What is Stablecoin

Cryptocurrencies like Bitcoin and Ethereum are famously volatile – their prices can swing wildly from day to day. This volatility makes them less practical for everyday transactions or savings. Stablecoins emerged as a solution to this problem. A stablecoin is a type of cryptocurrency designed to maintain a stable value by pegging itself to an external asset (an “anchor” of value) such as a national currency (like the US dollar) or a commodity (like gold)

In simpler terms, 1 unit of a stablecoin is meant to be worth about $1 (or 1 euro, or whichever asset it’s tied to) at all times. By being linked to more stable assets, stablecoins avoid the sharp price swings of other crypto, making them useful as a medium of exchange and store of value within the crypto ecosystem.

What’s the purpose of stablecoins?

In the crypto world, stablecoins serve as a kind of bridge between volatile cryptocurrencies and traditional money. They allow traders to park value on-chain without exiting to fiat currency, facilitate digital payments and remittances, and enable DeFi (decentralized finance) applications like lending and borrowing with low volatility assets. In short, stablecoins combine “the stability of fiat and the speed and programmability of crypto,” offering the best of both worlds to users.

For example, if you sell Bitcoin for a stablecoin like USDC, you now hold a digital dollar that you can use in the crypto markets or send globally, without worrying that tomorrow it will be worth 20% less. This utility has made stablecoins incredibly popular. They are now integral to crypto trading, payments, and decentralized finance.

Types of Stablecoins

Not all stablecoins work the same way. There are different types of stablecoins based on how they maintain their price peg. The three main categories are: fiat-backed stablecoins, crypto-backed stablecoins, and algorithmic stablecoins. Each type uses a different mechanism to stay stable, and each comes with its own trade-offs. Below, we break down how each type works and give real-world examples of each.

Fiat-Backed Stablecoins (Fiat-Collateralized)

Fiat-backed stablecoins are the simplest and most common type. These are backed 1:1 by traditional fiat currency reserves held in bank accounts or vaults. In practice, a company issues stablecoin tokens and for each token issued, an equivalent amount of fiat currency (like USD) is kept in reserve as collateral. Because you can theoretically redeem the token for the fiat money at any time, the stablecoin’s price stays pegged to that fiat value. For example, if an issuer has $100 million in a bank, it can issue 100 million stablecoin tokens each worth $1, since they’re all backed by actual dollars.

The largest stablecoins in the world are fiat-backed. Tether (USDT) and USD Coin (USDC) are both pegged to the U.S. dollar and backed by dollar-denominated reserves.

How they maintain stability: Whenever the stablecoin’s market price drifts from $1, arbitrage and the redemption mechanism pull it back. For instance, if a USD-backed stablecoin falls to $0.98, traders can buy it cheap and redeem it with the issuer for $1 of actual USD, profiting $0.02 – this drives the price back up to $1. Conversely, if it trades above $1, traders can issue (or release) new tokens by depositing fiat with the issuer and sell those tokens, pushing the price down. In this way, the peg is kept very tight under normal conditions.

Trust and transparency: Users of fiat-backed stablecoins must trust that the issuer truly has the reserves it claims. Reputable issuers publish regular audits or attestations of their reserves. For example, these stablecoins typically rely on independent custodians and auditors to verify that every token is fully collateralized by assets. USDC’s issuer (Circle) provides monthly reserve reports, and USDT’s issuer releases quarterly attestations.

Crypto-Backed Stablecoins (Crypto-Collateralized)

Crypto-backed stablecoins are stablecoins backed by other cryptocurrencies as collateral instead of fiat. These are usually implemented via smart contracts on blockchain platforms, making them more decentralized – no bank is holding your collateral; instead, everything is on-chain. The challenge here is that crypto prices are volatile, so to maintain a stable peg, crypto-backed stablecoins are over-collateralized. This means the value of the cryptocurrency locked up as collateral exceeds the value of the stablecoins issued. The extra cushion guards against price swings in the collateral.

How they work: Suppose you want to create $100 of a crypto-backed stablecoin. You might need to lock up $150 worth of Ether (ETH) or other crypto in a smart contract. You then receive $100 of the stablecoin. As long as the collateral (ETH) retains enough value to cover the stablecoins, the peg holds. If the collateral’s value falls too much (say a market crash), the system will automatically liquidate the collateral to buy back stablecoins and keep the system solvent. This over-collateralization (e.g. requiring 150% or more collateral) and on-chain liquidation mechanism help the stablecoin maintain its $1 target even during crypto market volatility.

Example: The best-known crypto-backed stablecoin is Dai (DAI), created by the MakerDAO protocol. DAI is pegged to $1 and is backed by a basket of cryptocurrencies (like ETH, USDC, and others) locked in MakerDAO smart contracts. To issue (borrow) DAI, users deposit crypto collateral and can borrow up to a certain percentage of that value in DAI (for instance, a 150% collateralization ratio means depositing $150 in ETH allows borrowing up to $100 DAI). The system automatically triggers collateral sales if needed to maintain backing.

