Arbitrage: Peg Stability

Peg Stability and the Interaction of Borrowing, Repayment, and Liquidation

The relationship between borrowing, loan repayment, and liquidation creates a dynamic system that constantly pushes the synthetic asset price back toward the protocol price:

Borrowing increases supply when the market price is higher than the protocol price, driving prices downward.

Loan repayment reduces supply, increasing demand when the market price is below the protocol price, pushing prices upward.

Liquidations create immediate market demand when collateral falls below the liquidation ratio, helping stabilize the peg by reducing the supply of synthetic assets and driving prices upward.

The Role of Borrowing and Liquidation Ratios in Peg Stability

The spread between the borrowing and liquidation ratios is crucial for determining how frequently liquidation events occur, which in turn affects peg stability:

Narrow Spread: A narrow spread between the borrowing ratio and liquidation ratio leads to frequent liquidations, driving more consistent market demand for synthetic assets. This results in a more stable peg, as liquidators continuously correct price deviations.

Wider Spread: A wider spread provides borrowers with more flexibility, reducing the frequency of liquidations. However, this can allow larger deviations from the protocol price before corrective action is taken, which might lead to less frequent but larger price corrections.