TL;DR

Stablecoins are cryptocurrencies designed to maintain a stable value, often pegged to fiat currency like the US dollar, though true stability hasn't always been achieved. The sources identify five primary types: Fiat-backed (most common, backed by reserves, but less decentralized), Cryptocurrency-backed (backed by other crypto, often overcollateralized), Algorithmic (rely on code and incentives, history of failures like Terra/Luna), Commodity-backed (linked to assets like gold, niche and require verification), and Flatcoins (emerging, aim to preserve purchasing power over time rather than a fixed nominal value, presenting unique collateral and regulatory challenges, with energy-backed designs being explored as an alternative approach).

The 5 Types of Stablecoins

Stability in crypto is more than a fixed dollar peg. This is a dynamic space, and it has not consistently demonstrated perfect stability, despite the name. However, they are by far of the most globally useful things out there.

Most people are familiar with USDT & USDC with their 90%+ market cap dominance, but there is more to stablecoins than that.

Fiat-Backed Stablecoins

These are the dominant players, widely recognized. Examples include USDT and USDC. The underlying principle is straightforward: one cryptocurrency coin is intended to represent one unit of fiat currency, typically the US dollar. They are the most popular type and, in my assessment, have exhibited the highest degree of stability to date, capturing over 90% of the market share. Public trust in these is considerable. However, a key challenge is their reliance on traditional banking infrastructure and government bonds for backing. From my perspective, this counteracts the core principle of decentralization inherent in cryptocurrency. Nevertheless, they provide significant utility, particularly for individuals who face challenges accessing the US dollar through conventional banking channels. While functional, they do not fully embody the decentralized ethos of cryptocurrency.

Cryptocurrency-Backed Stablecoins

These emerged as a decentralized alternative to fiat-backed variants. The objective remains the same – a peg to the US dollar. One coin represents one US dollar value on-chain. The distinction lies in the reserve assets; instead of relying on bank reserves or treasury bonds, they utilize other cryptocurrencies such as ETH or BTC. The most notable example is DAI from MakerDAO. DAI operates on an overcollateralization model. This necessitates depositing significantly more collateral (~150% or more in other cryptocurrencies) to mint $1 worth of DAI. Requiring 150% collateral for a stablecoin representing merely $1 lacks capital efficiency while still being risky. See Black Thursday: The sell-off of 12 March resulted in $4.5 million of unbacked DAI in the MakerDAO system.

Algorithmic Stablecoins

This category involves more complex designs, and their history has been challenging. These systems aim to minimize reliance on substantial collateral, depending instead on code, algorithms, and market incentives to maintain their peg. They frequently employ a two-token system where one token is designed for stability, while a correlated, volatile token absorbs price fluctuations. Smart contracts manage these processes, adjusting supply through minting or burning to facilitate arbitrage and price stability.

While theoretically compelling, practical implementation has faced significant difficulties. The notable collapse of the Terra/Luna USD system in 2022 serves as a primary illustration. This event resulted in a collapse ("death spiral"), the peg was entirely lost, and substantial financial losses occurred. This incident has cast a significant shadow upon algorithmic stablecoins. Presently, they exhibit low adoption, and it remains to be seen if a viable new design will emerge.

Commodity-Backed/Tied Stablecoins

The concept here is to link value to a commodity such as gold. Attempts involve either an algorithmic peg to the commodity price or claims of holding the physical commodity in reserve. Frankly, this segment is highly specialized. The algorithmic variants face similar trust challenges as algorithmic stables. For those claiming physical reserves, verification is critical. Rigorous audits would be necessary to establish personal trust in such claims. A mere assertion of gold reserves in a vault is insufficient. (I am personally curious to see where this goes with gold as this really seems to be a market with high interest.)

Flatcoins

This represents a relatively nascent narrative that is gaining attention. Instead of targeting a fixed dollar value (nominal value), flatcoins aim to preserve their real value or purchasing power over time. Various approaches are being explored:

My principal concern with these designs relates to collateral management. How is the required collateral level maintained as the purchasing power target increases over time? If an initial deposit of $1 is made today, but that value must represent $1.05 in the future, could this lead to undercollateralization unless users contribute additional collateral? I believe these designs encounter numerous hurdles analogous to those faced by algorithmic stablecoins. Without genuinely more robust or innovative mechanisms, I remain unconvinced regarding their long-term viability. Furthermore, the regulatory classification of these instruments is also less defined. Their classification, whether as derivatives or indices, remains ambiguous because they are not merely stable; their value is intended to rise, which introduces a speculative element. With low volume, they possess the potential to behave more like speculative altcoins than stable assets. While I appreciate the underlying concept of maintaining purchasing power, I do not believe simply using an inflation oracle and an algorithmic model is sufficient.

Energy Money as Digital Cash?

But what if you do not rely on the US dollar at all? What if its value was linked to an asset that possesses intrinsic stability potentially exceeding that of the US dollar? Energy could serve as such an asset.

This concept leverages the Proof-of-Work infrastructure. By analyzing global mining costs, primarily electricity prices (as hardware costs have become less significant), one can estimate the cost of producing the coin. The aim is to tie the coin's value to these production costs. This is conceptually similar but not the same as the historical gold standard, where value was linked to a resource. A key distinction is the one-way backing. Energy contributes to the creation of coins (via mining cost), but coins are not exchanged back for physical energy. This model is rational given that the cost of energy is fundamental to the production of almost everything.

The potential for a crypto-native asset that does not rely on central bank infrastructure for its value is, in my opinion, exceptionally valuable. Bitcoin is effective for storing value, but its volatility limits its utility for everyday transactions; it is typically hodled rather than spent. Therefore, there is a need for an asset with greater value stability than Bitcoin and that possesses a propensity for spending.

The Evolving Landscape

Currently, fiat-backed stablecoins like USDT and USDC dominate the market due to user comfort and their reliable peg to the US dollar. However, the other types represent ongoing innovation in the pursuit of different forms of stability. Current USDT alternatives face hurdles, but it is exciting to see innovative approaches like the energy concept offer potential pathways toward creating truly crypto-native assets. As it stands now, the stablecoin focus will continue to grow and evolve, especially as they are accepted for day-to-day payments in more places.

If you prefer an MP4 format, here is a video I made on the topic:

https://youtu.be/Z_Clqd91fHQ?embedable=true

Key Terms Glossary

When preparing this article, I have referenced multiple terms that might be not widely familiar to you if you are not that deep into crypto. So, here is an FAQ-style glossary for those (yes, AI helped me with that):

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