Stablecoins are cryptocurrencies whose value is pegged, or tied, to that of another currency, commodity, or financial instrument. Stablecoins aim/try to provide a better alternative to the high volatility of the most popular cryptocurrencies like Ethereum (ETH), Bitcoin (BTC).... which due to their high volatility make crypto investments less suitable for common transactions and for traders in general.
To serve as a medium of exchange, it must be able to remain relatively stable in order to preserve its purchasing power at any given moment. So as the name implies, stablecoins aim to address this problem by promising to maintain a stable value. There are many kinds of stablecoins so you should understand them before you pick the one to use as your stable currency.
The different types of stablecoins
There are three main types of stablecoins, and they are differentiated based on their stabilization mechanism:
Fiat-Collateralized
Fiat-Collateralized stablecoins maintain a reserve of fiat currency (or currencies) such as the U.S. dollar, Euro, or any other fiat currency as collateral assuring the stablecoin's value. Most fiat-collateralized stablecoins hold their reserves in U.S. dollars due to its status as the world's reserve currency.
The reserves are maintained by independent custodians and are regularly audited to ensure that they are backed 1-1 (i.e. for every stablecoin, there is an equivalent fiat dollar). Some of the most popular stablecoins backed by the U.S. dollar are USDT, BUSD & USDC.
Crypto-Collateralized
Instead of being collateralized by fiat, crypto-collateralized stablecoins are backed by a basket of cryptocurrencies. As such, depending on the volatility of the underlying cryptos, such stablecoins tend to be more volatile.
Crypto-collateralized stablecoins usually implement some form of liquidation mechanism to ensure the value backing the stablecoin. DAI is the most popular example of r acrypto-collateralized stablecoin.
Algorithmic
Algorithmic stablecoins received a bad reputation following the crash of UST. The reason why such a failure was possible in the first place was due to the fact that algorithmic stablecoins are not collateralized but rather maintain their value through changes in supply based on an algorithm.
