The Role of Stablecoins: Cryptocurrencies Sought Stability and Found Gold and Dollars

This paper empirically assesses the ability of three putative stablecoins (two dollar-backed, Tether and USD Coin; and one gold-backed, Digix Gold) to reduce the risk of a traditional cryptocurrency portfolio during the COVID-19 pandemic. A monthly rebalance experiment is conducted over an out-of-sample period, so that the effects of including stablecoins in terms of diversification can be clearly assessed. The GO-GARCH model is implemented to obtain dynamic estimates of conditional co-moment arrays up to order four. Then, assuming a CARA utility function and a risk defensive investor profile, an extension of the certainty equivalent with co-skewness and co-kurtosis is conducted for portfolio allocation purposes. Using the Cornish-Fisher expansion of the parametric VaR (i.e., the modified VaR), we evaluate how the introduction of every single stablecoin into a traditional cryptocurrency portfolio affects the downside risk of the combined strategy. The empirical evidence highlights that the two dollar-backed tokens have high diversification and hedging capabilities against traditional cryptocurrencies and can even act as safe havens, whereas Digix Gold shows a high diversification potential, but constrained by its high intrinsic volatility. In addition, our results also reveal the importance of considering higher order moments when forming cryptocurrency portfolios and measuring their risk.