Peg Recovery

The most common recovery mechanism, leveraging market participants to correct price deviations. When a stablecoin trades below its peg (e.g., $0.98), the protocol allows users to redeem it for $1.00 worth of collateral, creating a risk-free profit. This arbitrage burns the discounted stablecoin, reducing supply and pushing the price back up. Conversely, if the price is above peg, users can mint new stablecoins by depositing $1.00 of collateral and selling them for a profit, increasing supply to push the price down.

A protocol-enforced mechanism where users can directly exchange their stablecoin tokens for the underlying collateral at the peg value, regardless of market price. This on-chain redemption burns the stablecoins, permanently removing them from circulation. Used by collateralized models (like MakerDAO's DAI) and algorithmic models with reserve assets. It provides a hard price floor when the collateral is sufficient and liquid, as rational actors will always redeem a token worth $0.99 for $1.00 of assets.

Used primarily by algorithmic stablecoins without full collateral backing. The protocol algorithmically adjusts the total token supply in wallets to restore the peg.

• Expansion (Below Peg): If price < $1, the protocol mints and distributes new tokens to holders, diluting supply but increasing the nominal value per holder's wallet.
• Contraction (Above Peg): If price > $1, the protocol burns tokens from holders' wallets or sells bonds, reducing supply to increase scarcity. This relies on future demand expectations to maintain value.

A defensive mechanism for over-collateralized stablecoins to protect the peg by ensuring the backing collateral value never falls below the stablecoin's value. When a user's collateral ratio drops below a liquidation ratio, their position is automatically liquidated. The collateral is sold via an auction (often at a discount) to cover the debt, and the stablecoins used to pay the debt are burned. This removes stablecoin supply from circulation and ensures the system remains solvent, which is critical for peg confidence.

A monetary policy tool used by lending-based stablecoin systems (e.g., MakerDAO). The Stability Fee is an annual interest rate charged on debt positions used to mint stablecoins. The protocol governance can adjust this rate to influence supply:

• Increase Rate: Makes borrowing (minting) more expensive, discouraging new supply, used when price is below peg.
• Decrease Rate: Makes borrowing cheaper, encouraging new minting and supply increase, used when price is above peg. This indirectly manages supply and demand for the stablecoin.

A direct market operation where a protocol uses a treasury or reserve fund (often containing other stablecoins like USDC or ETH) to defend the peg. When the stablecoin trades below its peg, the protocol uses reserves to buy back and burn its own tokens on the open market, creating buy-side pressure. This is common in fractionally-algorithmic or hybrid models. It provides a direct, capital-intensive defense but depends on the size and liquidity of the reserve fund.

For bridged assets (e.g., bridged USDC), peg recovery relies on the mint-and-burn mechanism across chains. The canonical asset is locked in a vault on the source chain (Ethereum), and a representative token is minted on the destination chain. Arbitrage occurs if the bridged asset depegs: users can buy the discounted asset on the destination chain, bridge it back to the source chain to redeem the canonical asset at 1:1, and sell it at full value. This relies on the bridge's liquidity and withdrawal finality.

Most peg recovery systems rely on price oracles to determine when the asset is trading off-peg. Attackers can exploit oracle vulnerabilities through flash loan attacks or data source manipulation to trigger unnecessary or harmful recovery actions, such as mass liquidations or incorrect minting/burning. The security of the peg is directly tied to the oracle's decentralization and attack resistance.

For collateralized stablecoins, peg recovery depends on the liquidity and quality of the backing assets. Key risks include:

• Collateral Volatility: A sharp drop in collateral value can trigger a de-peg and overwhelm the recovery mechanism.
• Custodial Risk: If reserves are held by a centralized entity, they are vulnerable to seizure, mismanagement, or fraud.
• Liquidity Risk: Insufficient on-chain liquidity to execute large redemptions at the peg price can cause slippage and failed recovery.

Recovery parameters (e.g., fee rates, redemption thresholds, collateral ratios) are often set by protocol governance. This creates risks:

• Governance Attacks: An attacker gaining control of governance tokens can alter parameters to break the peg or drain funds.
• Timelock Bypass: If emergency functions lack sufficient timelocks, a malicious actor could execute a recovery attack instantly.
• Admin Key Risk: Protocols with upgradeable proxies or admin keys pose a single point of failure if keys are compromised.

Algorithmic models, especially rebasing or seigniorage types, are vulnerable to reflexive feedback loops. If market sentiment turns negative, the recovery mechanism (e.g., minting more tokens to buy the peg) can be perceived as inflationary, driving the price further down in a death spiral. This highlights the critical role of market psychology and the potential failure of purely algorithmic guarantees.

Wrapped assets (e.g., wBTC, multichain USDC) rely on cross-chain bridges for peg maintenance. Bridge-specific risks directly threaten peg integrity:

• Validator Set Compromise: A malicious majority of bridge validators can mint unlimited wrapped tokens, destroying the peg.
• Smart Contract Bugs: Exploits in bridge contracts can lead to the theft of locked collateral.
• Liquidity Network Risks: Liquidity network models (e.g., LayerZero) depend on third-party oracles and relayers, adding more potential failure points.

External, systemic events can break pegs in ways technical mechanisms cannot counter:

• Regulatory Action: A jurisdiction banning a backing asset (e.g., USDC reserves) or the stablecoin itself can trigger a permanent de-peg.
• Black Swan Collapse: The failure of a major correlated entity (e.g., a bank holding cash reserves, a foundational DeFi protocol) can collapse confidence and liquidity simultaneously.
• Network Congestion: During market stress, high gas fees or slow transactions can prevent users from executing arbitrage or redemptions, hampering recovery.