How Crypto-Collateralized Stablecoins and Other Stablecoins Work

Volatility has long been the Achilles’ heel of cryptocurrencies, deterring many users from fully embracing them for everyday transactions or long-term holdings. Stablecoins were developed to tackle this issue by offering price stability, though their level of decentralization and transparency varies depending on the type, ranging from centrally issued fiat-backed coins to more decentralized crypto-collateralized models.

Crypto-collateralized stablecoins use digital assets instead of fiat reserves, aiming for greater decentralization and automated value stabilization through smart contracts. However, their effectiveness depends heavily on system design and governance mechanisms.

But are they actually “stable” as the name suggests? This blog unpacks how stablecoins work, what the types of stablecoins are, how stablecoins are gaining traction in DeFi, and what risks and opportunities they bring for crypto users and investors alike.

What Are Stablecoins?

Stablecoins are digital currencies designed to maintain a steady value, typically by being pegged to assets like fiat currencies (e.g., USD) and commodities such as gold, or maintained through algorithmic models. Their main idea is to tone down the wild price swings you see in things like Bitcoin, so they're more useful for day-to-day transactions and can hold their value better over time.

How Do Stablecoins Stay Stable?

Stablecoins are a special kind of digital money. Stablecoins aim to keep their value stable through various mechanisms, assets like fiat or gold back some, while others use algorithms to regulate supply and demand. They aim to provide a more reliable alternative to volatile cryptocurrencies like Bitcoin or Ethereum, making them more practical for daily transactions.

Why Do Stablecoins Matter?

The significance of stablecoins in the crypto landscape lies in their ability to dampen price volatility. While decentralized and borderless payment systems like Bitcoin are promising, their extreme price swings hinder widespread adoption for real-world applications. Stablecoins tackle this by pegging their value to more stable assets, thus preserving purchasing power and facilitating their use in routine transactions and decentralized finance (DeFi) platforms.

Now that we understand stablecoin and why it matters, let’s focus on the types of stablecoins.

Types of Stablecoins Explained

Stablecoins are typically sorted into four primary groups, depending on what keeps their value steady: fiat-backed, crypto-collateralized, commodity-pegged, and algorithmic. Understanding these categories is essential for anyone using crypto, whether you're just a regular person or a whole business dealing with digital assets.

1. Fiat-Pegged Stablecoins

Fiat-backed stablecoins are the most popular type out there. They’re usually tied directly to fiat currencies like the US dollar (USD) or the euro (EUR), at a 1:1 ratio. The issuers reserve the same amount of fiat currency or other easily traded traditional assets to keep things stable. Examples include:

• Tether (USDT) is pegged to the U.S. dollar and backed by a mix of reserves, including U.S. Treasury bills, cash, and other assets. The reserve breakdown has evolved and is published periodically by Tether.

• USD Coin (USDC) is fully backed by cash and short-term U.S. Treasuries, and third-party accounting firms publish monthly attestation reports. However, these are attestations, not complete audits.

• Stasis Euro (EURS) tracks the euro’s value with verified collateral backing.

2. Commodity-Backed Stablecoins

These stablecoins are linked to the market value of real-world assets such as precious metals. They enable users to indirectly access commodities without needing to possess them physically. Examples include:

• PAX Gold (PAXG) is a token that represents one troy ounce of gold held in a secure vault.

• Tether Gold (XAUT) is a gold-backed token with physical redemption features.

3. Crypto Collateralized Stablecoins

Crypto-collateralized stablecoins are supported by overcollateralized digital assets to manage price fluctuations. This model uses smart contracts to maintain transparency and ensure solvency under volatile conditions. Smart contracts manage issuance and redemption, ensuring transparency and decentralization. A key example:

• Dai (DAI) is pegged to USD and supported by cryptocurrencies like Ethereum (ETH), which is a common example. The MakerDAO system governs it. To create Dai, people put up cryptocurrency as collateral in special contracts called smart contracts. This whole process is run by autonomous on-chain mechanisms, making sure that Dai keeps its stable value.

