The rise of stablecoins has been nothing short of extraordinary. In July, Coinmetrics published a report that showed how the value of Tether (USDT), the biggest stablecoin, has increased over time from $1m in early 2016, to over $10 billion at the time of the report’s publication.

Furthermore, it’s not just Tether that’s in growth. Since 2018, new stablecoins from various issuers have been pouring into the market.

A stablecoin is a digital token pegged to the value of a stable currency, most commonly, the US dollar. They’re designed to overcome the volatility of cryptocurrencies, providing a stable medium of exchange and store of value for crypto users. However, they don’t all work the same way.

So, what are the different types of stablecoins available, and how do the underlying mechanisms operate?

Types of Stablecoins

Stablecoins fall into three broad categories:

• Collateralized stablecoins are backed by an asset of value to help them maintain their stability.
• Uncollateralized stablecoins aren’t backed by any asset of value, but their stability is maintained using an algorithmic model of issuance to control inflation.
• Hybrid stablecoins use a combination of the two methods above. There are some assets held in reserve, but an algorithm also helps to control the value.

By far, collateralized stablecoins are the most popular, well-used, and account for the lion’s share of total market cap. So far, none of the projects in the other two categories have achieved any meaningful success by comparison.

Fiat-Collateralized Stablecoins

Fiat-backed stablecoins were the first kind of stablecoin to arrive on the market, with Tether having launched the first stablecoin, USDT, in 2014. The idea behind a fiat-collateralized stablecoin is that $1 worth of stablecoin is backed by $1 of real dollars held in reserve.

While it’s by far still the biggest stablecoin by market cap, Tether has come under fire over recent years, mainly due to doubts around the level of reserves it holds to back up its coin issuance. In 2019, the New York Attorney General’s office brought a lawsuit against Tether’s parent company. The NYAG alleges that Tether had gambled with user’s funds after giving a $1 billion loan to sibling company, Bitfinex, which had lost the money. To date, Tether has declined to undergo an independent audit that would prove the level of funds it holds in reserve.

The case is still ongoing, but it hasn’t affected Tether’s popularity, as USDT has maintained its position in the top five cryptocurrencies.

Nevertheless, USDT is no longer the only fish swimming in the fiat-backed stablecoin pond. Since 2018, competitor stablecoins have flooded the market, including USDC, issued by Coinbase and Circle, GUSD from Gemini, and BUSD, issued by Binance. Most likely as a way of distancing themselves from the tribulations of Tether, the issuers mentioned here have all undertaken regular audits of their reserves.

Crypto-Collateralized Stablecoins

Crypto-collateralized stablecoins are backed by cryptocurrencies. However, due to the volatility inherent in cryptocurrencies, they generally use some kind of price stability protocol to adjust the required collateral, ensuring the price remains pegged to a stable value.

The oldest and best-known crypto-backed stablecoin is Maker’s DAI. The underlying mechanism is technically complex. However, in summary, users can deposit ETH and other cryptocurrencies into smart contracts known as Collateralized Debt Positions. The deposit will result in the issuance of the DAI stablecoin, which is pegged to the value of the US dollar.

Maker is a project based on Ethereum, meaning that it can only support the creation of DAI using Ethereum-based tokens. A newer project, Kava, is based on the interoperable Cosmos platform. Therefore, Kava aims to be a version of Maker that can ultimately allow the issuance of crypto-backed stablecoins based on assets from any blockchain.

How Are Stablecoins Used?

Fiat-backed stablecoins became popular among crypto traders as they provide a stable means of denominating profits and losses. If a trader chooses to exit a position in BTC or ETH, they can hold their profits in a USD-backed stablecoin until they’re ready to enter a new position, without risking losses due to crypto’s volatility.

However, the decentralized finance (DeFi) movement has created entirely new use cases for stablecoins. This has come about mainly due to the unregulated status of stablecoins and DeFi – although some do require KYC for onboarding. Nevertheless, because there is a high demand for stablecoins from traders, users can lend them out using DeFi protocols such as Compound or Aave and earn high yield.

Furthermore, the emergence of liquidity mining using stablecoins on protocols like Uniswap or Balancer has created new sources of revenue. When users contribute their stablecoins to a liquidity pool, they can now also earn governance tokens in DeFi protocols, which are often highly appreciative assets.

With over $9 billion staked in DeFi at the time of writing, it’s turning into a highly lucrative industry for those who understand how to play the system and are willing to accept any associated risks.

Whether or not the DeFi bubble continues to inflate, and stablecoin continue to remain unregulated is yet to be seen. However, in the meantime, stablecoins remain a hugely popular and ever-growing class of cryptocurrencies with many benefits for traders.