Stablecoins Reduce DeFi Volatility

Many of us who are using our cryptos for collateral on exchanges or DeFi platforms are a little nervous with the dip in the crypto market. Bitcoin is hovering above $41K, dragging other cryptos down to some bargain prices. If you have spare cash, this is a good time to buy. If you borrowed against your crypto, you're watching the LTV like a hawk to avoid getting liquidated. Leverage works great until it turns against you. However, that risk can be reduced by introducing stablecoins to your holdings.

Capital Preservation

In traditional finance, portfolio managers would manage risk by diversifying your equities into different sectors and also introducing fixed-income products, such as bonds. The mixes vary, depending on the portfolio objective. Just as a very rough example, you might have 50% in bonds, 25% in blue chip stocks, and 25% in growth stocks. Our focus today is in the part that bonds play in traditional finance. They won't make you rich. But, they won't lose money either. At least, they used to not lose money. These days, bonds lose in real value with inflation. They barely pay out any interest, however.

Similarly, if you have a portfolio of cryptos, it helps to have a portion in stablecoin. The practical reason is that you need some money set aside and ready to jump on any market dips. But, in a crypto portfolio, stablecoins may offer low growth on your capital. At the same time, they protect you against market volatility.

Portfolio managers will periodically rebalance portfolios to put them back to the same weighting. If your growth stocks went ape, they would take profit and put that into bonds to bring things back to 50/25/25 ratio. This way, you are still in the market while locking in your gains.

The Maths

Let's say that you have$1000 with 50% in stablecoins. The other 50% is in some awesome crypto, MOON.

$1000 portfolio = $500 stablecoin + $500 MOON

Then, one day we have a dump of 30%. After the dump, your mixed portfolio has:

$850 portfolio = $500 stablecoin + $350 MOON

OR

After 30% dump with 100% moon, you'd have $700 in MOON remaining.

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As you can see, when you have some stablecoin in your crypto portfolio, your overall holding is less volatile. Of course, this also is a factor on the upside. Your gains won't be as large overall. However, when the market dumps, you can rebalance by taking some of your stablecoin to buy more MOON, bringing you back to 50%/50%. This way, when the market pumps again, you'll have some sicker gains.

Playing With Margin

I mentioned lowering risk on your portfolio. The risk is the price volatility. You could easily lose money, which is against one of the rules of investing. When you invest using margin, also known as taking out loans, you introduce more risk.

If you're going to use leverage on your investments, then you especially want to play with less of your portfolio at stake. You want asymmetric gains. That is, you want a big upside and small downside. Borrowing amplifies the risk both ways. You can win big and lose big by using margin.

Or, maybe you aren't using margin to invest. Maybe you just borrowed money to pay some bills. A big market dump can still end up liquidating your collateral.

Whatever the reason for borrowing, you can reduce the risk of liquidation by having stablecoin in your collateral.

The Disadvantage

The disadvantage of having stablecoin deposited as collateral in DeFi is that it tends to not earn as much interest as other cryptos. But, low interest is better than no interest. Even if the interest was practically zero, your stablecoin collateral would still help defend your earnings against volatility. It's an acceptable tradeoff.

From Experience

We try to not borrow more than a 50% LTV ratio. Most lending platforms won't let you borrow more than a set percentage. Let's say, for example, that the most you can borrow is 70% of your collateral, with a margin call at 80%. There's not a lot of wiggle room between 50% and 80%. Without the stablecoin component, your portfolio could easily lose that 30%, leading to liquidation. You'll need to scramble to add more collateral or pay back the loan to avoid getting liquidated.

We reduce our liquidation risk by borrowing against less than 50% of our collateral. We also reduce our risk by having stablecoins serve as part of our collateral. This allows us to have stress-free crypto investing.

On the surface, it doesn't make sense to deposit stablecoin and borrow back stablecoin. Why not just use what we already have?

One answer is that by depositing, we are lowering our cost of borrowing. In that $1000 fictional portfolio, if I supply $500 in stablecoin and $500 in MOON, then I would only be able to borrow $500 to keep within the 50% LTV.

First, by doing this, we are reducing our cost of capital. If I borrow at 4% and earn 2%. Then, I am only paying 2% interest on the loan.

You can consider that 2% interest as the cost of protecting MOON from liquidation. If things work out right, MOON will make up way more than the 2%.

By depositing $500 and borrowing $500, I now have $1000 stablecoin and $500 MOON under my direction. If I spend the loan, then I'd still have all of my original capital under my direction. If I didn't take the loan, then I'd only have MOON under my direction.

If I ever needed to take out stablecoin from my DeFi supply, I would not have to worry about capital gains or losses. At most, I'd end up with extra stablecoin as interest income.

When you give it ample thought, having stablecoin in your DeFi portfolio, or even just your holdings, makes a lot of sense.

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