Introduction

Stablecoins are the bedrock of the modern cryptocurrency ecosystem. By pegging their value to a stable asset, typically the US Dollar, they provide a safe haven from volatility and a crucial medium of exchange for DeFi trading, lending, and borrowing. However, not all stablecoins are created equal. Their whitepapers reveal fundamentally different underlying models, each with unique mechanisms, trade-offs, and risk profiles.

This article will categorize and analyze the major types of stablecoins through the lens of their foundational designs. We will explore fiat-collateralized (USDC), crypto-collateralized (DAI), and algorithmic models (the failed UST), explaining how they attempt to maintain their peg and the critical points of failure for each.

Fiat-Collateralized Stablecoins: The Simple Giants

This is the most straightforward and common model.

Mechanics and Key Examples

For every stablecoin in circulation, the issuing company holds an equivalent amount of fiat currency (or cash equivalents) in a bank account. The whitepaper for such a project is less about complex algorithms and more about the legal structure, redemption process, and attestations/audits of the reserves. Examples include USD Coin (USDC) and Tether (USDT). Users trust that the company is indeed holding the dollars it claims to hold.

Pros, Cons, and the Centralization Trade-off

Pros: Simple model, high stability if reserves are verified.

Cons: Highly centralized, reliant on trust in a single entity and the traditional banking system. Subject to regulatory risk.

Key Points

Fiat-collateralized stablecoins (USDC) are simple but centralized and require trust.

Crypto-collateralized stablecoins (DAI) are decentralized but complex and overcollateralized.

Algorithmic stablecoins (UST) are the most decentralized but have proven to be highly fragile and prone to death spirals.

Crypto-Collateralized Stablecoins: Decentralized but Complex

These stablecoins are backed by other cryptocurrencies, not fiat.

The MakerDAO and DAI Model

The whitepaper for MakerDAO and its DAI stablecoin is a masterpiece of decentralized finance design. Users lock up crypto assets (like ETH) in a smart contract vault to generate DAI. The system is overcollateralized, meaning you must lock up more than $1 worth of ETH to borrow $1 of DAI. This protects the system from price volatility. Stability is maintained through a combination of liquidation mechanisms, stability fees (interest), and governance by MKR token holders.

The Trade-offs of Decentralization

Pros: Decentralized, transparent, and permissionless.

Cons: Capital inefficient (requires overcollateralization), complex, and exposed to black swan events in the crypto market that could trigger mass liquidations.

Algorithmic Stablecoins: The Pursuit of Pure Code

This model aims to maintain the peg without any collateral, using algorithms and smart contracts to control supply and demand.

The TerraUSD (UST) Case Study and Its Demise

The Terra whitepaper described a dual-token system: the stablecoin UST and its volatile sister token, LUNA. The peg was maintained through a mint-and-burn arbitrage mechanism. If UST traded below $1, you could burn 1 UST to get $1 worth of LUNA, reducing UST supply and pushing the price back up. This model failed catastrophically in May 2022. A loss of confidence led to a "bank run," creating a negative feedback loop—a "death spiral"—that cratered both UST and LUNA.

The Inherent Fragility

Algorithmic stablecoins are the holy grail because they are potentially fully decentralized and capital efficient. However, they are built on the assumption of perpetual growth and confidence. As UST proved, they are extremely fragile under stress and vulnerable to speculative attacks, as they lack a fundamental asset backing.

Conclusion

Choosing a stablecoin is a choice about trust. Do you trust a centralized entity (Fiat-Collateralized), a decentralized system of overcollateralized smart contracts (Crypto-Collateralized), or a purely algorithmic mechanism (Algorithmic)? Each model has its place and its risks. The collapse of UST was a stark reminder that in finance, there is no such thing as a free lunch, and the pursuit of decentralization without robust, fail-safe mechanisms can lead to disaster.