Most stablecoins operate on a reserve-based model: each token is backed by a specific amount of an asset. For example, for every USDC issued, the company is expected to hold one US dollar in reserve. Crypto-collateralized stablecoins are more complex, relying on overcollateralization, where the value of the crypto collateral exceeds the stablecoins issued.
Algorithmic stablecoins function differently. They don’t hold reserves in fiat or crypto. Instead, they regulate the token supply via automated smart contracts that increase or decrease the number of tokens in circulation. Think of it like a thermostat: when the token’s price falls, the system “burns” some tokens to reduce supply and push the price up. If the price is too high, it mints more tokens to increase supply. This approach is fully decentralized but, in practice, has proven to be less stable.