Investing in cryptocurrency can be, well, volatile. While prices of bitcoin, ethereum and other top cryptocurrencies can fluctuate 10–20% a day, there are a few investing strategies that can smooth the volatility. One strategy uses Dai, a US dollar equivalent stablecoin from MakerDAO, to hedge a cryptocurrency portfolio. Below I breakdown what Dai is, why would one use this hedge strategy, and how to execute this strategy to decrease the effect of volatility on a cryptocurrency portfolio.
What is a Stablecoin?
From an investing standpoint, stablecoins are equivalent to $1. Now, most stablecoins like Tether, TrueUSD, Paxos and Gemini Dollar are supported by an underlying fund of US dollars, normally in a 1–1 ratio.This means that there is a dollar funded account that fluctuates in value with the supply of the stablecoin out in the market.
So if Paxos has $10 million worth of tokens circulating, there is $10 million in a Trust account backing the supply of tokens. If next month, the supply of Paxos increases in value to $15 million, then the Trust increases its account value to $15 million so that 1 Paxos token = $1 collateralized US dollar. Traditional stablecoins are basically tokenized IOU’s for US dollars. Since these stablecoins are supported by a centralized Trust and traditional banking system, it is not decentralized and has the same risks associated with traditional banking that the entire cryptocurrency/blockchain industry was founded to alleviate. Using these stablecoins seems to be quite a crypto-conundrum.
Dai, the Improved Stablecoin
Dai achieves dollar-equivalency through a completely decentralized method, making it fundamentally different from other stablecoins.
Dai is kept equivalent to $1 through a system of “Collateralized Debt Positions”. This is simply a loan that ethereum holders make by using ethereum as the collateral. The cost associated with creating Dai through a collateralized debt position of ethereum fluctuates based on the current supply of Dai, so that Dai will remain stable at $1. Dai exists entirely though decentralized blockchains — making it the only stablecoin that inline with cryptocurrency’s decentralized mission.
At Coinplan, we looked at all the stablecoins and chose Dai for our portfolio investing platform because it is completely decentralized, unlike other trust-backed stablecoins.
Why Hedge Your Crypto Portfolio
Hedge: an investment to reduce the risk of adverse price movements in an asset. (Investopedia)
As anyone invested in cryptocurrency, or really anyone who has watched the news in the past year, knows cryptocurrency is volatile. Hedging your cryptocurrency portfolio lowers the overall risk of your portfolio, which is important as cryptocurrency is naturally risky due to its volatility. In a volatile market where most cryptocurrencies are correlated (the asset’s prices move similarly), a viable way to hedge your crypto investment is to move OUT of cryptocurrency and INTO the US dollar equivalent stablecoin.
It’s essentially crypto-on, crypto-off. Risk-on, Risk-off.
Moving in-and-out of cryptocurrency normally goes like this:
- Sell your cryptocurrency on whatever exchange you invest on.
- Send the bitcoin or ethereum to an exchange like Coinbase or others that allow crypto-to-fiat (US Dollar) withdrawal.
- Withdraw your bitcoin or ethereum into your bank account through ACH.
These three steps can take up to an hour to complete and the money will not be available in your bank account for 3 days to a week. In a weeks time, the cryptocurrency market could have completely changed direction making your hedge worthless. Plus, an investor will be incurring fees at every step of that process.
That’s a headache.
By the way, this idea is the same in traditional markets — when the stock market starts to dive into a recession, investors move out of equities and into things like gold, low risk Treasury Bonds and other less-volatile positions.
How to Hedge Using the Dai Stablecoin — Crypto Price Decrease
Instead of going through the headache of moving in-and-out of crypto, investors can use Dai to move out of crypto and into US dollar. Since Dai is a cryptocurrency that is always equivalent to $1, investors can almost instantly sell bitcoin or ethereum to buy Dai without leaving their preferred cryptocurrency exchange.
The hedge strategy is simple — assume a portfolio of $100 with 50% bitcoin and 50% Dai ($50 BTC, $50 Dai).
Now, if the price of bitcoin declines by 20%, the portfolio is over-allocated to Dai (55.56%) and under-allocated in bitcoin (44.44%).
Now to rebalance the portfolio, buy $5 of bitcoin with Dai. The portfolio is now rebalanced with 50% bitcoin and 50% Dai.
With this hedge strategy, the investor instantly bought bitcoin at a discounted price, using Dai and rebalanced his or her portfolio.
Since only the price of bitcoin decreases comparatively to the US Dollar — and the actual amount of bitcoin an investor holds does NOT change — the investor has accumulated more bitcoin at a cheaper price by taking advantage of this strategy.
How to Hedge Using the Dai Stablecoin — Crypto Price Increase
Now, here is an example of when bitcoin prices increase and the investor can harvest the gains made by moving bitcoin into Dai.
We start with the same portfolio of $100, 50% bitcoin and 50% Dai:
Now lets say bitcoin increases in price by 20%, leaving the investor’s portfolio over-weighted in bitcoin:
To harvest, or take, the gain made from bitcoin’s price increasing, the investor sells $5 of bitcoin and buys $5 of Dai. This rebalances the portfolio back to 50% bitcoin and 50% Dai, however the overall portfolio has increased in value by $10.
The investor has taken a $5 profit and lowered the risk of the new portfolio by rebalancing into equal weights.
Don’t just take my word for it. MakerDAO, the community that built and supports the Dai ecosystem, intended cryptocurrency investors to utilize Dai to hedge.
Automating the Dai Hedge
Using Dai, the decentralized stablecoin, investors can hedge their portfolios by lowing their risk in the volatile cryptocurrency markets. By using this strategy, investors can smooth both gains and losses in their cryptocurrency portfolio.
So at Coinplan, we’ve built a platform to help investors do just that — use Dai to rebalance their cryptocurrency portfolios with just one-click.
Coinplan has pre-built portfolios like the Bitcoin Hedge, Ethereum Hedge, and Crypto Hedge, that are built for using Dai to rebalance and hedge your overall cryptocurrency investment.
Utilizing the Coinplan platform to buy, hedge, and rebalance cryptocurrencies portfolios allows investors to execute the Dai hedge strategy in a matter of seconds. No confusing spreadsheets, no calculations — we automated the whole thing to make it as simple as possible for you.