How Stablecoins Work: Fiat-Backed vs Crypto-Backed vs Algorithmic

Every stablecoin makes the same promise — a token worth exactly one dollar (or one euro, or one gram of gold) — but they keep that promise with very different machines. There are three dominant designs: fiat-backed reserves, crypto-collateralized vaults, and algorithmic supply mechanics. Knowing which machine stands behind a token tells you what can break it.

The shared trick: arbitrage

All stablecoins rely on the same force to hold their peg: if the market price dips below $1, someone should be able to buy the token cheap and exchange it for $1 of value, pocketing the difference — and their buying pushes the price back up. Where designs differ is what you can redeem the token for: actual dollars, collateral in a vault, or nothing at all.

Fiat-backed: the IOU model

USDC and USDT work like tokenized bank deposits. Circle takes your dollars, puts them in bank accounts and short-term Treasury funds, and mints an equivalent token. When you redeem, it burns the token and wires back dollars. The peg holds because arbitrageurs can always redeem at par with the issuer — buying discounted USDC on an exchange and cashing it out with Circle is free money until the price recovers.

The model's strength is simplicity: reserves are verifiable and redemptions are reliable. Its weaknesses live off-chain — the issuer must actually hold the money (attestations matter), its banks must stay solvent (the 2023 SVB crisis briefly depegged USDC to $0.87), and the issuer can freeze tokens at the contract level.

Crypto-collateralized: the pawnshop model

DAI removes the company but keeps the collateral — the backing just lives on-chain instead of in a bank. You lock $150 of ETH in a smart contract vault and mint up to $100 of DAI against it. If your collateral's value falls toward the loan, the contract automatically sells it (liquidation) before the system becomes under-backed. The over-collateralization buffer — typically 150% or more — absorbs ETH's volatility so the stablecoin does not have to.

This design is genuinely decentralized at the contract level: no company can freeze your DAI or deny your redemption. The compromises are capital inefficiency (you need $1.50 to create $1) and collateral drift — a large share of DAI's backing today is itself USDC and tokenized Treasuries, reintroducing the centralized dependencies it was built to escape.

Algorithmic: the confidence model

Algorithmic stablecoins removed collateral entirely and tried to hold the peg with incentives alone. TerraUSD (UST) could always be swapped for $1 of its sister token LUNA: buy UST at $0.95, burn it for $1 of LUNA, profit. That mechanism worked — until it did not. When confidence broke in May 2022, redemptions minted so much LUNA that its price collapsed, making each redemption worth less, triggering more redemptions. The reflexive "death spiral" erased roughly $40 billion in days.

Side by side

Which model should you trust?

For payments, savings, and building products, fiat-backed stablecoins from transparent, regulated issuers are the practical choice — their risks are known and monitored. For censorship-resistant DeFi collateral, over-collateralized designs offer real (if imperfect) decentralization. And for algorithmic designs promising yield, the lesson of UST is permanent: ask what the peg redeems into, and what happens when everyone redeems at once.

Keep exploring in the stablecoins hub — read USDC vs USDT, see how USDC works on Stellar, or practice with the Stablecoins in Practice masterclass.

Frequently asked questions