Stablecoin Peg Arbitrage

A stablecoin doesn't hold its $1 peg because a central authority declares it so; it holds the peg because traders are financially rewarded for pushing the price back toward $1 whenever it drifts. That reward structure is peg arbitrage, and how robust it is depends entirely on how the stablecoin is backed.

A fiat-collateralized stablecoin (like USDC) is typically backed by a direct mint/redeem window with the issuer: anyone can hand the issuer $1 and get 1 token, or hand back 1 token and get $1, at a fixed rate, subject to KYC and minimum size. That window means the peg can never drift far on secondary markets, because arbitrageurs can always mint or redeem at par to correct it. An algorithmic or crypto-collateralized stablecoin has no such guaranteed 1:1 window — its peg is defended only by market incentives (like a bonding mechanism that changes supply) or by overcollateralized loans, both of which can fail under stress.

The two directions of arbitrage

Worked example

USDC trades at $0.995 on a DEX during a brief liquidity shock, while the issuer's mint/redeem window still functions normally at exactly $1.00 (subject to a $100,000 minimum and same-day settlement). A trader buys 1 million USDC on the open market for $995,000 and redeems it directly with the issuer for $1,000,000, netting $5,000 minus minor transaction costs — a trade that also adds buying pressure back into the open market, pushing the price back toward $1.00.

Contrast that with an algorithmic stablecoin that lost its peg during a bank run: it trades at $0.60 with no functioning redemption window because the mechanism meant to defend the peg (burning the stablecoin to mint a volatile companion token at a floating rate) breaks down once the companion token's price also collapses under the selling pressure. A trader who buys at $0.60 hoping for the same $1.00 arbitrage has no reliable redemption path — the "arbitrage" is really a bet that confidence returns, not a mechanical trade with a known payout.