Stablecoins are intended to maintain a stable value over time. They offer an alternative to traditional cryptocurrencies which typically exhibit a high degree of volatility. When constructing a portfolio of crypto assets for a DAO’s treasury, stablecoins provide three major benefits:
- They are relatively uncorrelated to other cryptocurrencies. Combining them with risky assets reduces total portfolio volatility while increasing expected return relative to the standard deviation.
- Since stablecoins are typically pegged to $1, operational expenses that are denominated in USD can be offset by an allocation to stablecoins.
- A reserve of stablecoins can be used to rebalance into risk-on assets during periods of market turbulence. Having a defined allocation target also ensures that profits are taken during bull markets as the allocation is rebalanced toward stablecoins.
This report discusses the sub-asset class and will serve as a guide for how Index Coop manages the stablecoin allocation within the treasury. Stablecoins have a role in both the Operations Account and the Investment Account.
Many of the Index Coop’s expenses are priced in USD. Since the major stablecoins are pegged to $1, holding a reserve can help ensure immediate funding needs are met regardless of the price fluctuations of the INDEX token. If INDEX has a major drawdown event, we would ideally avoid selling the token to fund USD-denominated expenses. Instead, we would want to rely on liquid stablecoin assets where possible.
A stablecoin allocation within the Investment Account will reduce total portfolio volatility, increasing total return relative to the standard deviation via a less correlated risk profile relative to other crypto assets. Within the context of the Investment Account, a bias will be given to productive stablecoin opportunities as immediate liquidity is not necessary as long as the Operations Account is properly funded. A regular rebalancing program will allow us to take advantage of dynamic market conditions by rebalancing toward stablecoins as other crypto assets appreciate and by trimming stablecoins in favor of volatile assets during market declines.
There are three main types of stablecoins:
- Off-chain Collateralized - Value is pegged by a traditional currency or commodity (e.g. USD or gold) and collateral is held by a third party custodian.
- On-chain Collateralized - Value is backed by one or more cryptocurrencies on-chain. Collateral verifiable on-chain at all times.
- Algorithmic Stablecoins - Value is dependent on a combination of algorithms and smart contracts. Users’ expectation of future purchasing power supports the combination.
A brief description of the ERC-20 stablecoins with a market cap of $5b or more follows:
DAI is an on-chain collateralized stablecoin issued by MakerDAO. The original Dai was generated by leveraging ETH as collateral (Single Collateral DAI) with intentions of supporting multiple collateral types, and today the Maker Protocol accepts any Ethereum-based asset that has been approved by MKR holders. Users generate DAI by depositing assets into Maker Vaults within the Maker Protocol. Every DAI in circulation is directly backed by excess collateral. Different collateral types have different collateral ratios (101% - 175% at time of writing) and liquidation ensures that Dai is always backed by an appropriate amount of collateral.
One risk area is that a majority of the collateral in DAI is USDC. This was done to help bring DAI back to its $1 peg, but could mean that Centre Consortium has the ability to influence Dai. We hope to see a reduction of USDC as a percentage of the total collateral and will continue to monitor the situation.
As of June 30, 2021 the total market capitalization of DAI was $5.0 billion.
USDC is an off-chain collateralized stablecoin managed by Centre Consortium and founded by Circle Internet Financial, LLC. According to Circle’s website, “USDC is issued by regulated financial institutions, backed by fully reserved assets, redeemable on a 1:1 basis for USD dollars.” USDC releases audited financial statements that demonstrate the fair value of US denominated assets held in segregated accounts are at least equal to or greater than the USDC tokens outstanding at the Report Date. Circle only recently disclosed their reserve breakdown, with 61% in cash & cash equivalents, which includes deposits at banks and Government Obligation Money Market Funds, 13% in USD denominated CDs issued in the US by branches of Foreign Banking Organizations, 12% US Treasuries, and the remainder in Commercial Paper, Corporate Bonds, and Municipal Bonds & US Agencies.
As of July 20, the May 31, 2021 statement is the latest available and $22.2 billion USDC tokens were outstanding, compared with $25.2 billion as of June 30, 2021 according to Coingecko.
Tether is an off-chain collateralized stablecoin issued by Tether Limited. According to Tether’s website, “Tether is a token backed by actual assets, including USD and Euros. One Tether equals one underlying unit of the currency backing it, e.g., the U.S. Dollar, and is backed 100% by actual assets in the Tether platform’s reserve account.” With the initial breakdown of Tether reserves, they showed approximately 76% of reserves were cash & cash equivalents, primarily made up of Commercial Paper, and the remaining 24% was secured loans, corporate bonds, and other investments. As of early July 2021, the March 31, 2021 statement is the latest available and $40.9 billion digital tokens were issued, compared with $62.7 billion as of June 30, 2021, according to Coingecko.
Tether has been challenged on the verification of assets backing USDT and started releasing reports on their reserve account around the same time as they settled with the New York Attorney General’s Office, admitting no wrongdoing, but committing to additional information about Tether’s reserves including a daily update and quarterly independent accountant’s report.
Nevertheless, Tether is the oldest stablecoin with the highest market cap and daily volume.
Stablecoins are exposed to a variety of risks specific to the crypto ecosystem.
