Cryptocurrency Stablecoins as an Alternative to Low Interest Fixed Income Investments

Preface added May 12, 2022

In light of the collapse of the TerraUSD ($UST) stablecoin and it's paired coin ($LUNA), it is important to stress a few things:

• Always properly research any investment you are about to make, especially when it comes to cryptocurrencies and digital assets. The asset class is new and sometimes very difficult to understand.
• There are greater risks with many digital assets, and you should fully understand them before making any investment.
• Diversify investments and never have too much of your portfolio in one single investment, no matter how safe it may appear to be.
• If anyone provides a warning or concern about an investment, it doesn't hurt to hear them out and look at the details of what they may be saying. There were plenty of warnings about Terra's stablecoin long before the collapse occurred.

If you don't know what this is about, and wish to know and understand more, I recommend doing a web search for UST and Luna. You will find plenty of information about the collapse and how it cost many people their life savings.

Please be careful with your investments. If you would like advice for making the right decision, Escient Financial, a Certified Digital Assets Advisor (CDAA), is here to provide advice on traditional investments and cryptocurrency, blockchain, and digital asset investments.

Many investors are starting to question the traditional fixed income investment options and their current inability to keep up with inflation. Inflation is officially at 7.9%, but many experts think it's actually much higher due to the limited goods that are used within the Consumer Price Index (CPI). Some experts say it could actually be as high as 20% and, depending on what goods you actually purchase and what your expenses are, that may be a reality for you. Interest rates are still considerably low at 0.25%-0.50%, even after the Fed raised rates earlier this month. Many fixed income investments actually yield no more than 2%, and if your fixed income investments are a type of fund, then your returns are likely lower after paying fees. Granted, there are some fixed income investments that are meant to provide a higher yield, but without taking on a lot more risk, you're unlikely to find something worthwhile earning more than 5%. That's still nearly 3% below the current official inflation rate.

It's important to make sure there's an understanding of what fixed income is. There are a couple important key features of fixed income. One is the actual fixed income part. That means the investment provides a regular predictable income. For example, you buy a bond and that bond pays interest every six months. Or you invest in a money market fund that pays interest every month.

When a financial advisor allocates a portion of an investment portfolio to fixed income, it's in large part to protect the principle from potential market volatility so it doesn't lose as much value as it could with riskier investments. As an investor gets closer to retirement and then progresses through retirement they would typically see the portfolio change from riskier assets such as stocks to less risky assets such as bonds, especially U.S. Treasury bonds. This is to protect their assets from potential market downturns so they have enough money to cover their expenses during retirement.

The issue here is that we're now in a situation where the traditional fixed income investments generally do not provide enough return to compensate for inflation, potentially resulting in retirees not having as much money as was expected during their retirement because their money has lost value with rising prices of goods. This is called purchasing power risk. What are the solutions to this?

One option is to not allocate as much or even any of the portfolio to traditional fixed income investments. That would require investing in all equities. However, equities are more volatile and have more risk. If a retiree has their entire portfolio allocated to equities and the market experiences a downturn of 30%, that could be disastrous for their retirement as they may find themselves without enough money to cover all of their expenses throughout their entire retirement.

Another option is to keep the fixed income portion in cash, such as high-yield savings accounts. At this time, high-yield savings accounts only yield about 0.50% per year, which is below many fixed income options and well below the current inflation rate. The only real advantage with this option is even better protection of principle than a lot of fixed income investments.

A stablecoin is a type of cryptocurrency that has its value pegged to a fiat currency. What's a fiat currency? Be sure to read the earlier Escient Financial Insights article About Those Objections to Cryptocurrency You May Have Heard.... There are stablecoins pegged to some of the biggest fiat currencies in the world, and a number of them are pegged to the US dollar. There are different ways in which these stablecoins obtain their value. Some are backed by actual US dollar currency. Some are backed by other assets, such as bonds, other debt obligations, and even other cryptocurrencies. Some also use computer algorithms that tie them to other assets and adjust the supply to keep the value stable.

It's important here to point out that the value of these stablecoins are not completely stable. For US dollar stablecoins, they do aim to maintain a value of one dollar, but they do fluctuate. Generally the fluctuation is within a couple cents, give or take, but still, most of the time they are actually approximately one dollar. Some exchanges will even automatically allow people to buy and sell stablecoins at the dollar-pegged value. There would still be trading fees in most cases, but there are some exchanges that don't charge trading fees for stablecoin trades.

