Built to Bend, Not Break: Why Stablecoins Must Embrace Flexible Pegging

The notion of ‘de-pegging’ is enough to send a shiver down the spines of stablecoin developers everywhere. The clue’s in the name, after all: stablecoins are supposed to be, well, stable. An unstable stablecoin is like an uncrossable bridge, an unlivable hotel, an undrinkable beverage – you get the idea.

And yet history shows us that stablecoin de-pegging is a very real phenomenon. The most egregious example was Terra’s uncollateralized stablecoin UST, which lost its peg to the dollar amid a catastrophic cascade of events in 2022. Even the market’s leading stablecoins like Tether (USDT) and USD Coin (USDC) have occasionally lost their peg, albeit temporarily.

The topic returned to the news earlier this month, when DeFi protocol Balancer suffered a major exploit after hackers drained $110 million of funds in a breach affecting its V2 stablecoin pools. Within a matter of hours, Singapore-based stablecoin xUSD de-pegged, its value plummeting as low as $0.24.

When a hack affects stablecoin pools, either directly or indirectly, it’s natural for depositors to scramble en masse to withdraw liquidity. Ironically, these kinds of events are likely to recur as long as stablecoins dogmatically rely on rigid pegs – and as long as volatility threatens them.

The Need for Elastic Stablecoin Stability

A stablecoin without a rigid peg? To some ears, it’s a shudder-inducing proposition. Yet the idea of an elastic peg is starting to gain traction. Protocols robust enough to absorb temporary volatility while leveraging algorithmic incentives to restore balance are better protected against abrupt shocks caused by black swan events like the one affecting Balancer.

Elastic stability might sound like an oxymoron, but just as skyscrapers are engineered to sway in the wind rather than keel over under the stress, this emerging design philosophy is actually ingenious. Indeed, it could set the scene for the next generation of stablecoins, the sort better equipped to weather the extreme market choppiness that is a hallmark of the cryptosphere.

This vision for a different kind of stablecoin is exemplified by SMARDEX, which refers to the concept as ‘flex-peg.’ With this system, volatility actually becomes a stabilizing mechanism rather than a threat. SMARDEX’s yield-generating synthetic stablecoin, USDN, is the linchpin of a delta-neutral protocol featuring both a vault side and a long side: the former caters to those seeking exposure to USD with added potential yield via USDN, while the latter is for those pursuing exposure to the underlying asset with leverage.

With each chasing different goals, the protocol is designed to activate a mathematical, self-healing mechanism during periods of turbulence, with dynamic funding rates deployed to rebalance the system. In other words, there is a strong financial reward that compels users to provide collateral to restore the $1 peg.

Repairing Stablecoins’ Achilles Heel

The idea of replacing rigid pegging with a system that encourages responsive repegging is certainly novel, but it is this out-of-the-box thinking that could restore peace of mind to the stablecoin market, which is, after all, critical to the popularization of Web3 as a whole. At the time of writing, stablecoins are a $305 billion market.

Balancer’s hack highlights a critical Achilles heel of synthetic stablecoins, namely their reliance on third-party custodians and interconnected DeFi/CeFi platforms for collateral management. Thus, ensuring your own stablecoin security is no longer enough: if a partner is rocked by a breach, confidence in your product can falter dramatically, triggering liquidity pool drainages that jeopardize the all-important peg. 

Partly, this is an incentive problem. When shit hits the fan, there is no incentive for users to reactively repeg their tokens. On the contrary, the market effectively tells them to cut their losses and run for the hills. It is this incentive problem that SMARDEX solves: rather than panic during a temporary depegging, incentives start flowing to ensure timely, organic repegging. Moreover, the on-chain, delta-neutral framework eliminates third-party risks entirely. Of course, the USDN token itself is fully backed, its circulating supply corresponding to the dollar amount deposited in its vaults. 

Stablecoins 2.0

Vulnerability outbreaks will continue to blight DeFi protocols, as sure as the wind will keep blowing. The long and short of it is that hackers gonna hack and risky DeFi protocols gonna take risks.

What’s needed is a stablecoin system less sensitive to stress, less vulnerable to liquidity crises, and more flexible when it comes to maintaining a 1:1 peg. The time for a new era of stablecoins has arrived.

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