What started as a little experiment in 2014 when Tether, the first stablecoin was launched, has grown to become a $156 billion market. This is a result of the gradual but increasing adoption of cryptocurrencies as a better alternative to the fiat system. On a closer look, the stablecoin market seems to have benefitted the most from this trend owing to the fact that they serve as the first point of call for anyone entering the crypto economy because they provide the on-ramp and off-ramp options and now serve as a bridge between crypto and the fiat system.
In a less than a decade, Stablecoins have evolved to cover a broad range of three categories:
Fiat-backed stablecoins
Crypto-backed Stablecoins
Algorithmic Stablecoins
Fiat-backed Stablecoins
When a stablecoin maintains its stability by being pegged to the price of a local currency like the US dollar, it is called a fiat-backed stablecoin. They maintain 1-to-1 collateralization with fiat currencies held in reserves somewhere around the globe.
For example, USDT is a stablecoin pegged to the US dollar. For every USDT circulating in the crypto economy, there are USD equivalents held in a reserve bank, that is, for every 1 USDT minted, 1 USD must be deposited and locked up in a reserve.
Other examples of stablecoins in this category include: USDC, BUSD, PAX, etc
Crypto-backed (Decentralized) Stablecoins
Crypto-backed stablecoins are pegged to the value of other crypto assets held in smart contract reserves. Using DAI, a crypto-backed stablecoin issued by Maker, it is pegged to the price of dollars.
To mint 1 DAI, one has to deposit at least 1.75USD worth of ETH into the DAI smart contract and then redeem 1 DAI for his deposit.
Unlike a fiat-backed stablecoin that is 1:1 pegged, a crypto-backed stablecoin is usually over-collateralized to make room for the volatile nature of the assets the stablecoin is backed by. In order words, they are over-collateralized to absorb to a degree the volatility of underlying assets.
Other crypto-backed (decentralized) stablecoins in this category include cUSD, MIM, etc
Algorithmic Stablecoin
Algorithmic Stablecoins (Algos) are designed to work based on pre-set conditions in a smart contract that adjusts its value using a seignorage (mint-and-burn) mechanism, a system where more tokens are minted when demand exceeds supply and tokens burnt when supply exceeds demand. To achieve this, many algorithmic stablecoins introduce a governance token for their protocol which can be burnt and minted by design.
Using UST as an example, it is backed algorithmically by LUNA which allows $1 of UST to be minted when $1 of LUNA is burnt and vice versa.
Applying the law of supply and demand, when $1UST is above $1USD (meaning more demand over supply), LUNA holders are incentivized to burn their token to earn from the peg difference.
In the case where $1UST is below peg (when supply is greater than demand). To achieve equilibrium, UST supply is reduced by incentivizing users to redeem their UST for LUNA and earn some profit).
The above mechanism is a basic overview of how algorithmic stablecoins work, though with slight variations based on the issuing protocols.
Other stablecoins in this category include: FRAX, USDD, UXD, etc