Figure 3: Google Trends analyzing the increasing interest in stablecoins relative to Tether (not to scale).
2.2. Three Types of Stablecoins
2.2.1. Type 1: Fiat-Collateralized Stablecoins
The first classification of stablecoins is fiat-collateralized stablecoins. Collateralization refers to a pledge to a specific asset by a lender. By this, a collateralized stablecoin is sold to an individual for one USD with the promise of a reserve backing of each token.  This category includes Tether as well as second-movers, such as TrueUSD, Paxos, Stably, and Circle. These projects derive their stability from the promise that each token is issued on a 1:1 basis with a corresponding fiat currency held in reserve.
The second-movers differentiate themselves from Tether with a more thorough regulatory compliance (including Know Your Customer and Anti Money Laundering compliance) and increased transparency for consumers at the onset. However, this requires these currencies to have 100% reserve of fiat (as a reference, banks exceeding $122.3 million in net transaction accounts are required to have a reserve ratio of 10%). Furthermore, despite the fact that this model is simple and proven, there are risks associated with its centralized nature.  This can include default risk (also known as counterparty risk), which means a stablecoin company can make claims of redemption that it does not have the reserves to satisfy the requirements. This is a trust-reliant model; if consumers don’t trust the integrity of the bonds, their value will not hold. For example, many countries trust the value of U.S. bonds because they believe that the U.S. government is unlikely to default on its loans.
These stablecoin companies issue tokens on a 1 to 1 basis with fiat reserves that they hold. For example, if we were to purchase $5 worth of Tether, the company will issue 5 USDT tokens. Fiat-collateralized stablecoin companies earn interest on the reserves that they hold. Therefore, a larger market cap means more revenue. As a result, the fiat backed stablecoin companies that are valued higher are those which have the potential for more adoption. For example, let’s assume company A’s projected market cap is $275M. At the current risk-free rate (1-yr = 2.7%), the stablecoin entity would be earning $7,425,000 per year from the incurred interest. Because many valuation methods use earnings or cash flow, the value directly relates to the interest earned. It
should be noted that companies with other forms of revenue may have earnings in addition to interest.
Fiat-Collateralized Token Benefits:
Fiat-Collateralized Token Drawbacks:
2.2.2. Type 2: Crypto-Collateralized Stablecoins
The second class of stablecoins are those collateralized with cryptocurrency. Unlike the first category, the collateralized asset for this category of stablecoins is highly volatile. Because of this, the value of the collateralized cryptocurrency has the potential to fall below the value of the stablecoin—at which point the stablecoin would also drop in value. For example, if a stablecoin is collateralized with Ethereum, it would need to have a collateralization ratio which accounts for this volatility—meaning the stablecoin must be overcollateralized. In other coins, it is not in fact a 1:1 to ratio for redemption,  but one that is >1:1.
The most popular project using this framework is MakerDAO. To put it simply, the MakerDAO platform is a decentralized, autonomous organization where investors can generate Dai (a stablecoin) by locking up ETH in instruments called Collateralized Debt Positions (CDPs). MakerDAO uses a 150% reserve ratio (1.5 USDs of ETH to 1 USDs worth of Dai). If the total volume of collateral falls below this ratio, the system automatically starts selling MKR (which bear interest and grant voting rights) for Dai. This removes Dai from the system—pushing the ratio back up to a safe level.
While this suggestion does not bear the responsibility of investment advice, hypothetical projected returns for investors in this project could be calculated as follows:
(Interest on MKR tokens via closing of CDPs) * (percentage of yearly revenue) * (market cap of tokens) - (% dilution of MKR from undercollateralized CDPs).
Crypto-Collateralized Token Benefits:
Crypto-Collateralized Token Drawbacks:
2.2.3. Type 3: Uncollateralized Stablecoins   
The third classification addresses fully algorithmic systems—a notable project is Kowala. These systems are not collateralized. Instead, they rely on a strong monetary policy to act as a fully algorithmic central bank. The algorithm maintains the stability of the coin by issuing new tokens when the supply is too low and by burning tokens when the demand is too low.
Investors purchase the promise of future tokens at a discount via bond tokens. Bonds are typically paid for using the platform’s stablecoin—this is the mechanism by which the algorithmic central bank reduces the supply. When the algorithm must expand the supply, it issues tokens to bondholders. Bonds have a set expiration date at which point they no longer represent a future payment of stablecoins. Therefore, investors who purchase bonds are essentially betting that the demand for these stablecoins will outstrip supply before the expiration date.  However, bonds and shares are fundamentally designed to make investors money. But with the obvious costs of selling securities, the popular Basis project disbanded. They have since promised to return the $133 million raised in its initial investment round with big backers, such as a16z crypto fund (Andreessen Horowitz), GV (formerly Google Ventures), Bain Capital Ventures, and Polychain Capital.
Uncollateralized Token Benefits:
Uncollateralized Token Drawbacks:
3. Five Use Cases of Stablecoins
The demand for stablecoins arises from the core advantages of stablecoins over their fiat alternatives. As discussed previously, some of these advantages include programmability, independence from traditional centralized systems, and non-physicality. Stablecoins offer the ability to capitalize on use cases where fiat currencies fall short. However, it is unlikely that one stablecoin will be dominant over all use cases. This is a result of the differences between various stablecoins themselves. As a result, there are many investment opportunities within the realm of stablecoins which flow from various use cases.
This section seeks to shed light on these investment opportunities by looking at five key use cases: safe haven assets on cryptocurrency exchanges, dollarization in emerging regions, peer to peer (P2P) and peer to business (P2B) payments, value transfer over smart contracts, and reserve currencies in an international context. As will be shown, these use cases vary in time frame, upside potential, and requirements from the individual stablecoins.
3.1. Use Case 1: Safe Haven for Traders
Solving the problem of crypto volatility.
In order to avoid downside volatility, traders use “safe haven” assets. These assets are relatively stable, even when broader market prices fluctuate. In U.S. equity markets, when traders sell, they sell into USD. This point is often taken for granted. In crypto markets, when traders want to sell out of an asset which has appreciated, they have many options to sell into. In order to protect the gains made on a trade, traders often choose to sell into stablecoins.
As we can see from figures #3 and #4 below, during periods of high downside volatility, the trading volume of stablecoins significantly increases until stability returns. Further evidence of this finding is that six out of the top ten pairs (by 24-hour volume) contain a stablecoin (figure 5)—meaning that when people buy or sell, they do so with a stablecoin.