Financial risks for stablecoins include credit risk, market risk, and liquidity risk.
- Credit Risk - This type of risk is specific to off-chain collateralized stablecoins such as USDC and USDT. Credit risk is associated with the custodian and their ability to properly collateralize and manage the stablecoin. If an off-chain collateralized stablecoin issuer suffers significant losses or if they collateralize their stablecoin with volatile assets, there is a risk that the stablecoin loses its peg and cannot be converted at a 1:1 ratio.
- Market Risk - Market risk is inherent in any investment vehicle that trades freely on secondary markets and stablecoins are no exception. Volatility in price relative to the peg is the most common example of a market risk. As an example of this, during the Black Thursday event in 2020, sUSD prices dropped to around $0.40 in a single day.
- Liquidity Risk - Stablecoin liquidity can be a risk during periods of network congestion or in the event liquidity is removed from AMMs.
Similar to other crypto assets, stablecoins have varying levels of infrastructural risks related to the Ethereum network and smart contracts. When the Ethereum network is clogged during periods of intense volatility, the stablecoin may lose its liquidity since transactions cannot be processed. In addition, smart contract exploits (e.g., inflation of the stablecoin via exploitation of a minting function) can destroy the value of the stablecoin. Of note, when deploying stablecoins productively, it is important to consider each additional layer of smart contract risk involved.
Since off-chain collateralized stablecoins are dependent on the traditional banking system, they are potentially subjected to the legal or regulatory authority of centralized governments. Asset seizure, redemption halts, and enforced AML/KYC are just a handful of potential actions that could be taken against the custodians of these more centralized solutions.
On-chain collateralized stablecoins could also face regulatory scrutiny with potential action taken against core contributors, any of the centralized collateral assets used (e.g., the USDC held within DAI), or user interfaces.
The Treasury Working Group recommends the following principles be taken into account when making stablecoin asset allocation decisions:
- The stablecoin allocation should be diversified across major stablecoins. No more than 50% of the stablecoin allocation should be concentrated in a single asset.
- Stablecoin assets should be diversified across smart contracts when used productively.
- A bias will be given to passive, safer investment strategies (e.g., PAY, yearn vaults, lending on Aave, depositing in PoolTogether, etc.) over active, riskier investment strategies (e.g., aggressive yield farming, active LPing, experimental stablecoins, etc.).
The TWG recommends that the Operations Account’s investable universe be composed of USDT, USDC, and DAI - the three largest stablecoins by market cap - and their productive derivatives (e.g., aDAI, USDC/DAI SLP, etc.) to start.
The Investment Account can be more exploratory with stablecoin assets, but will remain biased toward holding larger market cap assets with longer historical track records and/or structured products that fit within our risk management framework (e.g. PAY).
Stablecoins paired with uncorrelated assets (e.g. ETH) in LP positions will not be considered part of the stablecoin allocation.
Ideally, assets held within the stablecoin allocation will be productive. When considering productive opportunities, the TWG will take into account:
- Concentration - Stablecoin assets should be spread across multiple productive opportunities when possible. This reduces the idiosyncratic risks of any one strategy (e.g. exploits, design failures, yield fluctuations, etc.). The TWG recommends that no single strategy exceed 50% of the stablecoin allocation.
- Smart Contract Risk - Each additional layer of smart contract risk significantly alters the risk profile of a productive strategy. The TWG recommends that smart contract layers on assets in the Operations Account be reasonably minimized.
- Sustainability of the Opportunity - Yield strategies can be fleeting in DeFi. Rather than chasing yields, a bias toward strategies that are economically sustainable with established protocols will be maintained.
- Leverage - Leverage is allowable, but liquidation risk should be appropriately managed and monitored if used.
To ensure the stablecoin allocation is being managed appropriately, there should be a defined performance parameter to measure it against. This will differ between each account based on the the unique goal of each.
When reviewing a stablecoin investment strategy, performance should be measured versus a benchmark index (such as PAY). Ideally, performance of the total stablecoin allocation within the Investment Account will exceed this benchmark rate. This will be further defined in the future performance reporting package.
Performance of the stablecoin allocation within the Operations Account should be secondary to immediate financing needs and not a primary goal. Performance will be measured versus the DAI Savings Rate (DSR), the DeFi risk-free rate.
- Place 3 months of stablecoin reserves into the Operations Account. This is approximately $500k based on the USD denominated forecasted expenses (excludes contributor rewards and liquidity mining, which is paid in INDEX). We currently have $7.8mm available in USDC.
- Diversify half of the Operations Account reserves into DAI. This moves half of the allocation into an on-chain collateralized stablecoin, diversifying both financial and legal risks.
- Make the reserves productive. This will be detailed in a separate post.
- No more than 50% of the stablecoin allocation should be concentrated into a single strategy or productive opportunity.
- No more than 50% of the stablecoin allocation should be exposed to a single asset (DAI/USDC/USDT).
We are utilizing this post to highlight the TWG’s thinking around stablecoin asset management for the Index Coop treasury. We welcome any feedback and suggestions. After gauging community sentiment, we will put up an IIP that enacts points 1 and 2 within the ‘Current Recommendations for Index Coop’s Treasury’ section. We will also be releasing a separate post and IIP for making these reserves productive.