A Differentiated Solution to Address Global Inflation Risk

Greetings $WSB community,

We’ve been thinking, and what we see happening on a global basis has cause for concern. So we thought it was timely to spark up a discussion and further ideas around an Inflation Hedging ETP.

I wanted to acknowledge this post: Inflation-Hedge ETP by Isaac. Thank you for contributing to the discussion.

As a quick update: WSB Engineering team has been working almost daily with the core developer of Balancer Labs, to speed up getting our ETP’s out the door. The main issue is the time to audit the code. Currently we expect the audits to start next week and take 5-7 days. Then, subject to balancer v2 pools being liquid enough, we can launch not just the WSB Crypto 20 ETP but a 2nd ETP we are calling the “WSB Macro Hedge ETP” We are launching something first of it’s kind with our partners so the development is taking additional time, especially because we don’t want to settle for something that is just good enough.

  • Yes, we are making a global currency!

The process for ETP 2 will be similar to ETP 1:

  • Publish initial specs (this post).
  • Discuss with the community for a couple of days and reconcile feedback.
  • Publish final ETP 2 specs and open for on-chain vote.

Since we have just been through all of this for ETP 1, this 1-2-3 process should be relatively quick. Outside of ETP’s 1 & 2 (estimated to both be live during week 2 July), we have been working on a different but related product - it’s looking like it might be ready before the ETPs. This will bring huge utility and fees to WSB also.

Speaking of Fees; now that the base technology considerations are matured, we will be publishing both a diagram of how we propose the fees to be used (burn, add liquidity, etc etc) as well as aiming to finally publish an updated product roadmap!

Stay tuned to our medium and this forum.

Meanwhile let’s dive right into ETP #2!

Inflation risk in a portfolio is not always a straightforward problem to fix:

  1. Traditional Treasury Inflation Protected Securities (TIPS) are driven by the Consumer Price Index (CPI) which is distorted by substitution that can understate the consumer’s inflation experience and make TIPS less effective. In simple terms, expensive goods can be replaced by less expensive goods (ie. Chicken for Steak).

  2. Commodities are generally not owned by ETFs in physical or cash form instead are owned via futures contracts.

Macro indications that global inflation is set to set to rise:

  1. Money printer goes Brrrr …. Money supply (M2) is expanding rapidly, see below chart.

CHART (m2 money supply)

The yellow shaded area to the right of the chart is part of the recent US government Stimulus. An increase of this size has not been seen in over 50 years (since WW2). This is likely to expand with additional stimulus. This is a representation of expanding money supply to pay for short-term needs with possibly long-term consequences.

CHART 2 (Stimulus)

  1. US Federal Debt has grown significantly since the GFC and the COVID-19 pandemic, where the pandemic has added $19.5 Trillion to Global Debt.

CHART (us total public debt)

  1. US Interest rates approach 0%

CHART (10yr Treasury rate)

  1. Energy prices have reached historic lows, America’s “binary” wealth distribution is likely to lead to higher wages, the availability of cheap goods may be ending and additional spending from the US government will be needed for business support etc etc. The list goes on.

Against this backdrop, we propose an idea for an effective Hedging ETP solution leveraging developments in the crypto sphere.

Investment Objective

A passive ETP that seeks to outperform inflation with the aim to retain purchasing power in an inflationary macroeconomic environment. The ETP would physically hold onto the underlying assets in a non-custodial way by deploying a Public Smart Pool on the Balancer protocol (Balancer.Finance).

The idea for this test portfolio was to use a basket of currencies (stablecoins) with a small exposure to precious metals (WDGLD) and Bitcoin (WBTC) and Ethereum (WETH). Due to the restrictions and liquidity of certain assets on Balancer Finance, not all inflation vectors could be included. However, over time the ETP could add tokenized representations of REITS, Royalty and Streaming company stocks and Traditional ETF Hedging Products. Even tokenizing the Internet Computer ICP cycles which are pegged to SDR (which was mentioned in the gov forum by a $WSB holder previously).

Strategy:

The ETP is a passively-managed ETP that seeks to achieve its investment objective by investing primarily in fiat-pegged stablecoins, tokenized commodities and wrapped crypto native assets.

Asset Constituent & Weighting

The below table was the starting allocation for the test basket portfolio. However, to capture historical data back to 2015, Tether USDT was used instead of USDC, and EUR/USD, NZDUSD and XAUUSD were used instead of their counterparts.