4. U.S. Treasury-Backed Stablecoins

Stablecoins backed by U.S. Treasury assets offer exposure to low-risk, short-duration securities and may share characteristics with tokenized money market instruments. However, they are not formally regulated and typically lack FDIC or SIPC protections. They appeal to users seeking yield-bearing, compliant, and transparent instruments. Notable examples include:

• Ondo USDY is a tokenized interest-bearing U.S. Treasury.

• Hashnote USYC is a stablecoin aligned with U.S. regulations and backed by short-duration Treasuries.

5. Algorithmic Stablecoins

These rely on autonomous algorithms that expand or contract the token supply to maintain a target price, usually without direct collateral. Though innovative, algorithmic designs can be fragile in stressed markets. Examples include:

• Ampleforth (AMPL) features an elastic supply that automatically adjusts based on market demand. Unlike stablecoins, it is not pegged to $1 but instead targets long-term price equilibrium through unique rebasing mechanics.

• Frax (FRAX) initially operated as a hybrid stablecoin partially backed by collateral and partially stabilized through algorithmic mechanisms. However, it has since transitioned toward a fully collateralized model for increased stability and regulatory alignment.

• Ethena USDe is a synthetic dollar, not a traditional reserve-backed stablecoin. It maintains price stability through a delta-neutral strategy using perpetual futures and crypto collateral. This innovative model is still experimental and carries elevated risk, especially during volatile market conditions.

Note: Algorithmic stablecoins, such as TerraUSD (UST), have experienced major failures due to insufficient collateral and reliance on market incentives that can unravel during stress events. The UST collapse in 2022 highlighted the systemic risk these models can pose, underscoring the systemic risk of undercollateralized or unstable peg mechanisms.

Knowing the types of stablecoins sets the stage for understanding how they maintain price stability. Let’s now break down how stablecoins work.

How Stablecoins Work?

Stablecoins are designed to maintain price stability by being pegged to an external reference such as a fiat currency (like the U.S. dollar), commodities like gold, or governed by algorithmic mechanisms. Unlike highly volatile cryptocurrencies, they serve better as a medium of exchange. Depending on their design, stablecoins can be fiat- or commodity-backed, or use algorithmic models that adjust supply based on demand, sometimes without traditional reserves.

Also Read: Understanding the Differences between Stablecoins and Fiat Currency

Now that we’ve broken down how stablecoins work, we need to figure out what's good about them and where they might trip up. Let’s plunge into the main pros and cons affecting their use in the real world.

What are the Benefits and Risks of Stablecoins?

Stablecoins such as USD Coin (USDC) provide a middle ground between the volatility of typical cryptocurrencies and the price stability needed for practical, everyday financial use. As adoption grows across industries, understanding the advantages and risks is key.

As stablecoins continue to reshape payments and DeFi, they are drawing increased attention from global regulators. Let’s explore what that means for users and issuers alike.

Regulatory Considerations

Regulatory frameworks worldwide are improving to address the growing influence of stablecoins. Each focuses on different aspects, such as consumer protection, financial stability, and innovation. Below is a comparison of how various regions are regulating stablecoins.

With new regulations on the horizon, how stablecoins operate is about to change, pushing issuers to be more transparent and accountable. Let’s take a look at the major players shaping the stablecoin economy.

Major Stablecoin Issuers

While hundreds of stablecoins circulate, a few key players dominate the market. Look at some of the most prominent issuers shaping the stablecoin ecosystem today.

• Sperax (SPA)

It is a decentralized finance (DeFi) protocol that introduced USDs, a fully collateralized, auto-yielding stablecoin aggregator operating on the Arbitrum Layer 2 network. USDs enable users to passively earn yield without manual staking, powered by auto-compounding mechanisms within the Sperax protocol.

• Tether (USDT)

Tether leads the stablecoin market with deep liquidity and a reserve portfolio primarily composed of U.S. Treasuries and other assets as disclosed in its quarterly attestations.

