Four major types of stablecoins

Stablecoins can be categorised into four different types by their reserve composition, reserve maintenance, and pegging mechanism.

👉 Fiat-referenced stablecoins

Fiat-referenced stablecoins are linked to a fiat currency by maintaining reserves in traditional, highly liquid assets.

To purchase fiat-backed stablecoins, buyers request the purchase and deposit fiat off-chain before receiving the newly-issued coins on-chain. These stablecoins can be traded on the secondary market. Sellers follow a similar route to return fiat-backed stablecoins and withdraw fiat.

One example of fiat-backed stablecoins is Tether USDT, whose reserve is over-collateralised by 6%, with only ~0.1% of the cash-equivalent reserve composed of cash and bank deposits.

👉 Crypto-backed (over-collateralised) stablecoins

Crypto-backed stablecoins can over-collateralise to ensure higher stability.

Instead of “buying” stablecoins, buyers receive stablecoins as crypto-backed loans from the issuer and stake cryptoassets as the collateral in the reserve.

To redeem the stablecoin, buyers repay the principal asset with relevant interests to receive the collateral. As no fiat is involved in the collateralisation, the whole process is completely on-chain.

One example of a crypto-backed stablecoin that is over-collateralised is MakerDAO’s DAI.

Issuers may sell the collateral assets to preserve the value of reserves, depending on price fluctuations.

👉 Crypto-backed (risk-hedged) stablecoins

Another type of crypto-backed stablecoin hedges price volatility risks with financial instruments.

The issuance and redemption process is largely similar to that of fiat-backed stablecoins, except that all transactions are done on-chain.

One notable example is Ethena Lab’s USDe. As the value of collateral changes, buyers may receive a different amount of collateral than what they initially deposited for issuance.

👉 Algorithmic stablecoins

Algorithmic stablecoins strive to maintain their value by adjusting the supply of the stablecoin using algorithms.

Many algorithmic stablecoins implement incentive mechanisms that encourage users to participate in maintaining the peg, such as rewards for providing liquidity or participating in governance.

TerraUSD is a prominent example of an algorithmic stablecoin that, despite gaining popularity in early 2022, lost its peg to the US dollar. This loss of stability led to a decline in market confidence and caused a liquidity crisis, ultimately resulting in its collapse.

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