Name Ticker Type Weight
USD Coin (Centre) USDC Currency 31.66%
Synthetic EUR SEUR Currency 25.26%
New Zealand Dollar Stablecoin NZDS Currency 23.08%
Wrapped Bitcoin WBTC Crypto 5%
Wrapped Ethereum WETH Crypto 5%
CoinShares Wrapped Digital Gold WDGLD Commodity 10%

DGLD, more specifically Wrapped DGLD was chosen as it represents a digital proof of ownership of allocated gold, which is physically held in a vault in Switzerland.

The original weightings were based on a 60/40 rule; where 60% was currencies based on the IMF SDR ratios and 40% metals and crypto. 15% BTC, 15% ETH and 10% Gold. We are currently slightly constrained as we wait for more liquidity to migrate over from the BalancerV1 pools to V2. Because of this limitation, we dropped CNY, GBP and JPY and gave more weight to NZD. This can be amended in the future.

However, after back testing the above weighting mechanism, the 30% allocated to BTC and ETH gave too much exposure so we reduced these down to 5% each.

Another approach for the weighting mechanism is to design the currency side of the basket based on trade merchandise shares with the base (country) being the United States (US). So, a Trade weighted basket for 80% of currencies and disperse the left over 20% to metals and crypto’s. As mentioned earlier we can add further tokenised assets in the future for the purpose of hedging against inflation.

The below chart displays the cumulative returns of the ETP Hedge vs the S&P 500 since August 2015.

CHART (cumulative returns since Aug 2015)

The below chart displays the cumulative returns of the ETP Hedge vs the S&P 500 from the start of the year, Jan 2021.

CHART (cumulative returns YTD)

Risk Adjusted Returns

The below tables measure how much risk is associated with producing a certain return. I compare the ETP to the S&P 500 over a 5 year period and another year to date (2021).

(Since 2015) ETP Hedge S&P
CAGR 17.87% 12.75%
Risk Free Rate 2.00% 2.00%
Annualised Volatility 12.47% 15.68%
Sharpe Ratio 1.27 0.69
Beta 1.39 1
Max Drawdown -14.15% -33.92%
(YTD 2021) ETP Hedge S&P
CAGR 24.84% 24.94%
Risk Free Rate 1.70% 1.70%
Annualised Volatility 10.64% 11.43%
Sharpe Ratio 2.17 2.03
Beta 4.28 1
Max Drawdown -4.96% -4.23%

We have used a conservative “risk free rate” of around 2% to calculate the Sharpe Ratio, although the crypto industry hasn’t quite established a risk free rate we could change this to 0% to see a slightly different measure of risk.

The below chart shows the Maximum Drawdowns (MDD) since August 2015. The MDD is the maximum observed loss from a peak to a trough of a portfolio, before a new peak is attained.

CHART (cumulative returns YTD)

Further research could include comparing this to the real-adjusted inflation rate, something like the Chapwood Index rather than the CPI or perhaps Purchasing Power Parity (PPP) such as the Big Mac Index.

Thanks for reading, it would be great to get the feedback of $WSB holders on this proposal in it’s early stages. If the charts and information is a bit too advanced, you can think about the assets in the basket and how they would combine to achieve this result. Obviously the central governments have printed. This would be a clear case of, if a considerable amount more of something exists it will devalue related to it’s scarcity.

10 Likes

Excellent post and analysis @wsb_g, love seeing all of the hard hard you’ve put into this!

I think this is all an excellent idea. We are likely about to see currency wars as many currencies “race to the bottom”, and with the real SDR simply being a unit of account for the IMF, having a permissionless globally liquid “crypto-SDR” like this controlled by the decentralized WSB DAO would be a huge advantage.

This aligns with the concerns of most crypto traders in general, so I think it’ll provide a huge opportunity for press and positive attention on our project. It’ll also be a great building block for dapps which need a single stable-value asset as part of their internal smart contract functions, since using a single stablecoin of only one country’s currency would limit the dapp’s appeal to a global audience. This actually takes things beyond our original goal of simply investing together within our own community, and actually helps us create something new and valuable for the global defi space as a whole!

If we make known some of our future plans for adding CNY, GBP, and JPY as this ETP gains exposure, that may help drive liquidity providers to supply these assets in Balancer V2 since they know they’ll be reliable long term trading volume for them.

