The technical mechanism behind stablecoins can vary depending on the type of coin. For example, some stablecoins are backed by a reserve of fiat currency, while a commodity like gold may support others.
The most common type of stablecoin is the fiat-backed variety. As the name suggests, these coins are pegged to a specific fiat currency, such as the US dollar or Euro. Each coin is backed by a real-world asset held in reserve to maintain the peg. For example, for every USD-backed stablecoin in circulation, a US dollar is stored in a bank account.
If the price of the stablecoin begins to fall, the issuer can buy back coins from the market to maintain the peg. Similarly, if the value of the stablecoin starts to rise, new coins can be issued and sold on the market to bring the price back down.
Fiat-collateralised stablecoins are the most popular type of coin due mainly to their simplicity. However, they are also the most centralised, requiring a trusted third party to hold and manage the reserves.
Crypto-collateralised stablecoins are coins backed by a reserve of cryptocurrency rather than fiat currency.
This approach has a number of advantages over fiat-collateralised stablecoins. First, it eliminates the need for a central authority to hold and manage the reserve. Second, it provides a hedge against fiat currency collapse, as the value of the cryptocurrency backing the coin is not linked to any single fiat currency.
The main downside of crypto-collateralised stablecoins is that they are subject to the same volatility as the cryptocurrency they are backed by. For example, if the price of Ethereum were to crash, so would the value of Dai.
Algorithmic stablecoins are a newer type of coin that use complex algorithms to preserve a peg to a specific asset, often USD. The advantage of this type of coin is that it should theoretically be much more resistant to sudden changes in market conditions, as the algorithms can adjust quickly to buy or sell the underlying asset.
This type of stablecoin offers a good middle ground between the security of a fiat-backed coin and the decentralisation of a crypto-collateralised currency.
The downside of this approach is that it is very complex, and there is a risk that the algorithms could fail, leading to a loss of value.