Stablecoins are a type of digital asset specifically designed to maintain a constant value. Unlike other digital assets such as Bitcoin (BTC) and Ethereum (ETH), which have experienced price volatility, stablecoins, as the name suggests, are designed to maintain a fixed value. This is achieved by pegging the stablecoin to a reserve of assets such as fiat currencies, commodities, or even other cryptocurrencies, which serve as a reference point to stabilise their price.

The primary objective of stablecoins is to offer the benefits of digital currency — such as transparency, low transaction costs, and fast settlement times — without the price swings that have become associated with cryptocurrencies. By offering a more predictable store of value, stablecoins bridge the gap between the traditional financial systems and the emerging world of decentralised finance (DeFi), making them suitable for a variety of applications, including trading, remittances, and payment solutions.

Their increasing popularity and the growing number of projects underscore their potential to redefine financial transactions. Today, there are dozens of active stablecoin projects, though only a handful account for a majority of all stablecoin trading volume.

Below I'll explore the different types of stablecoins and the different mechanisms they use to keep their value pegged to a certain value or the value of traditional fiat currencies, commodities, or other types of assets.

All stablecoins aim to follow the price of another asset. However, they don’t all accomplish this in the same way, meaning some have unique risks associated with their model. These risks have the potential to create the price fluctuations stablecoins aim to avoid.

For instance, collateral-backed and crypto-backed stablecoins rely on different reserve methods, which, while providing tangible support, introduce risks such as reserve volatility or mismanagement. Fiat-backed stablecoins are generally considered higher quality because they are pegged to the value of real-world currencies and backed by reserves in that currency held by a regulated financial institution.

Algorithmic stablecoins, in contrast, forgo reserve backing in favour of smart contract algorithms, which can lead to issues if the algorithms fail to adapt to rapid market changes.

Each model's underlying technology and execution impact its stability and trustworthiness, heavily influencing investor confidence and market acceptance. As such, anyone interested in investing or using stablecoins should carefully consider the specific risk factors and mechanisms that distinguish each type from another.

Generally, stablecoins fall into four ‘types’, each with unique characteristics.

This model is also referred to as off-chain stablecoins because the stablecoin derives its value from outside the blockchain. With collateral-backed stablecoins, cash or asset reserves act as collateral to prove that each coin is backed by its equivalent amount. As a result, they are also sometimes referred to as fiat-collaterised stablecoins.

These stablecoins are typically managed by a central operator that tracks circulation and allows users to mint and redeem tokens in their custody. They make it easier for users to make direct trades between fiat currency and tokens equally valuable to that fiat currency. For example, the largest stablecoins in terms of trading volume and market capitalisation are Tether (USDT), Circle’s USDC, backed by collateral to the US dollar and Circle’s EURC, backed by collateral to the Euro.

If the value of the currency changes (in terms of its purchasing power), then the value of the coin changes along with it. Therefore, the price of a fiat-backed stablecoin is guaranteed to align with its fiat target so long as the company behind the stablecoin is appropriately managing its coin supply and cash reserves.

In many cases, the reserves are regularly audited by a third party. This is often an accountancy firm, for example USDC is audited by Deloitte, and this can help ensure the stablecoins tokens in circulation are equal to the reserves held by the firm.

Often considered a sub-set of collateral-backed stablecoins, commodity-backed stablecoins are a token backed one-to-one by a standard unit of the commodity they are connected to. They are a newer asst class that some view as having the potential to offer a more cost-efficient and safer way to gain exposure to assets such as gold as tokenised commodities don’t require physical storage of the underlying asset.

As such, like collateral-backed stablecoins, the token issuers should maintain audited physical reserves so that users can redeem their tokens should they wish. Redemption can be a physical redemption of the underlying asset or the fiat equivalent.

For example, one of the most popular tokens, PAX Gold, issued by Paxos is equal to one fine troy ounce of a London Good Delivery gold bar and redeemable for physical gold or fiat currency. Tether Gold (XAUt), issued by stablecoin issuer Tether, shares similar characteristics but only issues XAUt against allocated gold, so a holder can always view the serial number of their reserve allocation by typing in the blockchain address of their tokens. However, XAUt can only be redeemed for physical gold.

