With 2021 coming to a close, investors may already be thinking about what it will take to hit their 2022 financial goals.
The long-term return of the S&P 500 is somewhere between 7% and 9%, depending on what period you're looking at. Over the last decade, however, the S&P 500 has produced a total return of over 360%, or a compound annual growth rate of just over 16%. Investors used to such high gains may raise their eyebrows at a mere 9% yield. But for most folks, a 9% yield is plenty to hit financial goals and grow wealth over time -- especially if it comes with less risk.
Let's look at the risks of high-yield stablecoins like the USD Coin (USDC -0.87%) to determine if they present a viable way to generate an attractive return in 2022.
A necessary tool in the crypto market
Stablecoins are no small industry. In fact, the market is estimated to exceed $100 billion. The circulating supply of USD Coin, the largest and most established stablecoin, is $42.1 billion.
Certain exchanges will offer high interest rates for these coins. For example, BlockFi offers a 9% annual percentage yield (APY) on the first $40,000 of USD Coin, and an 8% APY for any amount after that.
Asset management expert Ben Carlson, one of my personal favorite financial minds, put it well when he described stablecoins as the crypto industry's money market account. In other words, they provide a solid supply of capital that supports the broader crypto market.
Unlike the highly sophisticated workings of the traditional financial markets, crypto exchanges have limited options for accessing capital. Stablecoins provide an easy way to do that. Exchanges are more than happy to pass along high interest rates to their customers so long as they can lend that capital out for a higher rate than they are paying. The exchange operator gets to pocket the spread, and the retail investor gets a high return. It's a win/win if all goes according to plan.
Risks worth considering
The issue is that crypto interest accounts are not Federal Deposit Insurance Corporation (FDIC)-insured like the money held in a traditional savings account, or National Credit Union Administration (NCUA)-insured like funds held in a credit union. In addition to a lack of insurance, there are few regulations, not to mention firms like BlockFi are far less proven than, say, a major bank or credit union. Risky lending practices could lead to financial stress or even insolvency.
USD Coin's claim to fame is that it is a "fiat-backed stablecoin", meaning it is supported dollar-for-dollar by assets held in a bank. In theory, the price of USD Coin should always be no more than a rounding error away from $1. However, users must sell their stablecoins for the going rate to convert them back into U.S. dollars. In this sense, if the crypto market became unhinged and the price of USD Coin dropped to, say, $0.95, then the holder couldn't simply demand $1 for each USD Coin.
Over the summer, Circle Internet Financial LLC (Circle), which is the principal operator of USD Coin, came under fire when it was reported that the sum of all USD Coin was backed by the "fair value" of multiple assets. In fact, Circle's July 2021 reserve breakdown shows that cash and cash equivalents made up less than 50% of assets, the rest being a mix of bonds, CDs, U.S. treasuries, and commercial paper. However, Circle's most recent disclosure from October shows that 100% of its assets are now held dollar-for-dollar in cash and cash equivalents. Monthly disclosures that show Circle is keeping its word to back USD Coin with cash, not other vehicles, would add credibility to its product over time.
"Savings account" is a misnomer
Comparing the less-than-1% interest rate available at most U.S. savings accounts to the much higher yield available from stablecoins is like comparing apples to oranges. Like anything in the finance world, risk, returns, and rates are all determined by market forces. Because the market for crypto is so young, and the market for retail investors into crypto through increasingly secure exchanges is even younger, firms do not have access to the same financing opportunities available for equities or other securities.
There's a demand to use Bitcoin (BTC -4.21%), Ethereum (ETH -2.60%), or another crypto as collateral to buy more crypto. It's similar to using the equity in a home to buy another home, or owning stocks to buy more stocks on margin. So the basic concept of using an existing asset to buy more of that asset on interest isn't readily available in the crypto space. Stablecoins provide one solution to this challenge.
As the market matures, the likelihood that interest rates on stablecoins will go down is very high. It wasn't long ago that brokerages charged $10 per trade to buy a stock. Nowadays, most platforms offer free trading. A larger, more sophisticated market may even put an end to high yields from stablecoins down the road.
The term "savings account" or "interest account" is commonly used by firms offering high interest rates on stablecoins. But dig deeper, and it's clear to see stablecoins are a lot riskier than cash in a savings account, properly insured by the FDIC.
How to approach high-yield stablecoins
For most investors, a lower yield with less risk could be a better option than high-yield stablecoins. For example, investing in equal parts of Kinder Morgan, Clearway Energy, and Schweitzer-Mauduit is likely to produce a dividend yield of 5.5% in 2022, while diversifying risk across multiple companies and leaving upside in case the stocks go up.
For investors interested in crypto who don't want to buy Bitcoin or Ethereum at all-time highs, the 9% interest rate on stablecoins could provide a less volatile introduction to the crypto space.