What are the different types of stablecoins?

Stablecoins are a type of cryptocurrency intended to maintain a steady value. However, not all stablecoins employ the same methods to achieve this objective. They can be broadly categorized into three main categories: fiat-backed, crypto-backed, and algorithmic stablecoins.

Fiat-backed stablecoins

Fiat-backed stablecoins are designed to mirror the value of traditional currencies like dollars and euros and are by far the most popular category. Their issuers claim that they maintain a reserve of liquid assets to back their stablecoin on the blockchain. Ideally, they hold their reserves in cash or cash equivalents such as treasuries, which should match or exceed the circulating supply of their stablecoin. Tether’s USDT and Circle’s USDC are prominent examples of fiat-backed stablecoins.

Fiat-backed stablecoins are commonly used for trading, remittances, and lending and borrowing activities within the decentralized finance sector. However, these stablecoins are centralized, their reserves may include volatile and risky assets, and the absence of independent third-party audits presents additional risk. Nevertheless, the popularity, liquidity, and resilience against price manipulation of fiat-backed stablecoins underscore their importance within the cryptocurrency space.

Crypto-backed stablecoins

As their name suggests, crypto-backed stablecoins are backed by cryptocurrencies held as collateral. However, due to the volatile nature of cryptocurrencies, crypto-backed stablecoins typically require over-collateralization to a specific ratio to ensure stability. For instance, a collateralization ratio requirement of 150% means a user needs to deposit $150 worth of crypto to mint $100 of a stablecoin. The top example of a crypto-backed stablecoin is MakerDAO’s DAI, currently the largest crypto-backed stablecoin by market capitalization.

Crypto-backed stablecoins are decentralized and trustless but aren’t free from risks. Fluctuations in the collateral supporting these stablecoins have the potential to disrupt their peg, and if prices crash, automatic liquidations into the underlying collateral might take place.

Algorithmic stablecoins

Algorithmic stablecoins leverage algorithmic and incentive mechanisms to maintain their price stability. Unlike fiat-backed stablecoins, which are collateralized, or crypto-backed stablecoins, which are over-collateralized, algorithmic stablecoins often operate under-collateralized. This means they don't rely on a reserve of assets for their value.

The stability of algorithmic stablecoins is heavily dependent on market demand. If demand decreases below a certain threshold, the entire system can falter. That’s exactly what happened last year when the TerraUSD stablecoin experienced a significant de-pegging event when its price fell below $1, leading to a massive sell-off and a consequent drop in the price of Luna, the governance token of the Terra blockchain system. The Terra-Luna collapse wiped out over $40 billion in investor wealth in a matter of days in May 2022.

Despite these potential downsides, the transparency and decentralization offered by algorithmic stablecoins can be attractive to some users, as their operations are governed entirely by auditable code.

Finally, there are some asset-backed stablecoins, such as Paxos Gold and Tether USDT +0.038% Gold, that claim to be backed by physical reserves of precious metals, providing stability through tangible assets.