What Is a Stablecoin? The Three Types, Compared
Stablecoins hold a fixed value, until they don't. The three designs fail in three different ways, and the differences are worth knowing before you hold one.
What this covers
A stablecoin is a crypto token designed to stay at a fixed value, almost always one US dollar. It exists because moving between crypto and normal money is slow and expensive, and traders wanted somewhere to sit that did not move in price.
The interesting question is not what a stablecoin is. It is what makes it stay at a dollar, because the answer differs by design, and each answer fails differently.
Type 1: Backed by real dollars
The issuer takes in a dollar, mints a token, and holds the dollar in a bank account or in short-term government debt. Redeem the token and you get the dollar back. USDC and USDT work roughly this way.
Why it holds: because there is genuinely a dollar behind it, and arbitrage does the rest. If the token trades at 99 cents, someone buys it and redeems it for a dollar, which pushes the price back up.
How it fails: the reserves are not what the issuer claims, or they are held somewhere that becomes unavailable. This is not hypothetical. USDC briefly traded well below a dollar in March 2023 when part of its reserves sat in a bank that failed over a weekend. It recovered once the deposits were guaranteed, but for about two days, holders had no idea whether they would.
What to check: who audits the reserves, how often, and what the reserves actually consist of. Both major issuers publish attestations. Read the composition, not the headline number.
Type 2: Backed by other crypto
Instead of dollars, the token is backed by crypto locked in a smart contract. Because that collateral moves in price, the system demands more than a dollar of it per dollar issued, often $150 or more. If the collateral value falls too far, the position is automatically liquidated. DAI is the long-running example.
Why it holds: over-collateralisation plus automatic liquidation. The contract is public, so anyone can verify the backing exists rather than trusting a company’s statement.
How it fails: a violent price crash outruns the liquidation machinery, or the network gets so congested that liquidations cannot execute. Then the system is briefly backed by less than it owes.
The trade-off: you gain transparency and lose capital efficiency. Locking $150 to issue $100 is expensive, and someone has to want to do it.
Type 3: Algorithmic
No meaningful collateral. The peg is maintained by a mechanism, typically minting and burning a second, free-floating token to absorb demand.
Why it was supposed to hold: arbitrage incentives. When the stablecoin trades below a dollar, users can burn it for a dollar’s worth of the paired token, which reduces supply and pushes the price up.
How it fails: the incentive runs backwards under stress. If people doubt the peg, they exit; exiting mints more of the paired token; the paired token falls; which gives people more reason to doubt the peg. This is a death spiral, and it is not a theoretical risk. TerraUSD was the largest example, and its collapse in May 2022 erased tens of billions of dollars of value in under a week.
Current status: the category is largely discredited. Treat any new version with deep suspicion, regardless of how the mechanism is described.
Side by side
| Fiat-backed | Crypto-backed | Algorithmic | |
|---|---|---|---|
| Backed by | Dollars and short-term debt | Over-collateralised crypto | Nothing durable |
| Verify by | Trusting an auditor | Reading the chain | Trusting the model |
| Main risk | Reserves are not there or not reachable | Crash outruns liquidations | Confidence collapse |
| Track record | Mostly held, with scares | Held through several crashes | Repeated total failures |
| Beginner-appropriate | Yes, with care | Understand it first | No |
What a stablecoin is not
It is not a bank deposit. There is no deposit insurance. If the issuer fails, you are an unsecured creditor.
It is not risk-free yield. Platforms offering high returns on stablecoins are lending them out. The return comes from a borrower who might not repay, and several such platforms have frozen withdrawals and gone bankrupt.
It is not necessarily censorship-resistant. The major fiat-backed issuers can and do freeze specific addresses on request from law enforcement. That is a feature to regulators and a risk to you, depending on what you thought you were holding.
The practical takeaway
For ordinary use, meaning parking value between trades or moving money outside banking hours, a large fiat-backed stablecoin from an issuer that publishes regular reserve attestations is the reasonable default. Getting into one usually means going through exchanges that support direct bank transfer, since buying a stablecoin with a card adds a fee to an asset whose whole point is not moving.
Keep two things in mind. A peg is a claim, not a law of physics; it holds because a mechanism works, and mechanisms have failure modes. And “stable” describes the intent, not a guarantee.