These are also referred to as on-chain, or crypto-collateralised, stablecoins where cryptocurrency reserves function as collateral to ensure a stablecoin maintains a one-to-one value with an underlying asset. Most of these stablecoins are also pegged to the value of the US dollar, however, the collateral used to obtain the stablecoin does not have equal value to the dollar.

Unlike collateral-backed stablecoins, these assets generally lack a central administrator. Due to their design, the stablecoin supply cannot be altered by a single individual on the network. Instead, smart contracts are programmed to respond to changes in the market price of the locked assets.

Any price instability in the collateral impacts how much a user receives when they convert it back to dollars via a fiat off-ramp – as noted above – the value of that cryptocurrency can move significantly. To account for potential volatility of the underlying cryptocurrency, these stablecoins are often over-collateralised, or in other words, the value of cryptocurrency backing the stablecoins is greater than the value of stablecoins in circulation.

This type of digital asset relies on a smart contract to maintain a price peg between a stablecoin and an asset. Some algorithmic stablecoins also use a secondary native token to regulate their price stability. Others, called rebase tokens, automatically adjust their supply in circulation as a method to maintain the price of the asset they aim to track, such as the US dollar.

If the stablecoin price begins falling beneath its peg, the system will reduce (burn) the supply of tokens in circulation, thereby increasing demand for the remaining coins. However, if the stablecoin’s price climbs above its peg, the algorithm will release (mint) further tokens into circulation, effectively devaluing each coin. Rather than maintaining reserves to guarantee their price, these assets rely on the ability of the algorithm to respond accurately to changing market conditions and not be open to any manipulation.

This model has, historically, been viewed as the riskiest due to its vulnerability to manipulation. This was bought into focus in 2022 when Terra Luna, one of the largest algorithmic stablecoin projects at the time, collapsed. That began when a large volume of the platform’s algorithmic stablecoin TerraUSD (UST) was dumped on the market causing it to ‘break its peg’ to the US dollar, where its value fell below a one-to-one ratio with its associated asset. The project went from a market capitalisation of around $60bn to close to zero.

Stablecoins that aim to track the price of specific fiat currencies like GBP, the US dollar or Euro, can serve as a bridge between traditional finance and decentralised finance (DeFi). Stablecoins achieve this by facilitating easy, quick and reliable transfers across borders using DeFI principles and underlying distributed ledger technology (DLT).

Today, stablecoins are primarily being used to trade digital assets. However, there are several emerging use cases where firms are experimenting with stablecoins to determine how they can be scaled. This includes, for example, issuing a stablecoin to facilitate faster and cheaper cross-border retail payments.

One indicator of how stablecoins could be used for payments can be seen in global payment firm Stripe’s acquisition of Bridge, a platform that offers services to help businesses accept payments in stablecoins.

The future development of stablecoins within the payments mix will be determined by regulatory frameworks.

In the EU, the Markets in Crypto Assets regulation, MiCA, sets out stringent requirements for the digital assets industry. Any firm seeking to offer digital assets services within the bloc, whether that’s custody, trading, portfolio management or advice, must be authorised by one of the EU’s 27 national financial regulators. Stablecoins – referred to as “e-money tokens” (EMTs) if linked to the value of a fiat currency, or “asset-referenced tokens” (ARTs) otherwise, came into effect in June 2024, requiring issuers to hold suitable reserves and meet strict governance guidelines.

In late 2023, the UK Financial Conduct Authority (FCA) and Bank of England published proposals for regulating stablecoins. This was followed in November 2024 by the FCA publishing its Crypto Roadmap that set out an indicative timeline for various Discussion Papers, Consultation Paper and Policy statements. This suggests rules will come into effect in the second half of 2026.

In my next blog post, I'll explore some of the potential use cases in greater detail. In the meantime, you can also read more about the characteristics of an ideal stablecoin here.