How do stablecoins keep their peg? Arbitrage, collateral and confidence

What does “keeping the peg” actually mean?#

A peg is the fixed value a stablecoin targets, usually $1. There are two places where a stablecoin changes hands. In the primary market, the issuer creates (mints) new coins or takes them back (burns them) at the fixed rate. In the secondary market — centralized and decentralized exchanges — people trade coins with each other at whatever price they agree ^[2].

Market observers judge whether a stablecoin is “on peg” by its secondary-market price, because an issuer is unlikely ever to promise redemption at less than a dollar ^[2]. The Bank for International Settlements compares these deviations from par to the gap that can open between an exchange-traded fund’s price and the value of the assets it holds ^[3]. Keeping the peg therefore means keeping the exchange price close to $1.

How does arbitrage hold a fiat-backed coin at $1?#

Fiat-backed issuers usually promise to redeem tokens 1:1 for dollars on demand. The Federal Reserve describes the stabilization mechanism as working “through arbitrage”: any gap between the market price and the 1:1 redemption price is a profit opportunity, and people who chase it push the price back toward $1 ^[1]. Arbitrage simply means buying something where it is cheap and selling it where it is dear.

The two arbitrage trades that pull a fiat-backed coin to $1

In real life the margin is eaten into by fees and timing risk. The Fed notes that redemptions are usually subject to minimum transaction sizes, fees and processing delays ^[1], and that the trade is typically done against other stablecoins, often on decentralized exchanges, rather than directly with dollars ^[1].

Why does it matter who can redeem?#

The arbitrage only works for people who can reach the issuer. Fiat-backed issuers tend to mint and burn only with institutional customers, so retail traders affect the peg only through secondary markets ^[2]. Circle, for example, says its Mint service is for exchanges, institutional traders and banks and “is not available to individuals or small businesses” ^[4]. Tether’s primary market is described by Fed researchers as more restrictive still, with a reported minimum of $100,000 per on-chain mint ^[2].

Research cited by the Fed found that “access to the primary market matters for the efficiency of arbitrage design”, and that Tether’s design changes in 2019 and 2020, which broadened access, reduced peg instability ^[2]. Redemption terms also vary: the US Treasury notes that some issuers may postpone redemptions for seven days or suspend them ^[5]. Every limit on redemption weakens the force pulling the price back to $1.

How do crypto-backed stablecoins hold their peg?#

Crypto-collateralized stablecoins are backed by tokens locked in smart contracts, so there is no bank account behind them. Because crypto prices swing, these systems are typically over-collateralized: users must lock more value than the stablecoins they create ^[1]. Dai, issued through smart contracts governed by MakerDAO, is the Fed’s main example: a user might deposit $150 of ETH to generate 100 Dai ^[2].

The protocol keeps checking the value of each position’s collateral. If it falls below a required collateralization ratio set by the system, the owner must add collateral or reduce the stablecoins outstanding ^[1]; otherwise smart contracts liquidate the collateral and remove excess stablecoins from supply ^[2]. Dai also has a Peg Stability Module where users can deposit another stablecoin, such as USDC, to receive exactly the same number of Dai ^[2].

Before the buffer reaches zero, the protocol’s minimum ratio is breached and liquidation is meant to start. In Maker’s design that minimum differs by collateral type and is set by governance ^[6], so no single figure is shown here.

How does a Maker (now Sky) vault get liquidated?#

The Maker Protocol white paper, dated February 2020, describes the machinery behind Dai in detail ^[6]. MakerDAO has since rebranded as Sky and launched a second stablecoin, USDS, in 2024 ^[6]. The page now uses Sky-era names, but the rules and figures below are the white paper’s.

Dai is generated from vaults: smart contracts where a user locks collateral and draws Dai against it ^[6]. Each vault type has its own Liquidation Ratio — the collateral-to-debt ratio at which a vault becomes vulnerable to liquidation — and MKR holders vote on each ratio according to the risk of that collateral ^[6]. A high ratio means governance expects the collateral’s price to be volatile; a low one means it expects little volatility ^[6]. The white paper gives no single ratio that applies to every vault.

1. A keeper spots the breach

   An Auction Keeper — a person or bot rewarded by the protocol — triggers liquidation when a vault’s Liquidation Ratio is breached ^[6].

2. Phase 1: Dai bids rise

   Bidders offer increasing amounts of Dai for the vault’s collateral until the bids cover its debt plus a liquidation penalty, a fee set by MKR voters for that collateral type ^[6].

3. Phase 2: collateral bids fall

   Bidders then offer the fixed amount of Dai for less and less collateral, so as little as possible is sold; any leftover collateral is returned to the vault owner ^[6].

4. If the auction falls short

   The deficit becomes protocol debt, covered by a buffer of Dai from penalties and stability fees; if that is not enough, a debt auction mints new MKR and sells it for Dai ^[6].

