Section I: Types of Stablecoins
Stablecoins maintain their value through four distinct mechanisms, each offering different trade-offs between security, yield generation, and decentralization. The most established approach involves fiat-backed stablecoins (such as USDT and USDC), which maintain their peg by holding cash or cash equivalents such as treasuries and short-term government bonds in 1:1 proportion to circulating supply. Traditional fiat-backed stablecoins like USDT and USDC do not pass the interest they earn down to holders and instead keep it as revenue.
A second category, crypto-backed stablecoins like USDS from Sky (examined in detail in Chapter VII), uses other cryptocurrencies as collateral. These systems typically require overcollateralization where crypto holdings exceed the stablecoin's value to account for inherent asset volatility. This approach trades capital efficiency for the benefit of remaining within the cryptocurrency ecosystem.
More sophisticated synthetic stablecoins have emerged, exemplified by USDe from Ethena (discussed in Chapter VII's yield generation section). These maintain stability through automated hedging strategies using perpetual futures (detailed in Chapter VI) to offset the price movements of their underlying crypto assets. By holding crypto collateral while simultaneously taking short positions that profit when prices fall, these stablecoins neutralize volatility. They can also generate yield from funding rates, the periodic payments that flow between traders holding long and short positions in derivatives markets.
A new type of stablecoins, sometimes called "yieldcoins" (such as USDY from Ondo), uses the same backing mechanism as fiat-backed stablecoins but passes earned interest to holders, effectively creating tokenized money market funds that combine blockchain accessibility with traditional fixed-income returns. The distinction here is business model, not the mechanism for maintaining the peg.
Finally, algorithmic stablecoins represent perhaps the most ambitious but ultimately failed experiment in the space. These systems attempted to maintain stability through programmed mechanisms that automatically adjust token supply based on market demand, with no asset reserves. The fatal flaw emerged during confidence shocks: when users rushed to exit, the algorithms minted more of the backing token to maintain the peg, but this dilution crashed the backing token's value, further undermining confidence in the stablecoin and creating a reflexive death spiral where the stabilization mechanism itself accelerated collapse. While worth mentioning from a historical perspective, all major algorithmic stablecoins have failed, with the UST (Luna) collapse serving as the most prominent cautionary tale.
The remainder of this chapter focuses primarily on fiat-backed stablecoins, which dominate the market with over 95% of total stablecoin circulation and have proven most viable for institutional adoption.