• Circle (USDC)

USDC stands out for its monthly reserve attestations and full backing by cash and short-term U.S. Treasuries, earning strong institutional trust. It’s widely trusted by institutions and DeFi protocols.

• Paxos (USDP)

Paxos issues USDP and is also the regulated issuer behind PayPal’s PYUSD. It offers compliant, reserve-backed solutions and operates under regulation, with strict reserve management and monthly transparency reports.

• PayPal (PYUSD)

PYUSD, launched with Paxos, targets everyday payments with stable, fully backed reserves. It marks PayPal’s move into mainstream crypto finance.

Also Read: Stablecoin Adoption and Its Impact on Global Crypto Market

Real-World Use Cases of Stablecoins

Stablecoins have evolved far beyond their initial role in crypto trading. Today, they power a wide array of real-world applications across both decentralized finance (DeFi) and traditional finance (TradFi).

1. On-Ramp to DeFi

Stablecoins are essential for most DeFi platforms. Their price stability makes them well-suited for lending, borrowing, and yield farming, use cases where minimizing volatility is necessary. In liquidity pools, they help lower impermanent loss, making decentralized exchanges more efficient. For people in countries with unstable economies, stablecoins provide access to global finance without relying on a local currency that’s losing value.

2. Payments and Peer-to-Peer Transfers

From splitting the cost of a meal to sending payment to a freelancer overseas, stablecoins are gradually becoming the preferred choice. They offer fast transaction speeds and minimal fees, a clear edge over conventional banks. Moreover, they cut out the intermediaries, enabling secure, direct peer-to-peer (P2P) transfers. This is particularly helpful in areas where access to banking is restricted.

3. Cross-Border Transactions and Remittances

A powerful use case for stablecoins is in remittances and cross-border payments. Unlike traditional services that are often slow and expensive, especially for migrant workers, stablecoins offer a faster, low-cost alternative. Reducing fees and delays helps boost financial inclusion and gives underserved communities more control over their money.

The Future Road Ahead for Stablecoins

Stablecoins have bridged the gap between volatile cryptocurrencies and real-world use, making everyday transactions and DeFi participation more feasible. They’ve made international payments smoother and are a driving force behind decentralized finance (DeFi). Their growing adoption highlights their emerging role in reshaping digital finance. As rules get stricter and more people start using them, stablecoins are set to become a key part of both crypto and traditional finance.

Going forward, the focus will be on openness, effectiveness, and actual returns. In this space, forward-thinking platforms like Sperax are leading the way. Sperax, through its USDs stablecoin aggregator and SPA-based optimizer, offers passive earning potential via automated DeFi strategies, enabling users to benefit from on-chain opportunities with minimal effort.

Ready to explore yield with stability? Try Sperax USDs and start earning passively today.

FAQs

Q. What are crypto collateralized stablecoins?

Crypto collateralized stablecoins are digital assets backed by other cryptocurrencies as collateral. They maintain price stability through overcollateralization and smart contracts.

Q. How do crypto collateralized stablecoins work?

These stablecoins are issued by locking crypto assets in smart contracts. If the backing asset drops in value, more collateral must be added to maintain the peg.

Q. Are crypto collateralized stablecoins safe?

Due to transparent on-chain collateral, they’re considered safer than algorithmic stablecoins, but they still carry risks from crypto volatility and smart contract bugs.

Q. What is the difference between fiat and crypto collateralized stablecoins?

Cash reserves help support fiat-backed stablecoins, whereas crypto collateralized stablecoins are backed by digital assets such as ETH, which are kept in decentralized protocols.

Q. Why are crypto collateralized stablecoins used in DeFi?

They provide decentralization, transparency, and liquidity, which makes them perfect for lending, borrowing, and yield farming without having to depend on traditional banks.

Q. Can crypto collateralized stablecoins lose their peg?

If the collateral drops significantly in value and isn’t replenished in time, the stablecoin may depeg, affecting its 1:1 value stability.