In the example, 5,000 Dai is enough to cover the vault’s debt plus the penalty, and the keeper’s second-phase bid is 5,000 Dai for 40 ETH ^[6]. The 10 ETH is our arithmetic, using the rule that leftover collateral goes back to the vault owner ^[6]. The owner still bears the liquidation penalty, which the white paper describes as a fee paid by vault owners when their vaults are liquidated ^[6].

The Fed warns that because the collateral is itself volatile crypto, on-chain collateralized stablecoins “might experience more frequent and pronounced runs”, and that leveraged users can amplify a run as they rush to unwind ^[1]. For the lending side of the same mechanism, see how DeFi lending works.

How do algorithmic stablecoins try to hold the peg?#

Algorithmic (uncollateralized) stablecoins hold few or no reserve assets. Smart contracts instead change the supply to match demand: issuing new coins when the price is above $1 and removing coins when it is below ^[1]. The Fed describes two families:

• Rebase model — the protocol changes the balance in every wallet at regular intervals. If the price rises 10% above the peg, total supply is increased by 10% ^[1]. Ampleforth (AMPL) is the Fed’s example.
• Coupon (seigniorage) model — below the peg, holders are offered bond-like tokens in exchange for stablecoins, shrinking supply; above the peg, new stablecoins are issued ^[1]. Terra Classic USD (formerly TerraUSD) is the Fed’s example.

Both families share one weakness. Supply changes restore the peg “only if enough market participants believe that the price will revert to the peg eventually” ^[1]. When belief breaks, every holder has a reason to sell before the others, and the price can fall toward zero. The Fed’s glossary calls this a “death spiral”, which happens when the stablecoin and its linked crypto token fall in price at the same time ^[1].

Summary of the Federal Reserve’s 2022 and 2024 notes.

What happened when big stablecoins de-pegged in March 2023?#

The collapse of Silicon Valley Bank tested both fiat-backed and crypto-backed designs at once. Fed researchers traced the event across primary and secondary markets ^[2]:

1. 10 March 2023Circle says it could not wire out $3.3 billion of USDC reserves, out of around $40 billion, held at Silicon Valley Bank ^[2].
2. 11 March 2023Circle says USDC issuance and redemption are constrained by US banking hours. DEX trading volume tops $20 billion, against a typical $1–3 billion ^[2].
3. Following daysUSDC and DAI both fall below 90 cents on secondary markets and recover over about three days ^[2].
4. 1 March – 1 April 2023USDC’s market cap falls by about $9.7 billion while USDT’s rises by about $8.8 billion ^[2].

Two lessons stand out. First, DAI de-pegged alongside USDC even though it is crypto-backed. Part of Dai is collateralized by USDC, which the Fed says ties Dai’s market more directly to USDC’s — though the researchers still list why the two were priced so similarly as an open question ^[2]. Second, prices alone did not tell the whole story: the researchers conclude that “simply turning to pricing data on exchanges does not tell the full story of runs on stablecoins” ^[2].

Can any stablecoin design remove the risk of a run?#

Not completely. The Fed argues that a run driven purely by a change in sentiment disappears only when the collateral is the very asset the coin is pegged to — a dollar of stablecoin backed by a dollar held in reserve. Even then, risks around the custody of that collateral remain ^[1].

The BIS points to a deeper tension: issuers earn money by investing reserves in assets that yield interest, but any credit or liquidity risk in those assets means they “cannot fully guarantee stability under all possible contingencies” ^[3]. Rules such as the EU’s MiCA regulation say issuers of e-money tokens should ensure holders can redeem at any time and at par value ^[7].

What mistakes do beginners make here?#

• Watching only the price

  In March 2023, BUSD traded at a premium while its supply shrank, and DAI slipped below $1 yet ended the month slightly larger ^[2]. Check supply changes and redemption news too.

• Assuming you can do the arbitrage yourself

  For most fiat-backed coins, only approved institutions can mint and redeem with the issuer. Retail holders can only sell on the market.

• Thinking crypto-backed means independent

  A crypto-backed coin can hold other stablecoins as collateral. Part of Dai is backed by USDC, and in March 2023 DAI fell below its peg alongside USDC.

• Trusting an algorithm to defend the peg in a panic

  Supply rules restore the peg only if people believe they will. In a crisis, that belief is exactly what disappears.

Frequently asked questions#

The bottom line#

Every stablecoin keeps its peg the same way at heart: by giving someone a profitable reason to push the price back to $1. Fiat-backed coins depend on reserves and on institutions that can redeem; crypto-backed coins depend on surplus collateral and working liquidations; algorithmic coins depend on belief alone. When that reason disappears — reserves in doubt, collateral crashing, confidence gone — the peg can break.

Start from the basics in what are stablecoins, or see how stablecoin supply is used as a market gauge in the stablecoin supply ratio.

Sources#