Stablecoins are digital currencies that are pegged, or tied, to the value of another stable reserve asset like the U.S. dollar or Euro. Stablecoins are designed to be an alternative to highly volatile cryptocurrencies like Bitcoin (BTC) and Ethereum (ETH), resulting in a price-stable digital asset that behaves somewhat like fiat and is more useful as a medium of exchange.
The combination of price stability and flexibility of digital assets have proven to be tremendously successful with billions of dollars flowing into stablecoins like Tether (USDT) and USD Coin (USDC) as they have rapidly become some of the most popular ways to store and trade value in crypto. Stablecoins are able to achieve price stability, or maintain its peg, by holding reserve assets as collateral or through algorithmic designs that control the circulating supply, as well as some combination of the two.
The three main types of stablecoins are based on their underlying collateral structure and the mechanism used to stabilize their value.
Fiat-backed stablecoins are typically backed 1:1 by fiat currency like the U.S. dollar to ensure the legitimacy of the stablecoin's value. These reserves are held by centralized custodians and regularly audited to ensure the asset reserves are accurate. Popular stablecoins in this category include USDT and USDC.
Crypto-backed stablecoins are generally overcollateralized (value of reserve assets exceeds the value of stablecoins issued) by other crypto assets like BTC and ETH which are prone to high volatility. The advantage of an overcollateralized, crypto-backed stablecoin like MakerDAO's DAI is the reserve assets are stored on-chain in smart contracts and does not depend on any centralized entities for custody of assets.
Algorithmic stablecoins may or may not use fiat or crypto assets as collateral. Rather, their price stability is primarily managed through unique algorithms and smart contracts that control the token's circulating supply. An algorithmic stablecoin like Frax's FRAX works to reduce the number of tokens in circulation when its price falls below its peg to increase the stablecoin value upwards. When the price exceeds its peg, new tokens are then issued or minted into circulation to pressure the stablecoin value downwards.