-weighted average prices (TWAP) to resist short-term manipulation.

For collateralized stablecoins (e.g., MakerDAO's DAI), the peg band's defense depends on the liquidity and volatility of the underlying collateral. A sharp drop in collateral value can break the band's lower bound.

• Liquidation Cascades: Rapid collateral liquidation during market stress can exacerbate the de-peg.
• Reserve Audit: Algorithmic stablecoins must hold verifiable, liquid reserves to back redemption demands.

The peg band's parameters (width, trigger points) are often set by protocol governance. Poor governance decisions or attacks can destabilize the system.

• Example: Adjusting the stability fee or redemption curve impacts band defense.
• Risk: A governance attack could intentionally widen the band to hide insolvency or manipulate it for profit.

Different stablecoin designs enforce their peg band with distinct mechanisms, each with unique risks.

• Algorithmic (Seigniorage): Uses expansion/contraction of token supply. Risk: Death spiral if demand vanishes.
• Fiat-Collateralized (USDC): Relies on off-chain reserves and legal redemption. Risk: Censorship and counterparty risk.
• Crypto-Collateralized: Over-collateralization and liquidations. Risk: Collateral volatility and liquidation inefficiency.

A cryptocurrency whose value is pegged to a stable external asset, most commonly the US dollar. Stablecoins are the primary application for mechanisms like a Peg Band. They are categorized into:

• Fiat-collateralized: Backed by reserves (e.g., USDC, USDT).
• Crypto-collateralized: Over-collateralized with other crypto assets (e.g., DAI).
• Algorithmic: Use algorithmic mechanisms, like rebasing or seigniorage shares, to maintain the peg, often employing a Peg Band.

A data feed that provides external, real-world information (like an asset's market price) to a blockchain. For a Peg Band to function, the protocol relies on a price oracle to determine if the stablecoin's market price is within the designated band. The accuracy and security of this oracle are critical to prevent manipulation and ensure the stability mechanism triggers correctly.

An algorithmic mechanism where a token's supply is automatically adjusted (expanded or contracted) across all holders' wallets to influence its market price. If a stablecoin's price falls below its Peg Band, the protocol may execute a negative rebase, reducing the supply to create scarcity and push the price back up. This changes the token balance in every wallet proportionally.

In algorithmic stablecoin design, this refers to the profit generated when new stablecoins are minted. When demand is high and the price is above the Peg Band, the protocol mints and sells new tokens, capturing the seigniorage (often in a treasury or for protocol-owned liquidity). This mechanism funds operations and can be used to buy back tokens when the price is low.

The practice of buying an asset in one market and simultaneously selling it in another to profit from a price difference. A well-designed Peg Band creates profitable arbitrage opportunities for external actors. For example, if the price drops below the band, arbitrageurs can buy the cheap stablecoin, redeem it for more valuable protocol assets (like bonds or collateral), and profit, thereby increasing demand and restoring the peg.

A smart contract that holds reserves of two or more tokens, enabling decentralized trading via Automated Market Makers (AMMs). Deep liquidity in pools for the stablecoin/peg asset pair (e.g., USDD/USDC) is essential for a Peg Band's effectiveness. It ensures the market price accurately reflects supply/demand and allows the stability mechanisms (like minting/burning) to be executed efficiently.