Stablecoin Types Explained

Fiat-backed: The Stability of Cash and Reserve Reports

The most familiar stablecoin design uses a fiat currency as collateral. Other fiat-based stablecoins use government bonds or cash equivalents.

To declare reserve quality, fiat-backed issuers commonly publish attestations or audits.

Why would a fiat-backed stablecoin lose its peg? Questions about the quality, quantity, or management of the reserves. For instance, the issuance of tokens may exceed the reserves. Redemption restrictions can also prompt doubt. For most fiat-backed designs, one-one redemption is reserved for select business customers, not average retail users. The vast majority of retail stablecoin holders exit through an exchange sale, not direct redemption, .

Before holding a fiat-backed stablecoin, read the most recent attestations and audit reports. Verify the issuer's redemption terms. Confirm that a reputed firm signed the reserve report, and look for wording that the reserves are held in "US dollars" or "cash equivalents". Fiat-backed stablecoins are typically considered the most secure, but the specifics of the reserve disclosures and redemption policies will always matter.

Crypto-backed: Over-collateralised Vaults

In a crypto-backed design, the reserve is usually other cryptocurrencies. The best-known is Maker's DAI. Instead of collateralising one-on-one, Maker vaults require an excess reserve that serves as a buffer. The minimum collateralisation ratio is typically enforced through a smart contract, but may be adjusted. In other words: to borrow 1 DAI, you might have to collateralise 130% to 160% of that, .

Curated for practical users, the main risk of a crypto-backed design is a price drop in the collateral. If BTC, ETH or USDC falls, the collateralised vault becomes under-collaterised. This triggers an auction that sells off a portion of the collateral to restore the security ratio. The holder has an incentive to recollateralise quickly.

Given the possibility of under-collateralisation, crypto-backed stablecoins tend to be issued by DeFi protocols, rather than national banks.

DAI is often considered a reliable option for holding collateral. There are also other stablecoins, so market dynamics can vary.

Algorithmic: Supply-Rule Equations

An algorithmic stablecoin uses a program to adjust its supply in response to demand. One of the most widely known was TerraUSD (UST). Its sister token was LUNA.

Such a stablecoin doesn't hold collateral, but instead promises to expand or contract its supply (i.e. mint or burn units) to maintain the peg. A protocol might issue pegged stablecoin units at a discount, and on sale, release full issuances of a second "governance" token.

A crisis arises if users fear the algorithm might falter, starting a rush to sell the stablecoin. That triggers a sell-off in the sister token, meaning there are more prospectus units at a discount, pushing the stablecoin further from the peg. In enough market margins, that downward feedback loop can occur fast, causing a dramatic collapse.

In May 2022, TerraUSD's peg broke, . The underlying LUNA token lost almost all its value, as the community lost faith in its credentials.

What breaks the peg?

The stability of a peg red lines to the asset type and the strength of the mechanisms that manage it.

A fiat-backed stablecoin is usually quite stable, but the validity of attestations and controls can fail in a crisis. It may also be affected by redemption shortages or delays, which can affect investors' confidence. These risks are higher for less-established issuers.

A crypto-collateral stablecoin's stability draws on the price of the collateral. It can experience rapid depreciation if the collateral loses value, de-peg can occur if the collateralisation threshold is broken. Separately, if a protocol lacks oversight or funds are misplaced, it can affect the holder.

An algorithmic coin peg depends on the market's belief in its algorithm, which can fizzle out fast.