Collateral Types, Explained: Fiat, Crypto, and the Algorithmic Graveyard
The three ways a stablecoin tries to be worth a dollar — fiat reserves, crypto overcollateralization, and algorithmic supply mechanics — with the historical track record of each.
Ask a stablecoin “why are you worth a dollar?” and you will get one of three answers. Each has a twelve-year track record. Two are still standing.
1. Fiat-collateralized: “We hold the dollars”
The issuer holds cash and cash-equivalents — increasingly short-term US Treasury bills — in bank and custodian accounts, and promises to redeem each token for one dollar. USDT (2015) and USDC (2018) are the canonical examples; together they represent roughly nine-tenths of the entire stablecoin market.
The strength: simplicity and liquidity. T-bills are among the most liquid assets on Earth, and redemption at $1 is a straightforward banking operation.
The risk: it is a custody and honesty risk, not a design risk. You are trusting that the reserves exist, are unencumbered, and sit somewhere regulators can reach. Tether’s early years — opaque attestations, the Bitfinex entanglement, the 2021 NYAG and CFTC settlements — are the cautionary file. USDC’s March 2023 wobble, when $3.3 billion of its reserves froze inside Silicon Valley Bank, showed that even honest reserves can sit in the wrong place.
2. Crypto-collateralized: “The vault holds more than it owes”
Every token is minted against crypto collateral worth more than the token itself, locked in a smart contract, with automatic liquidation if the collateral’s value falls. MakerDAO’s DAI, launched in its modern form in November 2019, is the design’s flagship: mint $100 of DAI by locking, say, $150 of ETH. If ETH crashes, the protocol sells your collateral before the vault owes more than it holds.
The strength: no company to trust. The backing is on-chain, visible to anyone, enforced by code that does not take phone calls.
The risk: the collateral is volatile, so the system must be overcollateralized (capital-inefficient), and in extreme crashes liquidations can lag the market. DAI has nonetheless held its peg through multiple brutal drawdowns — and its later addition of real-world collateral (US Treasuries via special-purpose vehicles) makes it something of a hybrid today.
3. Algorithmic: “Trust the mechanism”
No meaningful reserves at all. The peg is maintained by supply mechanics — typically a mint-and-burn relationship with a sibling token that absorbs the volatility. BitUSD (2014) was the proto-type and, being crypto-collateralized, actually worked for years. The pure algorithmic designs — NuBits (collapsed 2018) and Terra/UST (collapsed May 2022, ~$60 billion destroyed) — both died the same death: in a panic, the mechanism pays fleeing holders in freshly printed sibling tokens, diluting the sibling, which prints still more, until the loop consumes everything.
The verdict of history: the market has run this experiment twice and both results were total loss. Algorithmic stablecoins now command effectively zero market share, and both the EU’s MiCA and the US GENIUS Act were written, in large part, to make a third experiment legally difficult.
The rule of thumb
Follow the collateral. If the backing is external and auditable — dollars, T-bills, or overcollateralized on-chain assets — the peg has a floor. If the backing is the system’s own token, the floor is made of the thing that is falling. That single question explains most of stablecoin history.