Soft Peg

The core mechanism uses on-chain algorithms to adjust the token's supply in response to market price. When the price is below the peg, the protocol contracts supply (e.g., by burning tokens or incentivizing locking). When above, it expands supply (e.g., by minting new tokens). This creates buy/sell pressure to push the price toward the target.

• Example: The original Ampleforth (AMPL) rebases all wallets' holdings daily based on deviation from its $1 target.

A specific algorithmic design that mints and distributes new tokens to participants as a reward for maintaining the peg. It typically involves two tokens:

• Stable Asset: Aims for the soft peg (e.g., $1).
• Governance/Share Token: Receives seigniorage (profit from minting) when expansion occurs and may be diluted during contractions.

This model aligns incentives but can be highly volatile for share holders.

The asset is partially backed by a reserve of collateral (e.g., other cryptocurrencies, real-world assets). The reserve provides a price floor and a redemption mechanism, but it is not sufficient to back 100% of circulating supply at all times. The peg is maintained through a combination of:

• Arbitrage opportunities via redeemability.
• Protocol-managed monetary policy to adjust parameters like the collateral ratio.

This offers more stability than pure algorithms but less guarantee than a full reserve.

Understanding what a soft peg is not is crucial:

• No Guaranteed Redemption: Unlike a hard peg (e.g., USDC, which is fully collateralized), you cannot always redeem 1 token for exactly $1 of underlying assets.
• Price Volatility Expected: The price is expected to fluctuate around the target (e.g., $0.97 - $1.03), not be rigidly fixed.
• Relies on Future Demand: Stability is predicated on the long-term success of the protocol's incentive model and sustained market participation.

Soft pegs are complex systems vulnerable to specific failure states:

• Death Spiral: A falling price triggers supply contraction, which can cause panic selling, leading to further price drops—a reflexive downward spiral.
• Hyperinflation: Loss of confidence can make expansionary mechanisms ineffective, leading to runaway minting and a collapsing peg.
• Oracle Manipulation: If the price feed (oracle) is compromised, the algorithm will execute incorrect supply changes, breaking the mechanism.

Historical examples include the de-pegging of TerraUSD (UST) and significant volatility in Ampleforth.

Elastic Supply is the broader tokenomic property that enables most soft pegs. These are tokens where the quantity held in each wallet fluctuates based on protocol rules, while the wallet's share of the total supply remains constant (for rebasing models).

• Key Feature: The unit count in your wallet changes, not just the market price.
• Purpose: To use supply elasticity as the primary tool for price targeting, distinct from stablecoins that maintain a fixed supply per token.

The most critical failure mode for algorithmic stablecoins. It occurs when the token's market price falls below its peg, triggering a mechanism (like burning the stablecoin or minting a governance token) intended to restore the peg. If market confidence is lost, this can create a positive feedback loop of selling pressure, causing the price to fall further from the peg. The collapse of Terra's UST in May 2022 is a canonical example of this risk.

Soft peg mechanisms often rely on price oracles to determine the market value of the stablecoin relative to its peg. If an attacker can manipulate this price feed (e.g., through flash loan attacks on a decentralized exchange), they can trigger faulty peg-stabilizing actions. This could allow them to mint stablecoins at an incorrect price or liquidate positions unfairly, draining the system's reserves or causing it to break its peg.

Many soft pegs are backed by volatile crypto collateral (e.g., ETH, BTC). Risks include:

• Liquidation Cascades: A drop in collateral value can trigger mass liquidations, exacerbating the price drop and threatening the peg.
• Insufficient Liquidity: During a market crisis, the liquidity needed to absorb selling pressure or execute stabilizing arbitrage may vanish, causing the peg to break.
• Concentration Risk: Over-reliance on a single type of collateral ties the stablecoin's health directly to that asset's market.

The parameters controlling a soft peg (e.g., collateral ratios, fee structures, oracle selections) are often governed by a decentralized autonomous organization (DAO). This introduces risks:

• Governance Attacks: A malicious actor could acquire enough voting power to change parameters destructively.
• Slow Response Time: DAO voting is too slow to react to sudden market crashes, leaving the protocol exposed.
• Implementation Bugs: Upgrades to the peg mechanism, voted on by governance, can contain critical vulnerabilities.

Soft pegs, especially algorithmic ones without clear fiat backing, exist in a regulatory gray area. They may face scrutiny as potential unregistered securities or be subject to new regulations targeting stablecoins. A regulatory crackdown could:

• Force the project to shut down or significantly alter its mechanism.
• Cause exchanges to delist the stablecoin, destroying its liquidity and utility.
• Create legal liability for developers and governance token holders.

Soft pegs are vulnerable to extreme, unforeseen market events that overwhelm their designed economic incentives. A black swan event (e.g., a major exchange collapse, a sovereign default impacting crypto) can cause correlated crashes across all collateral assets and a simultaneous flight to safety. This can break the peg and cause contagion, where the failure of one major stablecoin triggers panic and redemptions across the entire decentralized finance (DeFi) ecosystem.

A hard peg is a fixed exchange rate regime maintained by a central authority through direct convertibility and reserve backing. Unlike a soft peg, it has no tolerance band for fluctuation.

• Examples: A currency board or a fully collateralized stablecoin like USDC.
• Mechanism: The issuing entity holds reserves (e.g., dollars, treasuries) equal to the total supply, guaranteeing 1:1 redemption.

A crawling peg is an exchange rate system where the target rate is adjusted periodically in small, pre-announced amounts. It is a specific type of soft peg designed to manage gradual inflation differentials or economic trends.

• Purpose: Allows for controlled depreciation or appreciation over time.
• Implementation: Often used by central banks to transition between fixed and floating rates or to combat imported inflation.

A currency peg is the overarching policy of fixing a currency's value to another asset, such as a foreign currency or a basket of goods. It is the parent category for both hard and soft pegs.

• Objective: To provide monetary stability, reduce exchange rate volatility, and anchor inflation expectations.
• Trade-off: Requires the pegging entity to sacrifice independent monetary policy, as interest rates must align with the anchor currency's cycle.

A managed float is an exchange rate system where a currency's value is primarily set by the market, but the central bank intervenes occasionally to stabilize or guide the rate. It is more flexible than a soft peg.

• Key Difference: No explicit, publicly declared target band or parity. Intervention is discretionary and often reactive.
• Example: The monetary policies of the Swiss National Bank or the Reserve Bank of India involve managed floating regimes.

A basket peg is a system where a currency's value is fixed to a weighted average of multiple foreign currencies, rather than a single one. This can be implemented as either a hard or soft peg.

• Advantage: Reduces risk from volatility in any single anchor currency.
• Historical Example: The Special Drawing Right (SDR) from the IMF is a basket of major reserve currencies used as a unit of account.

Arbitrage is the practice of exploiting price differences for the same asset across different markets to make a risk-free profit. It is the primary market force that maintains a soft peg within its target band.

• Role in Soft Pegs: When the market price deviates from the peg, arbitrageurs buy the undervalued asset and sell the overvalued one, pushing the price back toward parity.
• Requirement: Requires sufficient liquidity and low transaction costs to be effective.