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How much of a stablecoin allocation is too much?

Cryptocurrencies are well-known for being volatile assets, which means that experienced traders have plenty of opportunities in the space. Investors can expect to be taken on a wild ride if they plan on holding for a long time.

Stablecoins, a class of cryptocurrencies that offers investors price stability pegged to the value of fiat currencies, offer investors a safe haven when market turbulence hits but may represent missed opportunities over time.

Speaking to Cointelegraph, several experts have stated that retail investors should approach cryptocurrencies with a “pay yourself first” attitude and that an allocation of up to 5% in crypto should be relatively “safe” while allowing for “marginal return.”

Stablecoins are entirely different: No “marginal return” can be expected from simply holding an asset tied to the value of the United States dollar, although yields can reach double-digit annual percentage rates (APRs) using decentralized finance (DeFi) protocols. These protocols, however, lead to higher risk.

Different stablecoins, different risks

Not all stablecoins are created equal. The largest stablecoins on the market — USD Coin (USDC), Tether (USDT) and Binance USD (BUSD) — are backed 1:1 by cash or assets with similar value by centralized companies. This means that for every token in circulation, there’s a dollar in cash, cash equivalents or bonds in custody.

For example, other stablecoins like Dai (DAI) and TerraUSD (UST) rely on different mechanisms. DAI is crypto-collateralized and ensures it can maintain its peg by being overcollateralized. It includes economic mechanisms that incentivize supply and demand to drive its price to $1.

UST, on the other hand, is a non-collateralized algorithmic stablecoin. An underlying asset doesn’t back it, as it works through algorithmic expansion and supply contraction to maintain its peg. Terra, the blockchain behind UST, has notably been building up reserves for the stablecoin. So far, it has already purchased nearly 40,000 BTC worth over $1.6 billion and over $200 million in Avalanche (AVAX).

Marissa Kim, general partner at Abra Capital Management — the asset management arm of crypto investment firm Abra — told Cointelegraph that the firm views “USDC and other U.S.-regulated stablecoins as safe as keeping reserves in a bank account,” as these are “required to prove on a regular basis that they are fully collateralized.”

To Kim, decentralized stablecoins like DAI and UST may “pose other risks,” as volatile markets could see DAI lose its peg to USD. She added its governance “is by the MakerDAO community, and nobody knows who holds and governs this protocol and where voting power may be concentrated.”

Speaking to Cointelegraph, Adam O’Neill, chief marketing officer at cryptocurrency trading platform Bitrue, said that the “role of USDC and USDT” in the cryptocurrency space is “synonymous to the role of the U.S. dollar in the traditional financial ecosystem.”

O’Neill added that investors should use stablecoins “as a go-to hedge when trading and storing their assets.” He added:

“The security outlook of stablecoin should not be compared, as both the centralized and decentralized versions are secure in themselves. However, it is not uncommon to find hackers exploit the frailty in protocols built to offer products bothering both classes of stablecoin tokens.”

To O’Neill, how much investors should allocate to stablecoins is a decision that is up to them and depends on their investment goals. Kent Barton, tokenomics lead at ShapeShift DAO, told Cointelegraph that while every stablecoin has its own risk profile, there are a few things investors should keep in mind.

For one, centralized stablecoins like USDC and USDT can be easily converted back into USD, but the entities behind these coins could “potentially blacklist certain addresses, for instance, in response to demands from legal entities.” Barton added that while there are long-standing concerns regarding USDT’s backing, it has maintained its peg so far:

“USDT has the advantage of being time-tested: It’s the stablecoin that’s been around the longest. It has deep liquidity across centralized exchanges and many DeFi platforms.”

Decentralized stablecoins like DAI and USDT, Barton said, are more transparent because of the nature of the blockchains they are built on. Still, there are other risks out there, including volatile markets threatening DAI’s over-collateralization.

To Olexandr Lutskevych, founder and CEO of crypto exchange CEX.io, the security of each stablecoin depends on how security is defined. In terms of code, technical audits should cover the risks of more susceptible stablecoins, while in terms of reliability of moving funds from A to B, most have been known to fit the purpose.