I’m sure we all have ideas for things we’d like to add, but in light of the current Balancer limitations the assets you’ve selected should suffice. I just have a few brief suggestions:

  1. I think we should lower the USD weight a bit if possible because of the unique risk it’s under as it’s world reserve currency status is being put under stress. While this will probably lower the historical returns because we’ve been able to “export our inflation” in the past, but as explained in this post, USD is in the riskiest position of all currencies right now. In a nutshell, 62% of the holdings across all foreign central bank reserves are in USD because it is the global reserve currency. If in the near future these countries start to sell their USD reserves to curb their own inflation, it’ll ignite a panic sell wave amongst all foreign banks and flood the global economy with enough USD to make it completely useless overnight. Fair warning, reading that long post I cited is super depressing.

  2. Inside each category we might consider diversifying further where possible, just to hedge against the failure of a particular stablecoin losing it’s peg. For example, with USD we might break it up further into a collection of USDC, USDT, DAI, and perhaps add even smaller sub-allocations for BUSD, UST, etc. For gold, I also like Pax Gold since they have all their legal paperwork in order, and that would add London gold to the mix.

  3. In connection to what I had mentioned earlier in my post, for this ETP in particular it may be useful to publish a running “wishlist” of assets we’d like to include in the portfolio but can’t due to liquidity or technology limitations. This would help individuals both internal and external to our community know what assets will have reliable long term trading demand and hopefully shorten the length of time that we are roadblocked from all the assets we’d like to have in our ETPs. Perhaps we could even include in the vote a few of these “wishlist” items so that they could be considered “pre-approved” and then set a minimum required liquidity target and allocation range. With this info handy, some crypto whales may then be able to swoop in with confidence and provide the necessary liquidity quickly so that we can add those assets to the ETP as soon as our liquidity qualifications are met without having to wait for another vote.

Excited to see how this all turns out, keep up the great work!

6 Likes

All awesome ideas!

This “stable” ETP is an awesome concept and I love the idea of community involvement in what assets to add in the future.

Also completely agree that this could be a hit product in the broader crypto community. Hopefully creating brand awareness.

:rocket::gorilla:

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This looks great! I don’t have as much of an understanding of some of this as I wish I did, but this post certainly has me interested. I will have to spend some time researching the thesis on this and will likely be investing in the ETP once it’s released.

Great work!

Nice. I like it. Thanks for the work put into this.

@Isaac raises some valid points.
If this is marketed as a hedge against the impeding doom of the dollar or even a “global inflation risk”, then I don’t think that having 80% in fiat currencies is in the best interest of this endeavour. If I allocate 1000 dollars to this ETP out of fear that the dollar might crash and cause the global monetary system to suffer, then I’m stuck with 800 dollars invested in fiat and only 200 in non-fiat. Wouldn’t it be better if I could have just invested 200 in non-fiat directly? I know this is to reduce volatility. However, if this is marketed as a solution to global inflation risk for people that want to invest in non-fiat, this seems a bit odd. I do agree with SEUR and NZDS, but I still think metals should receive a higher allocation and USDC should receive less. Although, I’m no expert on this stuff.

Super excited about this basket! Cheers wsb_g I think you make some really good points Isaac.

  1. Above is the current weightings of the IMF’s Special Drawing Rights (SDR) basket. The allocation towards USD is just over 41% US Dollars. As you state in your post, the US Dollar is the most commonly used and therefore liquid reserve asset in the globe. As much as we may not like it and as unfair as this system is for the central banks in developing countries, the greenback is still the ruling emperor of the global financial system.

I agree, there are some unique risks attached to US dollars being displaced as the world’s reserve currency and the post you link to is really compelling. My only question is timeframes and how long it will take for De-dollarization to occur? The post predicts that hyperinflation will take a few years to happen and it will not happen overnight and we’ll see it coming. I think the US dollar allocation of the basket could be drawn down but presently it remains the world’s most stable asset that commodities, including crypto, are priced in.

I quite like the concept of a shift towards a polar reserve currency policy. As opposed to full US dollar hegemony, different regions would have different reserve currencies. The US dollar being the currency for the USA and the America’s, The Euro would be the dominant currency for Europe and Africa and the Yuan would be the currency for Asia and Oceania.

  1. I think splitting up the US dollar position across various stable coins is a good idea for diversification purposes. I think maybe 3poolUSD or the sUSD pool token on curve finance could be options for diversified interest bearing USD options to add to the basket.

  2. A wishlist of potential assets to add to the pool is a great idea. You mentioned the inverse ETF against 20+ yr treasury bonds as an inflation hedge. This would be something I’d love to see in the basket.

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This is an amazing write up, clearly depicts the pros of having an ETP which combats inflation, and acting as a source of passive income regular Joes can rely on. I’m quite eager to see the work the engineers have been doing with the Balancer team!

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