Peg Defense

The primary defense, leveraging market participants to correct price deviations. When a stablecoin trades below peg, arbitrageurs can buy the discounted asset and redeem it for $1 of collateral via the protocol, profiting from the difference and pushing the price back up. The reverse process occurs when the price trades above peg, where arbitrageurs mint new tokens by depositing collateral and sell them on the open market.

• Key for: Algorithmic and collateralized stablecoins (e.g., DAI, FRAX).
• Requires: Efficient, low-fee redemption/minting mechanisms.

A risk-management mechanism for overcollateralized stablecoins (like DAI). If the value of a user's collateral falls below a required minimum collateral ratio, the position becomes eligible for liquidation. Liquidators repay the user's debt (burning the stablecoin) in exchange for the collateral at a discount, removing the undercollateralized stablecoin from circulation and protecting the system's solvency.

• Prevents: Systemic insolvency from collateral value decline.
• Tools: Liquidation engines, keeper bots, and liquidation penalties.

Protocols adjust interest rates or other incentives programmatically to influence supply and demand. To defend a downward peg, the protocol may increase the savings rate (reward for holding the stablecoin) to reduce circulating supply. To defend an upward peg, it may increase the borrowing cost (minting fee) or decrease the savings rate to encourage minting and increase supply.

• Examples: DAI's Stability Fee, Ethena's sUSDe yield.
• Analogous to: Central bank open market operations.

The protocol or its governing DAO actively intervenes in the market using its treasury reserves. This can involve using protocol-owned liquidity in AMM pools to buy back tokens below peg or sell tokens above peg. Some designs feature a Protocol Controlled Value (PCV) model, where the treasury autonomously executes these operations to stabilize the price.

• Seen in: FEI Protocol's original design, OlympusDAO's bonding system.
• Advantage: Direct, powerful intervention.
• Risk: Requires significant capital reserves.

A two-part mechanism that creates soft price boundaries. Redemption bands (e.g., $0.99 - $1.01) define a range where the protocol guarantees minting and redemption at exactly $1, creating a powerful arbitrage anchor. A stability fee (often dynamic) is charged on debt positions; increasing this fee during downward pressure makes it more expensive to mint new stablecoins, contracting supply.

• Implementation: Used by MakerDAO for DAI.
• Effect: Creates predictable arbitrage conditions and adjustable supply elasticity.

Last-resort mechanisms to protect the protocol and users in extreme scenarios. A circuit breaker may temporarily pause minting, redemptions, or liquidations during market volatility to prevent bank runs or oracle failures. Emergency Shutdown is a definitive, irreversible action that freezes the system, allowing all users to claim their fair share of the underlying collateral at the last valid price, ultimately settling all obligations.

• Purpose: Preserve capital and enable orderly settlement.
• Triggered by: Governance vote, oracle failure, or severe market attack.

Protocols like Ampleforth adjust the token supply held in every wallet to target a price peg. When the price is above the peg, the protocol mints and distributes new tokens to all holders (a positive rebase), increasing supply to push the price down. When below, it burns tokens from all wallets (a negative rebase) to reduce supply. This mechanism directly changes the quantity of tokens each user holds, not their proportional ownership of the network.

Fiat-backed stablecoins like USDT and USDC primarily defend their peg off-chain through the issuer's treasury operations, with on-chain arbitrage as the enforcement mechanism.

• 1:1 Redemption: Authorized institutions can mint/burn tokens directly with the issuer for fiat.
• On-Chain Arbitrage: If the market price drifts, arbitrageurs buy the discounted stablecoin to redeem for $1 with the issuer (or sell the premium one), profiting from the spread and pushing the price back to peg.
• Reserve Management: The issuer must maintain sufficient, liquid fiat reserves to honor all redemption requests, which is the ultimate peg guarantee.

A primary risk occurs when a protocol's collateral assets become illiquid during market stress. If a stablecoin is backed by volatile assets (e.g., ETH) and those assets crash, the protocol may be unable to liquidate sufficient collateral to redeem all stablecoins at par. This creates a bank run scenario where the last redeemers suffer losses. The 2022 collapse of Terra's UST demonstrated this when its algorithmic arbitrage mechanism failed under selling pressure.