It is also important to note that stablecoins have their own risk. They are supposed to be backed by either fiat currency, bonds, debt obligations, other cryptocurrencies, or other assets, but they tend to not be transparent. Some are audited to see if they are actually backed by their market value, but some are not. Anything that happens within those other markets, such as a decline in bond value, defaults on debt obligations, or a decline in value of any underlying asset could affect the value of or the solvency of the stablecoin. Also, any kind of major run on the stablecoin (i.e. everyone withdrawing their stablecoins and selling them for other assets or cash) could cause a decline in value of the stablecoin. The decrease in the value of a stablecoin is referred to as de-pegging of the stablecoin because it's value is no longer pegged to the value of the fiat currency it's supposed to be pegged to.

There is also regulatory risk with stablecoins. Currently, the amount of regulation with stablecoins is limited and there are a lot of questions about how they will be regulated in the future. Any future regulation could cause a decrease in the value of stablecoins and even make it difficult or impossible to purchase, sell, or transfer stablecoins.

As with any investment, it's important to fully understand the risks. With digital assets and cryptocurrencies, it's also very important to know how they work and what you can and cannot do with them, both in a practical and a legal standpoint.

There are three main uses for stablecoins. One use is as a form of monetary exchange, which means you can use them to purchase goods. There are some businesses and resellers that do accept cryptocurrencies, and some of those will accept some stablecoins. Some stablecoins are more prominent than others, so you'll likely see a handful of them much more often that others, but not every reseller will accept the same stablecoins. Some of the most prominent stablecoins include USD Coin (USDC), Tether (USDT), TrueUSD (TUSD), TerraUSD (UST), Binance USD (BUSD), Dai (DAI), and Gemini USD (GUSD). These are just some of them. There are more.

Another use is as a way of temporarily storing money. For example, some investors will trade other cryptocurrency for a stablecoin when they feel that particular cryptocurrency has reached a high and will decline, then trade back for that particular cryptocurrency when they feel it has reached a bottom. It's similar to selling stocks when they are high and buying when they are low with US dollars. Some cryptocurrency exchanges do not have fiat on- or off-ramps, so stablecoins are the alternative to US dollars in those cases.

Stablecoins are also used as an intermediary when trading one cryptocurrency for another. In some cases there may not be a trading pair to directly trade from one cryptocurrency for another. For example, an investor may want to trade Solana (SOL) for Avalanche (AVAX) on an exchange. There may not be a way to do that directly, so an investor would trade their Solana for a stablecoin and then trade the stablecoin for Avalanche. This allows them to do so without worrying about a decline in the value of the intermediary. If they used Bitcoin as the intermediary they could see a decline in value even in just a matter of seconds. They could also see an increase in value, but using a stablecoin helps avoid the risk.

Finally, another use for stablecoins is to simply have a cryptocurrency equal to the value the US dollar. Doing so allows for the protection of principle since the volatility is much lower for stablecoins than it is for non-stablecoin cryptocurrencies. This opens up opportunities in Centralized Finance (CeFi) and Decentralized Finance (DeFi) to earn interest and rewards.

CeFi refers to trading and holding cryptocurrencies, and transacting with cryptocurrencies, through a centralized exchange. Centralized exchanges include Coinbase, Gemini, Binance.us, Kraken, Nexo, Abra, and others. They are considered centralized because the exchange maintains custody of the crypto assets and thus ultimately has control of them.

With CeFi you can purchase crypto on (or transfer crypto to) a centralized exchange. Once there, many of these centralized exchanges have "earn" and "rewards" features that allow you to earn interest and rewards if you hold your crypto on the exchange. The yield can range from under 1% to over 20% per year, depending on the particular exchange and the cryptocurrency. These could vary wildly. For example, at this time, investors can earn 0.15% with USDC on Coinbase, but can earn 8% to 13% with USDC on Abra. The yield could depend on the amount of the cryptocurrency that is held or by holding a certain amount of another cryptocurrency or token. The interest and rewards are typically paid in-kind, meaning they are in the same cryptocurrency, but some do allow for bonus rewards that are paid in a special cryptocurrency or token that the centralized exchange uses. 

