There’s No Such Thing as Risk-Free & It’s Not Just for Cryptocurrencies

It may be time to rethink what we consider the “risk-free” rate of return when it comes to investments, and that may change how we view decentralized finance as well.

Thomas Billings was the epitome of caution. An accountant by trade, Billings would check four times before crossing the road, use a virtual private network and store his passwords in a safe, changing them periodically every three months.

At work, Billings could be found in the office late into the night, making sure that every ledger entry was accounted for and that every discrepancy was flagged and highlighted.

As accountants go, Billings was both favored and feared for his meticulousness.

And that attention to detail carried across to his daily life, where his modest stucco home was unadorned by any frivolity, his only indulgence being his pet cat, aptly named Integer, a play on its ginger coat.

Billings had the diet that would have driven any average American bonkers.

No high fructose corn syrup and no processed foods.

No GMO foods and no dairy.

So it wasn’t without some degree of irony that Billings went to the doctor’s office on a crisp autumn morning to receive the news that he had been diagnosed with stage four lung cancer.

He had months to live.

Despite never having smoked a single cigarette his entire life, Billings was now staring death in the face because of a disease more commonly associated with smokers.

Having dedicated the better part of his life to avoiding risk, he wondered if there was even a point to all of that.

Is there Such a Thing as “Risk-Free”?

Which is why the belief that there’s such a thing as “risk-free” instruments fools us into thinking that there’s even such a thing — especially when it comes to investing.

For the uninitiated, the “risk-free” rate of return is used as a yardstick with which to assess other investments.

Typically, particularly in the context of the United States, that “risk-free” rate of return, is the theoretical rate of return of an investment with zero risk, or the yield of a U.S. Treasury Bill minus the inflation rate.

In theory, the “risk-free” rate is the minimum return an investor expects for any investment, because they will not accept additional risk unless the potential rate of return is greater than the “risk-free” rate.

But what if the “risk-free” rate of return turns out to be negative?

Because that’s precisely what investors are having to contend with right now.

With the yield on a U.S. 10-year Treasury Bill hovering around 0.6% to 0.8% and with inflation forecast to be in the region of 2% over the course of the next 10 years, investors in the “risk-free” rate are actually losing money should they hold such bonds to maturity.

In an environment of sky high bond prices and lofty valuations for tech companies that dominate U.S. equity markets, investors are caught between a rock and a hard place.

With many asset managers forecasting single-digit levels of return over the next five years (and that’s if they’re lucky), even inflation slightly above the projected 2% target, which the U.S. Federal Reserve has repeatedly warned that it will tolerate, will start to seriously wear down portfolio performance.

As such, traditional investors, and in particular those relying on older metrics such as the “risk-free” rate of return are cornered by what appears to be a limit to further capital appreciation in both stocks and bonds.

And while there are pockets of the stock market where prices are still relatively cheap, they are cheap for a reason — because the pandemic has merely accelerated trends that would have affected them eventually.

Not only are global government bond yields near zero, fixed returns for highly rated corporate debt (think Apple and Google) are more closely resembling sovereign debt in their ability to borrow cheaply.

And while declining stock prices are typically accompanied by rising Treasury values, this year has upended such assumptions, with the U.S. 10-year Treasury Bill remaining appreciably flat, despite numerous pullbacks in stocks.

No Hedges For High Yields

The trend for bonds, which are typically seen as the “risk-free” asset to bolster a portfolio of stocks, has called into question the long-held assumption that a 60/40 stock/bond portfolio split should protect an overall investment portfolio in the long run.

With Treasuries stagnant, some investors are looking at higher-yielding corporate bonds, as potentially replacing the role of government debt in portfolios — but even these yields have come down thanks to the central bank backstop.

Because the U.S. Federal Reserve has stepped in to purchase the debt of once highly-rated firms, so-called “fallen angels,” even these companies are now able to borrow more cheaply than without the Fed’s guarantee and limits their usefulness in a portfolio.

This trend has forced investors to look further afield, seeking out less liquid areas, but which nonetheless provide regular payouts, including real estate, infrastructure and even decentralized finance.

Decentralize This

Decentralized finance or DeFi has been around for awhile, but it wasn’t until the summer of 2020 that it really took on a life of its own.

In the span of a few months, the amount of assets locked up in various smart contracts dealing in DeFi skyrocketed from around US$600 million, to US$11 billion.

Decentralized finance basically facilitates making loans, borrowing money and trading in assets without the intervention of a trusted third party.

Using blockchain-based smart contracts, anyone can provide assets for loan or borrow, on the surety that the contracts will automatically execute should any party default.

To be sure, much of the activity is highly speculative.

But DeFi smart contracts are paying out as much as 30% to 40% per annum on dollar-backed stablecoin deposits, unheard of rates in mainstream finance.

How is that even possible?

Part of the reason this is possible is that speculation runs rampant in these parts.

With each new DeFi protocol promising to revolutionize some new aspect of finance, its creators offer enticing yields if liquidity is provided to the platform.

If you can borrow at 7% to lend at 30%, less transaction fees, you’ve cleared about 23%, without necessarily having had to do very much.

And because these loan contracts are based on smart contracts, typically embedded on the Ethereum blockchain, there isn’t as much worry about default, because these loans are collateralized upfront.

Of course the smart contracts themselves may not be bulletproof, but presumably community-led audits of the smart contract code should help to account for obvious weaknesses — those are the risks that DeFi practitioners live with.

But using multiple liquidity hops, a plucky liquidity provider can obtain ridiculous yields.

How long can it last?

Not very long at all.

Most yields have fallen substantially from their highs last month and all but the most dodgy DeFi protocols are now offering yields in the high single-digits.

But even a 7% return on a dollar deposit is far in excess of the best returns from mainstream finance —again, how is that possible?

Because there are still ways to generate returns in excess of the borrowing rate in the cryptocurrency space, whether through trading or speculating, investors are willing to borrow at 7% on the prospect of gaining many times that amount in return.

In these circumstances, consideration of the so-called “risk-free” rate of return seem quaint.

Everything in the cryptosphere is risky, which is why some investors take the alternative view that the higher the risk, the better, so long as there is a prospect of a outsize return.

To be sure, this sort of behavior isn’t new, nor is it peculiar to the cryptocurrency industry either.

The mainstream markets are already having to contend with grossly distorted incentive patterns where the presence or absence of government fiscal stimulus has a direct impact on stock prices.

Some stocks of highly storied but grossly unprofitable companies are calling for valuations in the realm of fantasy, yet investors can’t seem to get enough of them.

And with the “risk-free” rate essentially nothing more than a guaranteed loss-making proposition, it comes as no surprise that investors are throwing long-held investment assumptions (as well as caution) to the wind.

The new normal is that everything is risky today, including doing nothing.

Whether we’ve got our investments primarily in cash stuffed in the mattress or in bonds that pay less than nothing, there’s no such thing as a “free lunch” anymore — options range from the guaranteed loss to the extremely risky with nothing in between.

As more money pours into alternative assets, including decentralized finance, the much smaller size of these markets and their limited capacity increases the risk to existing investors and new ones as well.

Returns from taking on greater amounts of risk will help, but more importantly, we’ll need to reassess what we understand by risk and ultimately acknowledge that there’s no such thing as “risk-free” anymore.

And that’s just a risk that investors will have to take, whether consciously or not.