How to choose your protocol's foreign reserve assets:
Several general rules to consider (they apply to countries & crypto projects alike)--
1. Uncorrelated volatility:
1. Uncorrelated volatility:
You need reserves to pay for stuff / defend your currency in time of crisis. So value of your forex reserve asset should be as uncorrelated w/ economic shocks to your protocol (or country) as possible.
Prices of BTC, ETH & most other tokens are highly correlated. By this criterium the former are not suitable reserve choices for the latter. Stablecoins (USDC, USDT, PaxDollar) make a lot more sense.
2. Currencies your imports are denominated in:
Oil & gas are a large share of imports for most countries. These're traded in int'l mkts in USD. That's why most countries hold largest share of forex reserves in USD--
Oil & gas are a large share of imports for most countries. These're traded in int'l mkts in USD. That's why most countries hold largest share of forex reserves in USD--
...so that if they actually need to use reserves to pay for stuff, they don't have to convert to USD & incur exchange rate risk.
By same token, if a country imports a lot from China it makes sense to hold some yuan as forex reserves.
By same token, if a country imports a lot from China it makes sense to hold some yuan as forex reserves.
3. Currencies your liabilities are denominated in:
For most countries foreign debt is in USD. It makes sense to hold dollars so when you need to pay your obligations there's no exchange rate risk. If your debt composition is different you adjust reserve comp accordingly.
For most countries foreign debt is in USD. It makes sense to hold dollars so when you need to pay your obligations there's no exchange rate risk. If your debt composition is different you adjust reserve comp accordingly.
Crypto counterparts for 2 & 3: Pair currencies of your token's largest liquidity pools.
For projects on ethereum, ETH-projectToken pools are typically among the largest LPs. It makes sense to have ETH in your reserves as it's what you'd need to spend to "defend your currency".
For projects on ethereum, ETH-projectToken pools are typically among the largest LPs. It makes sense to have ETH in your reserves as it's what you'd need to spend to "defend your currency".
For projects on other L1s, the L1's native token should prob be part of reserves for same reason.
And for projects on any chain, stablecoin-projectToken LPs are usually among the largest, too. So it's sensible to have those stablecoins in your reserves.
And for projects on any chain, stablecoin-projectToken LPs are usually among the largest, too. So it's sensible to have those stablecoins in your reserves.
4. Diversification.
Countries hold gold & other precious metals as part of reserves b/c they don't want to put all eggs in same basket. This is usually a small part of reserves b/c other practical concerns (esp factors 2-3 above) take priority.
Countries hold gold & other precious metals as part of reserves b/c they don't want to put all eggs in same basket. This is usually a small part of reserves b/c other practical concerns (esp factors 2-3 above) take priority.
Similarly for crypto projects, it's ok to hold some BTC as reserves for "diversification", though it doesn't really serve the purpose as, again, all crypto asset prices are strongly correlated.
Besides, BTC is not the pair currency for most LPs. No gains there.
Besides, BTC is not the pair currency for most LPs. No gains there.
Thus for most projects, foreign reserve holdings should prob look something like this:
- 1st largest holding: USDC, USDC
- 2nd largest holding: ETH / native L1 token
- 3rd largest holding: BTC
- 1st largest holding: USDC, USDC
- 2nd largest holding: ETH / native L1 token
- 3rd largest holding: BTC
Some projects got it all backwards it seems.
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