Most peg defense systems rely on price oracles to determine the value of collateral or trigger stabilization mechanisms. These are single points of failure. Risks include:

• Oracle delay/latency: Slow price feeds cause defenses to act on stale data.
• Manipulation attacks: Exploiting low-liquidity markets to feed false prices to the oracle (e.g., flash loan attacks).
• Centralization risk: Reliance on a small set of oracle providers creates censorship and downtime risks.

Many protocols have upgradable contracts or privileged functions (e.g., pausing minting, changing parameters) controlled by governance tokens or a multi-sig. This creates risks:

• Governance attacks: An attacker acquiring enough tokens can vote to drain collateral.
• Regulatory intervention: Authorities could pressure key individuals controlling multi-sig wallets.
• Coordination failure: In a crisis, governance may be too slow to enact necessary defense measures.

For assets pegged across chains (e.g., bridged USDC), the bridge custodian or validator set becomes the critical defense point. Historical failures show key risks:

• Validator compromise: A majority of bridge validators being hacked or acting maliciously (see Wormhole, Ronin Bridge exploits).
• Minting control: If the bridge's minting function on the destination chain lacks proper safeguards, infinite fake pegged assets can be created.
• Liquidity fragmentation: The pegged asset may trade at a discount on less liquid chains.

Algorithmic stablecoins that use seigniorage shares or rebasing tokens rely on market incentives and reflexive feedback loops. These are prone to death spirals:

• The belief in the peg is the primary backing. If that breaks, arbitrage mechanisms reverse.
• Selling pressure reduces the protocol's native token value, which erodes the collateral base for minting more stablecoins, creating a vicious cycle.
• These models often fail their first major stress test in a bear market.

Peg failures are rarely isolated. They can trigger contagion across DeFi:

• Collateral cascades: A de-peg forces liquidations of the stablecoin used as collateral elsewhere, causing cascading defaults.
• Protocol interdependence: Many lending protocols share the same major stablecoins. One failure impairs the solvency of multiple platforms.
• Black swan liquidity events: Extreme, unforeseen market conditions (e.g., March 2020) can simultaneously stress all peg defense mechanisms beyond their designed capacity.

The primary economic force for peg restoration. When a stablecoin trades below its peg, arbitrageurs can buy the discounted stablecoin and redeem it for $1 worth of collateral, profiting from the difference. This buying pressure pushes the price back up. Conversely, if it trades above peg, they can mint new stablecoins by depositing collateral and sell them on the open market.

The backing assets that guarantee redeemability. Systems use different models:

• Over-collateralization (e.g., MakerDAO's DAI): Users lock crypto assets worth more than the stablecoin minted, creating a safety buffer against price drops.
• Algorithmic (e.g., former UST): Uses on-chain algorithms and secondary volatile tokens to manage supply, without direct asset backing.
• Fiat-backed (e.g., USDC): Holds equivalent fiat currency in reserve, audited by a central entity.

The direct process for users to exchange a stablecoin for its underlying collateral at the peg value. This is the foundational promise that enables arbitrage. Key designs include:

• Direct 1:1 Redemption: Users burn stablecoins to withdraw specific collateral assets from a pool.
• Stability Fee/Interest Rates: Adjusting the cost to mint or borrow stablecoins to influence supply.
• Redemption Suspension: A last-resort defensive measure to halt withdrawals during extreme stress, often seen as a failure of other defenses.

Decentralized exchanges (DEX) pools that provide the market depth for peg arbitrage. A deep, liquid trading pair (e.g., DAI/USDC) is essential for:

• Enabling efficient arbitrage by allowing large trades with minimal slippage.
• Providing a real-time price discovery mechanism.
• Incentivizing Liquidity Providers (LPs) with rewards to ensure capital is always available to absorb trades.

The decision-making framework for adjusting defense systems. Governance token holders vote on critical parameters to respond to market conditions:

• Collateral Ratios: Adjusting how much over-collateralization is required.
• Stability Fees: Changing the interest rate on minted stablecoins.
• Liquidation Penalties: Setting the discount at which undercollateralized positions are automatically seized and sold.
• Adding/Removing Collateral Types: Managing the risk profile of the backing assets.

The critical source of external price data. Oracles provide the trusted market price for both the stablecoin and its collateral assets. This data triggers all automated defense actions:

• Determining collateral value for loan health.
• Initiating liquidations when collateral value falls below a threshold.
• Informing the redemption price for the system. Oracle manipulation or failure is a major attack vector.