The three different ways that stablecoins are backed - fiat, crypto and precious metals

Recently on the sub I encountered some confusion on how stablecoins were backed and what with. So today I am going to do a short write-up of the three main ways a stablecoin can be backed.

tl;dr Fiat-backed stablecoins, like USDC and USDT, are backed by traditional currencies, providing stability but relying on centralization and audits. Crypto-backed stablecoins, such as DAI, use cryptocurrencies like ETH as collateral, but their value can fluctuate, requiring over-collateralization for stability, with potential decentralization. Precious metal-backed stablecoins, like PAX, derive their stability from precious metals like gold.

Fiat-backed stable coins (USDC and USDT):

These stablecoins are pegged to a traditional currency, such as the US dollar. This serves as an IOU for a traditional currency that you use to purchase the stablecoin that you can later convert back to that FIAT. This leaves you safe against volatility but is centralised and must be audited (although there is FUD around Tether on whether these audits are actually meaningful).

Crypto-backed stable coins (DAI):

These stablecoins are backed by other crypto assets, like ETH. Their price depends on the value of the underlying asset (or collateral), which can be volatile. Because ETH's value can fluctuate, these stablecoins are over-collateralized to ensure the price stays as stable as possible. This means, for example, a $1 crypto-backed stable coin has an underlying crypto asset worth at least $2. So if the price of ETH drops, more ETH must be used to back the stable coin, else the stable coins will lose their peg. In DAI's case, this can be transparent and fully decentralised and there are no external custodians - all controlled by ETH accounts. This can be less stable than fiat-backed tokens in bear markets so you need to keep an eye on the price.

Precious metal-backed stable coins (PAX):

Similar to fiat tokens except they are backed by precious metals such as gold. Each coin represents ownership of a particular quantity of that material.