As for stablecoins’ ability to maintain their peg against the dollar, Lutskevych said how that peg is maintained should be the main focus on investors’ minds.

Stablecoin DeFi yields: Too good to be true?

While merely holding stablecoins ensures cryptocurrency investors aren’t dealing with the market’s volatility, it also means they aren’t really making any type of return unless they put their stablecoins to work.

There are several options when it comes to stablecoins such as lending them out on centralized exchanges or blue-chip decentralized finance protocols lead to relatively small yields — often below 5% — that are relatively safe. Moving to riskier protocols, or employing complex strategies to boost yield, could lead to higher returns and imply more risk.

For example, it’s possible to find yields above 30% for Waves’ Neutrino USD (USDN) stablecoin, which has recently broken its peg and fallen below $0.80 before starting to recover.

When asked whether investors should lend their stablecoins or add them to decentralized exchanges’ (DEXs’) liquidity pools to earn yield, ShapeShift DAO’s Kent Barton pointed out that DeFi protocols bring in smart contract risks to the equation, which need to be considered.

One-month USDN/USDT chart showing when the token broke its peg. Source: TradingView

To Barton, protocols that have been around for “more than a few months and have a track record of protecting billions of dollars in value are fairly secure.” However, there’s “no guarantee of future security and stability.” Protocols with higher rewards, he said, tend to be riskier.

Lutskevych suggested investors should first understand exactly what they’re putting their money into:

“Just because it is DeFi, the investment principles do not change. And, one of the foundational investment principles is: Before proposing any strategy, you should thoroughly understand one’s risk preferences and individual circumstances.”

To Lutskevych, investors’ capital, time horizon, goals and risk tolerance should also be weighed when considering staying put or moving stablecoins to earn yield. 

To O’Neill, it is “generally advisable that stablecoins should be deployed to harness yields from lending platforms,” although investors should also “be ready to jump at any investment opportunity.”

Stablecoins, partly thanks to the DeFi space, offer investors a plethora of opportunities across a wide number of blockchains. Using them outside of centralized exchanges may require some specific knowledge, without which investors may end up losing their funds by, for example, sending them to the wrong type of address.

Risk tolerance and sophistication

Speaking to Cointelegraph, Carlos Gonzalez Campo, research analyst at investment product issuer 21Shares, said that stablecoins provide investors with access to a “global network of value transfer similar to how the internet gave rise to a global and open network for information.”

Campos stated that February’s Consumer Price Index (CPI) data in the United States revealed a 7.9% year-over-year rise, meaning people are losing their purchasing power at a rate that hasn’t been seen in four decades.

What investors do with their stablecoins, the analyst said, depends on their risk aversion and level of sophistication as the “user experience is still lacking today” in DeFi platforms that let users earn passively on their holdings. Campos added:

“The clearest example is seed phrases, which are impractical and probably won’t achieve mass adoption. That is why leaders in the industry such as Vitalik Buterin have emphasized the need for wide adoption of social recovery wallets, which instead of relying on seed phrases, rely on guardians.”

Abra Capital Management’s Marissa Kim seemingly echoed Campos’ thoughts, as she said bugs and other exploits are possible in DeFi protocols which often pay higher yields in the protocol’s native tokens. They are “often highly volatile and may not be very liquid.”

To Marissa, some investors may be willing to take on the added risk, although others will be “more concerned with principal preservation.”

Whichever strategy investors choose to employ, it’s clear that stablecoins are a major part of the cryptocurrency ecosystem. More risk-averse investors may find they only trust the most transparent centralized stablecoins that offer limited opportunities, while more venturous investors may prefer higher yields and higher risk.

Over time, stablecoins’ influence in the cryptocurrency space is only set to keep growing, so it’s important that investors understand what they are dealing with and the risks involved with the stablecoins they choose to HODL and what they choose to do with them.

The views and opinions expressed here do not necessarily reflect the views of Cointelegraph.com. Every investment and trading move involves risk, you should conduct your own research when making a decision.