Knowledge Base Understanding Stablecoins: Types, Risks, and When to Use Them

Stablecoins play a critical role in the crypto ecosystem. While most cryptocurrencies are known for their volatility, stablecoins are designed to maintain a predictable value. They act as a bridge between traditional finance and digital assets, offering stability, liquidity, and efficiency.

This guide explains how stablecoins work, the main types available, the risks involved, and when they make sense within a crypto portfolio.

Stablecoins are cryptocurrencies created to maintain a stable price, typically pegged to a fiat currency such as the US Dollar or Euro. Unlike highly volatile assets, stablecoins aim to minimize price fluctuations.

Their stability makes them useful for trading, portfolio management, payments, and on-chain financial activity without repeatedly converting to traditional currency.

Stablecoins use different mechanisms to maintain price stability. Understanding these models helps investors evaluate risk and select the right tool for their strategy.

Fiat-backed stablecoins

These stablecoins are backed by reserves of fiat currency held by a centralized issuer. Each token is intended to represent one unit of fiat currency.

• Simple and easy to understand
• High liquidity and widespread adoption
• Depend on trust in the issuer and reserve management

Crypto-backed stablecoins

These stablecoins are backed by cryptocurrencies rather than fiat. They typically rely on overcollateralization to absorb market volatility.

• Greater transparency through on-chain collateral
• More decentralized than fiat-backed models
• Higher complexity and sensitivity to market crashes

Algorithmic stablecoins

Algorithmic stablecoins attempt to maintain their peg through automated supply adjustments rather than direct collateral backing.

• Highly experimental by nature
• Limited protection during extreme market stress
• Higher risk compared to collateralized models

While stablecoins reduce price volatility, they introduce different forms of risk that should not be overlooked.

Counterparty risk

Fiat-backed stablecoins rely on issuers to hold adequate reserves. A lack of transparency or poor reserve management can threaten stability.

Depegging risk

Stablecoins can temporarily or permanently lose their peg due to market stress, liquidity shortages, or loss of confidence.

Smart contract risk

Crypto-backed and algorithmic stablecoins depend on smart contracts, which may contain vulnerabilities or bugs.

Liquidity risk

During periods of high volatility, liquidity may decline, making it difficult to exit large positions without price impact.

Stablecoins are most effective when used deliberately as part of a broader portfolio and risk management strategy.

Managing volatility

Stablecoins allow investors to reduce exposure during uncertain market conditions while remaining within the crypto ecosystem.

Trading and liquidity management

Traders often use stablecoins as a base asset to move efficiently between positions across exchanges and protocols.

Earning yield and on-chain utility

Stablecoins are commonly used in lending and DeFi protocols to earn yield while avoiding direct price volatility.

Portfolio rebalancing

Holding stablecoins provides flexibility to rebalance quickly and deploy capital when new opportunities emerge.

• Diversify exposure across multiple stablecoin models
• Understand how each stablecoin maintains its peg
• Monitor liquidity and transparency regularly
• Avoid overexposure to experimental designs
• Use secure wallets and reputable platforms