One Label, Three Very Different Systems
When people talk about stablecoins, they often lump them into one category: digital currencies that don’t change in price.
But behind the word “stablecoin” lie three entirely different mechanisms — each with its own way of achieving price stability. Some are backed by real money in banks. Others use volatile crypto. And some… rely purely on math.
Understanding these models is essential — not just for choosing the right coin, but for seeing which ones are safe, which are sustainable, and which are playing with fire.
Let’s unpack the 3 major types of stablecoins in detail.
Type 1: Fiat-Collateralized Stablecoins
Overview
These are the most common and easiest to understand. The issuer holds actual fiat money (like U.S. dollars) in a bank account. For every 1 stablecoin issued, there should be 1 dollar (or equivalent) in reserve.
Real-World Examples
- USDC (USD Coin – issued by Circle, backed by U.S. banks)
- USDT (Tether – widely used but more opaque)
- EUROC (Euro Coin)
- TrueUSD, PAX Dollar
Stability Mechanism
- Stability is maintained by redemption guarantees: 1 stablecoin can always be exchanged for 1 fiat dollar.
- Peg enforcement relies on trust in the issuer’s reserves and regular audits.
Pros
- Easy to use and understand
- Low volatility
- High liquidity in crypto markets
- Easy to integrate into apps and services
Cons
- Centralized: control rests with a single company
- Requires trust in traditional banks and regulators
- Subject to blacklisting and censorship
- Audit transparency varies
What to Watch
- Look for coins with monthly attestations or full audits
- Check how the fiat reserves are stored (cash vs. commercial paper vs. treasuries)
Type 2: Crypto-Collateralized Stablecoins
Overview
Instead of being backed by dollars, these coins are backed by other cryptocurrencies like Ethereum. Because crypto is volatile, these coins are usually overcollateralized.
Real-World Examples
- DAI (MakerDAO)
- sUSD (Synthetix)
- LUSD (Liquity)
Stability Mechanism
- Smart contracts lock up more crypto than the value of the stablecoin.
- If the value of the collateral drops, the system may automatically liquidate positions to maintain the peg.
- Governance often handled by DAOs (Decentralized Autonomous Organizations)
Pros
- More decentralized than fiat-backed coins
- Transparent and programmable
- Resistant to government control
Cons
- Complex to manage and understand
- Vulnerable to black swan events (e.g. massive ETH crash)
- Requires stable network activity (high gas fees can disrupt liquidations)
- Lower scalability due to capital inefficiency
What to Watch
- Look at the collateralization ratio (e.g., 150%)
- Check the liquidation system and governance model
- Study historical peg performance during market crashes
Type 3: Algorithmic Stablecoins
Overview
These stablecoins don’t use any collateral. Instead, they use smart contracts and economic incentives to control supply and demand.
When the price goes above $1 → print more tokens
When the price goes below $1 → burn tokens or incentivize buyback
Real-World Examples
- FRAX (partially algorithmic)
- AMPL (elastic supply)
- USDD (on Tron)
- UST (TerraUSD) – failed in 2022
Stability Mechanism
- Relies on investor confidence in the protocol
- Often tied to a dual-token system (e.g., UST and LUNA)
- Adjusts supply automatically to push price toward $1
Pros
- Fully decentralized (in theory)
- No need for large capital reserves
- Potentially highly scalable
Cons
- Extremely fragile – if confidence is lost, the system collapses
- Death spiral risk is real (e.g., UST crash wiped $40B)
- Highly experimental and not widely trusted
- Vulnerable to coordinated attacks and market manipulation
What to Watch
- Is there any collateral backup at all?
- How did it behave during past volatility?
- Is the ecosystem dependent on unrealistic growth assumptions?
Side-by-Side Comparison Table
| Feature | Fiat-Backed | Crypto-Backed | Algorithmic |
|---|---|---|---|
| Collateral Type | Fiat (e.g. USD) | Crypto (e.g. ETH) | None / Dynamic |
| Stability Method | Reserve + Redemption | Overcollateralization | Supply/Demand Algorithm |
| Centralization | High | Medium-Low | Low (in theory) |
| Transparency | Varies by issuer | On-chain | Code-based, often opaque |
| Scalability | High | Medium | High (in theory) |
| Risk Level | Low–Medium | Medium–High | Very High |
Which One Should You Use?
It depends on your use case:
- For storing stable value or making payments → use USDC or USDT
- For DeFi and decentralization → try DAI or LUSD
- For experiments → only approach algorithmic coins with extreme caution
You don’t have to choose one forever. Many advanced users diversify across models based on risk tolerance and purpose.
Final Thoughts: Know the Mechanism Before You Trust the Name
Not all stablecoins are created equal — and not all deserve the “stable” label.
Fiat-backed coins depend on banks.
Crypto-backed coins depend on smart contracts.
Algorithmic coins depend on market psychology.
Before you send your paycheck, your savings, or your business revenue into a stablecoin… make sure you understand what keeps its value stable.
Because when the backing collapses, the coin goes with it.