Algorithmic Stablecoins

Algorithmic stablecoins are an experimental type of stablecoin that maintains its peg through algorithmic market operations rather than being fully backed by collateral. In other words, they may not hold reserve assets at all (or only partially do); instead, they rely on smart contracts, game theory, and sometimes secondary tokens to control the stablecoin’s supply and demand. The algorithm will expand or contract the supply of the stablecoin in response to price changes, aiming to push the price back to the target. This approach is somewhat analogous to how central banks adjust money supply, but in this case it’s predefined by code.

How they work: There are various models, but a common theme is that the system will mint or burn stablecoins (or related tokens) to keep the price at $1. For example, one model is a dual-token system: you have the stablecoin and a volatile token. If the stablecoin’s price goes above $1, the system mints more of it (or allows users to mint more by burning the other token) to increase supply and push the price down. If the price falls below $1, the system might allow the stablecoin to be burned (retired) in exchange for the other token, reducing supply and pushing price up.

This was the approach used by TerraUSD (UST), which was paired with a sister token, LUNA. Users could always swap $1 worth of UST for $1 worth of LUNA, theoretically stabilizing UST’s price. However, this mechanism collapsed spectacularly in 2022, when a crisis of confidence triggered a death spiral: UST lost its peg, LUNA hyperinflated, and both tokens ultimately crashed to near zero. This failure remains one of the most dramatic examples of how algorithmic stablecoin designs can unravel under stress.

Why algorithmic stables are risky: The big appeal of algorithmic stablecoins is complete decentralization and capital efficiency – they don’t rely on holding massive reserves, and theoretically anyone can use them without trusting an issuer. However, in practice this stability is extremely hard to achieve. These systems depend on market confidence and flawless execution of complex algorithms. If users lose faith that a $1 token is really worth $1, a run can occur (everyone rushing to sell or redeem), and the algorithmic mechanisms can fail to stop a collapse in price. Small fluctuations can be managed, but large swings or attacks on the system can break the peg. Additionally, the dynamics are often hard for users to understand (they are far more complex than simply holding $1 in the bank for each token), which can itself erode confidence. Due to these issues, algorithmic stablecoins are considered the most high-risk type.

Comparison of Stablecoin Types

The table below summarizes the key differences between fiat-backed, crypto-backed, and algorithmic stablecoins, including what backs them, how they keep their value stable, their relative risk levels, and examples of each:

Pros and Cons of Stablecoins

Like any financial tool, stablecoins come with advantages and disadvantages. Below, we outline the general pros and cons of stablecoins as a whole.

General Pros of Stablecoins

• Price Stability: Stablecoins aim to maintain a stable price (often $1), avoiding the wild swings of other crypto. This stability makes them useful for everyday transactions, payments, and savings.
• Useful for Trading and DeFi: Stablecoins are heavily used on crypto exchanges and DeFi platforms as a base trading pair and liquidity asset. Instead of cashing out to a bank, traders swap volatile coins into stablecoins to lock in value. In decentralized finance, stablecoins are used for lending, borrowing, and earning yield (interest) because they remove price risk.
• Fast, Global Transactions: Stablecoins combine the stability of fiat with the technological advantages of cryptocurrency networks. You can send stablecoins to anyone in the world 24/7 within minutes, for often low fees, without needing a bank. This makes them promising for cross-border payments and remittances, potentially cheaper and faster than traditional money transfers.
• Access to the Unbanked or Underbanked: Because stablecoins only require a crypto wallet, they can offer dollar-like stability to people who don’t have easy access to USD bank accounts. In countries with high inflation or limited banking services, stablecoins let users hold a stable value (often in USD) on their phone, protecting against local currency devaluation.

General Cons of Stablecoins

• Counterparty and Trust Risk: Not all stablecoins are created equal, and they rely on trust in their mechanisms or issuers. A fiat-backed stablecoin user must trust the issuer is honest and solvent (will always have the dollars to redeem). History has shown cases where stablecoins deviated from their peg due to trust issues or insufficient reserves – e.g., when USDC briefly lost its $1 peg in March 2023 after a portion of its cash reserves were stuck in a failing bank. Decentralized stablecoins require trust in their smart contract design and collateral management. In short, stablecoins are usually stable until suddenly they’re not, so users must be aware of the backing and risks.
• Regulatory Uncertainty: The rapid growth of stablecoins has drawn regulatory scrutiny worldwide. Regulators worry about scenarios like a stablecoin run (if many people suddenly redeem), the impact on traditional finance, and use in illicit activities. Different jurisdictions are starting to regulate stablecoins – for example, the EU’s MiCA law will require issuers to hold adequate reserves and ban algorithmic stablecoins, and in the U.S. lawmakers have proposed bank-like regulation for stablecoin issuers. New regulations could affect how stablecoins operate or whether some can be issued at all.
• Lower (or Negative) Yield: This is a more minor point, but holding stablecoins may offer little to no inherent return. In fact, some fiat-backed stablecoins have fees or rules that can eat into value (for instance, certain stablecoins might charge a small redemption fee or not pay interest on reserves, whereas if you held actual dollars in a bank you might earn some interest). In DeFi you can earn yield on stablecoins, but the base asset itself is just stable by design, not growing in value.