Types of Stablecoins

Stablecoins are often talked about as a single category, but under the surface, they operate in very different ways. Each type relies on a different mechanism to maintain its stability—and understanding how they work helps you evaluate how reliable, transparent, or decentralized they really are. Here's a closer look at the main types of stablecoins in use today.

Fiat-backed stablecoins

Fiat-backed stablecoins are the simplest and most widely used. Each token is backed 1:1 by fiat currency—usually U.S. dollars—held in reserves by a centralized issuer. These reserves are typically stored in bank accounts and may include cash, short-term government bonds, or other liquid assets.

How they work: When a user deposits $1, the issuer mints 1 stablecoin. When the user redeems it, the stablecoin is burned, and they receive $1 back. The idea is that the token always represents an actual dollar sitting in reserve.

Examples: USDT (Tether), USDC (Circle), BUSD (Binance USD — now winding down)

Pros:

• Price stability is generally very strong
• Easy to understand and widely accepted
• Fast transaction times compared to traditional fiat transfers

Cons:

• Requires trust in the issuer and custodians
• Transparency depends on third-party audits (which aren’t always regular)
• Centralized—subject to regulation, seizure, or blacklisting

Crypto-backed stablecoins

Crypto-backed stablecoins are secured by collateral in other cryptocurrencies. Because crypto assets are volatile, these stablecoins are typically overcollateralized. That means users must lock up more value in crypto than the value of stablecoins they receive.

How they work: A user might deposit $150 worth of Ether to mint $100 worth of stablecoins. If the collateral value drops too far, the system automatically liquidates it to maintain solvency. Everything runs through smart contracts—no central authority controls the process.

Examples: DAI (by MakerDAO), LUSD (by Liquity)

Pros:

• More decentralized than fiat-backed models
• Transparent—collateral levels and liquidations are visible on-chain
• Resistant to censorship or seizure

Cons:

• More complex and less intuitive
• Can become unstable in volatile markets
• Depend on active governance oracles and incentives

Algorithmic stablecoins

• Algorithmic stablecoins don’t use traditional collateral at all. Instead, they rely on code-based supply-and-demand mechanisms to hold their price steady. The most well-known model uses two tokens: one acts as the stablecoin, and the other absorbs volatility.

• How they work: If the stablecoin trades above $1, the protocol mints more to drive the price down. If it trades below $1, coins are burned or bought back using a secondary token. The goal is to keep the value centered around the peg algorithmically.

• Examples: TerraUSD (collapsed in 2022), Frax (partially algorithmic), Ampleforth (more experimental)

Pros:

• Fully autonomous—no need for banks or collateral
• Can scale quickly without needing reserves
• Vision aligns with decentralized ideals

Cons:

• Very fragile in practice—prone to death spirals
• Requires constant market confidence to stay stable
• Few have proven long-term sustainability

4. Hybrid and commodity-backed stablecoins

Not all stablecoins fit cleanly into one category. Some combine elements—like partial collateral and algorithmic controls. Others are backed by commodities like gold or tokenized treasury bills.

Examples:

• Frax (partially collateralized + algorithmic)
• Paxos Gold (PAXG) — backed by physical gold
• USDM by Mountain Protocol — backed by U.S. Treasuries

These options serve more specialized use cases—for example, offering exposure to gold without physical storage, or offering yield-bearing stablecoins tied to real-world assets.

Summary table

Type	Backed By	Stability Mechanism	Decentralization Level	Examples
Fiat-Backed	Cash or cash equivalents (USD, etc.)	1:1 reserve and redemption	Low	USDC, USDT
Crypto-Backed	Crypto collateral (e.g., ETH)	Overcollateralized + smart contracts	Medium to high	DAI, LUSD
Algorithmic	None (code-based)	Supply/demand adjustments	High (in theory)	Frax, Ampleforth
Hybrid/Commodity-Backed	Mixed collateral (crypto, fiat, gold)	Partial collateral or assets	Varies	Frax, PAXG, USDM

Final thoughts

No stablecoin design is perfect. Each model involves trade-offs between transparency, decentralization, capital efficiency, and trust. Fiat-backed coins dominate for now because they’re simple and familiar, but more decentralized models are gaining traction—especially in regions or use cases where banking access is limited or trust in institutions is low.

As the technology matures, expect to see new hybrid models that aim to combine the best parts of each approach.