With many CeFi exchanges, you may need to move your cryptocurrency from one part of your account at the exchange to another part. This typically is called staking. Staking is essentially committing to hold your crypto on the exchange and allowing the exchange to use your crypto for liquidity purposes and also for loaning to other investors. The exchange charges investors interest for borrowing cryptocurrency, and they give you a cut of that interest for making your crypto available. This is similar to what banks do with your cash you hold in checking and savings accounts and CDs. The difference here is that you can get a significantly higher interest rate with crypto staking than with a high-yield savings account or CD.

The advantage of earning interest and rewards with a centralized exchange is that your assets could be held with an exchange where you can purchase and sell your cryptocurrency. They are generally easier and quicker to use than DeFi at this time, and most of the time there are no fees involved with staking. Some do charge staking fees, though.

As with everything, there are disadvantages as well. CeFi tends to have lower yields than yields that are available in DeFi. Keep in mind though that with higher yields comes higher risk. The exchange also maintains control of your assets. In addition, with some exchanges your crypto is locked in staking for a certain amount of time. This might range from a month to six months. Some might give you an option and will offer a higher interest rate with longer commitments.

DeFi refers to holding your digital assets and cryptocurrencies yourself and conducting transactions outside of a centralized exchange. This is done by getting your own digital wallet and then transferring your digital assets and cryptocurrencies to that wallet. Within DeFi there are a multitude of options for what you can do with your cryptocurrency. Among these are staking, lending, and placing crypto into liquidity pools to earn interest. Although liquidity pools can yield upwords of over 50,000% (that's not a typo) annually, they can be very complex and present unique risks, including loss of value of the principle. Therefore, liquidity pools won't be covered here.

With DeFi staking and lending there are many more options for earning interest on cryptocurrency. Like interest earned in CeFi, stablecoin interest in DeFi can range from under 1% to over 20%.

With staking, you lock up your crypto within a protocol on the network. This allows for increased liquidity that allows for the network to function in a more stable and secure manner. In return for staking, a user will usually receive in-kind crypto as interest, or in a different token in some cases.

With lending, one party lends crypto to another party. The borrower puts up other crypto as collateral, so if something happens to the loaned crypto or the borrower doesn't pay the interest, then the lender can recover the value they loaned out. The lender earns interest on the loaned amount. This process is governed by smart contracts, which is code that functions as a digital contract that the parties agree to. Everything is automated. During the term the lender receives the interest. When the contract term is over, the loaned crypto plus interest is returned to the lender.

The advantages with DeFi are the number of options available for earning interest and being able to have complete control of your crypto. There's no worrying about a central exchange failing, being hacked, or some other event causing a loss of assets.

DeFi does have disadvantages. DeFi can be complex and difficult to use, especially when needing to move cryptocurrencies between different blockchains and protocols. There are more fees involved with DeFi. Almost every transfer or transaction will involve at least a small fee, and some fees could be hundreds of dollars depending on the amount of the transaction.

There is also smart contract risk. Smart contracts are code, and code can have bugs and security vulnerabilities. If a bad actor were able to exploit any vulnerabilities it could result in a loss of assets. Currently, most financial crime involving cryptocurrency involves the exploitation of bugs and vulnerabilities in DeFi and smart contracts.

If you currently have a lot of cash in a high-yield savings account earning 0.5% interest annually, or bonds or other fixed-income investments earning around 2.5% interest, it might be difficult to justify keeping your hard-earned money in those when they are still losing value because inflation is so high. At some point we may see them even out more where high-yield savings accounts earn the same as the inflation rate so you're not losing purchasing power every year, or where bonds and other fixed income investments start to maybe earn a little more than inflation. It's unknown how long that will take or if it will even happen. So what should you do?

Every person is different, with different needs, wants, and risk profiles. Investing in 100% equities may be the right choice for some people, but not others. Investing part of a portfolio in cryptocurrencies may be the right choice for some people, but not others. Holding money in cash and investing in traditional fixed income investments may be right for some people as well.

With cryptocurrencies, the potential reward may seem greater, but along with that comes greater risk. Utilizing stablecoins and other cryptocurrencies to earn higher yields and greater returns isn't going to be right for everyone.

Each individual needs to determine their needs, wants, and the amount of risk they're willing to expose themselves to when deciding what to invest in. That's not always easy, especially when it comes to digital assets and cryptocurrency. Fortunately, Escient Financial, a Certified Digital Assets Advisor (CDAA), is here to help clients make those decisions. If you need help with determining the right investments to help you reach your goals and build your financial future, feel free to...