Fiat-backed, crypto-backed and algorithmic stablecoins

How are stablecoins grouped?

A stablecoin is a token built to hold a steady value, usually one US dollar (see what is a stablecoin). The useful way to tell them apart is to ask what stands behind that dollar. A 2022 Federal Reserve note sorts them into three groups:

• Off-chain collateralized — backed by bank deposits or other cash-like assets held in the traditional financial system. Most people call these fiat-backed.
• On-chain collateralized — backed by assets that live on a blockchain, usually other crypto-assets. Usually called crypto-backed.
• Algorithmic — little or no collateral; smart contracts try to match supply to demand, often with a second token absorbing the swings.

The label tells you who you are relying on. With a fiat-backed coin it is a company and its banks. With a crypto-backed coin it is code, collateral prices and the people who govern the protocol. With an algorithmic coin it is mostly market confidence.

How do the three types compare?

The mechanics of keeping $1 are covered in depth in how stablecoins keep their peg. Here we look at what each design asks you to trust.

What is a fiat-backed stablecoin?

A fiat-backed stablecoin is the simplest idea: a company takes in dollars, issues the same number of tokens, and keeps the dollars (or very short-term government debt) in reserve. Circle, for example, says USDC is backed 100% by highly liquid cash and cash-equivalent assets and is redeemable one-for-one for US dollars — although only through its Mint service for businesses, not for individuals.

The strength of the design is that the backing sits outside crypto markets. Its weakness is that you cannot see the reserves yourself. You depend on the issuer's honesty, the safety of its banks, and the quality of its reserve reports and attestations. Regulators have stepped in here. The US GENIUS Act requires one-to-one reserves in assets such as cash, insured deposits and short-term Treasuries, published monthly. In the EU, MiCA treats a stablecoin tied to one official currency as an e-money token, while tokens referencing other assets or baskets are asset-referenced tokens; see MiCA explained.

We compare the published terms of the two best-known dollar issuers in USDT vs USDC.

How does a crypto-backed stablecoin work?

Crypto-backed coins replace the bank account with a smart contract. In the Sky protocol (formerly MakerDAO), users lock collateral in a vault and generate DAI against it. Sky's documentation says DAI is backed by a mix of stable collateral and an excess of volatile collateral. If the value of a vault's collateral drops below its liquidation ratio, the collateral is sold to cover the debt. Governance can also change the fee vault owners pay to encourage more or less DAI.

The open design is a strength: anyone can inspect the contracts and anyone can mint. The catch is that the collateral is itself volatile, so a fast crash can overwhelm liquidations. Sky also runs a Peg Stability Module that swaps USDC for DAI at a fixed rate; its governance manual notes this concentrates exposure to other stablecoins. Lending mechanics like this are explained in DeFi lending and borrowing.

Why are algorithmic stablecoins so fragile?

Algorithmic stablecoins try to hold $1 without a full pool of reserves. The usual trick pairs the stablecoin with a sister token. In TerraUSD's case, the US Department of Justice describes the promise that one UST could always be swapped for $1 worth of LUNA, and the reverse. When UST dipped, traders could burn it for newly created LUNA, shrinking UST supply.

The flaw is circular. The swap only works while the sister token keeps its value, but heavy selling of the stablecoin floods the market with new sister tokens, pushing their price down. The Federal Reserve studied an earlier case: IRON, minted against 75% USDC and 25% of its sister token TITAN. On 16 June 2021 TITAN fell from about $60 to zero within hours, and IRON dropped below $0.75. In May 2022 TerraUSD followed; the SEC says UST and its sister tokens fell close to zero. The full story is in what happened to TerraUSD.

What mistakes do beginners make when comparing stablecoin types?

• Treating all stablecoins as the same. A token named "USD" can be a fully reserved claim, a crypto-backed loan or a pure incentive scheme.
• Equating transparency with safety. On-chain collateral is visible, but it can still crash faster than liquidations work.
• Being drawn in by yield. TerraUSD's Anchor protocol offered about 20% a year, according to the DOJ. High returns on a "stable" asset are a warning sign, not a feature.
• Forgetting the layers. A crypto-backed coin that holds fiat-backed coins inherits their issuer risk too.
• Ignoring who can freeze it. Circle's USDC terms, for example, let it block addresses and freeze tokens linked to illegal activity.