"How Stablecoins Hold Their Peg: Three Models, Three Trade-offs"

The word *stablecoin* describes the goal, not the mechanism. A dollar-pegged token that always trades at $1.00 can achieve that stability through entirely different architectures — and the architecture determines everything: how it fails, who controls it, and whether the peg holds under stress.

## Model One: Fiat-Backed Reserves

USDC and USDT are the clearest examples. For every token in circulation, the issuer holds approximately one dollar in cash, short-term Treasuries, or equivalent assets in a custodial account. The peg holds because redemption at face value is always possible through the issuer. If the token trades below $1.00, arbitrageurs buy it cheaply and redeem it with the issuer for exactly $1.00, pocketing the difference and restoring the peg.

This model is simple and robust under normal conditions. Its vulnerability is equally simple: it requires trusting the issuer. *Centralization is not a bug in this model — it is the mechanism.* The failure mode is not algorithmic; it is reputational and operational. When Silvergate Bank collapsed in March 2023, USDC briefly depegged to $0.87 because Circle held reserves there. The peg was restored within two days once the extent of the exposure was clarified.

## Model Two: Crypto-Collateralized

DAI, issued by MakerDAO, maintains its peg through overcollateralization. Depositing $150 worth of ETH allows you to mint $100 in DAI. If ETH's price falls toward the liquidation threshold, the protocol automatically liquidates the collateral to cover the outstanding DAI. No centralized issuer. The smart contract enforces the peg mechanics directly.

The trade-off is capital inefficiency. You must lock significantly more value than you receive in stablecoins. The failure mode is a rapid drop in collateral value faster than liquidations can execute — which nearly occurred during the March 2020 market crash, when ETH fell 50% in 24 hours and the liquidation mechanism temporarily produced undercollateralized DAI.

## Model Three: Algorithmic

Terra's UST demonstrated exactly how algorithmic models fail. The peg was maintained by allowing users to swap $1 of UST for $1 of LUNA at any time, creating an arbitrage mechanism. When confidence in the system wavered in May 2022, the mechanism ran in reverse: UST was sold to buy LUNA, which was then sold, inflating LUNA supply, which collapsed LUNA's price, which reduced the value of the reserve mechanism. The numbers suggest something different than the designers intended: a peg maintained only by confidence is not a peg — it is a coordination game.

It's worth noting that algorithmic models are not inherently doomed. The mechanisms simply require a reserve asset with independent demand to anchor the loop. Without it, the system is circular and fragile under stress.

> **Key Takeaway:** Every stablecoin peg is a balance between three competing values — decentralization, capital efficiency, and robustness under stress. No model maximizes all three simultaneously. The question is not which model is best in equilibrium; it is which failure mode your risk tolerance can accept.

"How Stablecoins Hold Their Peg: Three Models, Three Trade-offs"

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