Why All the Fuss About Tether?

Bitfinex and Tether reached a $18.5 million settlement with the New York Attorney General (NYAG) over allegations that they hid the loss of commingled client and corporate funds and misrepresented the truth about the reserves backing Tether’s USDT stablecoin. The two firms also agreed to provide to the NYAG quarterly reports on the composition of Tether reserves over the next two years, starting within ninety days of the February 18, 2021 effective date of the settlement. Without admitting or denying any wrongdoing, Tether committed to publicly share these reports. However, the lawsuit did not cover the rumored role of Tether in a huge BTC pumping scheme.

According to the Financial Stability Board, stablecoins are crypto-assets that aim to maintain a stable value relative to a specified asset, or a pool or basket of assets. U.S. dollar pegged USDT is the biggest stablecoin by market capitalization.

Although USDT’s market capitalization is a small fraction of BTC’s ($35 billion versus $940 billion on February 24, 2020) in terms of trading volume it is by far number one. USDT’s main use case appears to be as a crypto-asset trading on-ramp for residents of countries where there are crypto-asset trading bans and/or capital controls, and as a “reserve currency” for unbanked exchanges.

Is USDT fully backed U.S. dollar assets?

Tether claims that USDT is always 100% backed by currency and cash equivalents, plus “other assets and receivables from loans made by Tether to third parties, which may include affiliated entities.” In an ongoing lawsuit launched in 2019 by the New York Attorney General (NYAG) against Tether parent iFinex, it came to light that Tether had loaned $850 million of USDT’s reserves to its sister company Bitfinex. Since then, Tether has been dogged by suspicions that USTD is not 100% backed by U.S. dollar assets, although Tether claims that the Bitfinex loan has been paid off.

Tether has not helped its cause with its opacity regarding USDT’s reserve holdings. Although not audited, other stablecoin issuers at least publish monthly attestations that they are fully backed. However, attestations remain very vague about what comprises the reserves. The last time Tether published anything like an attestation for USDT was in 2017., but  claim full details will be released later in 2021.

What kinds of assets back USDT?

But even if USDT’s are fully backed, questions remain around what they are invested in, although the other stablecoin issuers are not paragons of transparency. The USDC attestation report only tells us the reserves are held in segregated accounts at US federally insured depository institutions and in approved investments. The BUSD and PAX reports are equally vague, telling us that the reserves are held at US depository institutions sometimes in amounts backed by debt instruments expressly guaranteed by the full faith and credit of the US Government. Gemini’s attestations seem more transparent and imply that all of the reserves are invested in US Treasury securities.

The perception that Tether’s investments aren’t exactly top-tier, is not contradicted by the redemption restrictions: “Tether reserves the right to delay the redemption or withdrawal of Tether Tokens if such delay is necessitated by the illiquidity or unavailability or loss of any Reserves held by Tether to back the Tether Tokens, and Tether reserves the right to redeem Tether Tokens by in-kind redemptions of securities and other assets held in the Reserves.” (Crypto traders get around this by buying BTC with USDTs on an exchange that trades the BTC/USDT pair, transferring them to an exchange that trades the BTC/USD pair, and cashing them out.)

Is Tether part of a Bitcoin pumping scheme?

Some claim that USDT issuance is part of a BTC price pumping scheme. For example, a 2019 paper found that Bitcoin purchases with Tether “are timed following market downturns and result in sizable increases in Bitcoin prices. Rather than demand from cash investors, these patterns are most consistent with the supply-based hypothesis of unbacked digital money inflating cryptocurrency prices.” See also David Gerard’s succinct description of the process in this Twitter thread.

But according to Frances Coppola, USDT’s asymmetric mechanics both support and disprove this claim. An opposing theory says that what look like BTC pumps are merely Tether reacting to BTC price volatility by supplying more “lubrication” to markets. The “lubrication” idea stems from Tether’s key role as a “reserve asset” for unbanked crypto platforms. Also, a recent paper used USDT deviations from its fiat currency peg to show that USDT acts as a “safe haven” for crypto-asset investors. They found evidence of significant premiums over parity during the crash in non-stable crypto-assets in early 2018 and during the March 2020 COVID-19 crisis. Discounts were found to derive from liquidity effects and collateral concerns. For example, USTD spiked to as low as around $0.90 in April 2017 when doubts were raging about the sufficiency of Tether’s reserves.   

So, if BTC’s price is falling, investors wanting to cash out is likely to increase demand for USDT, which will in turn raise its price. In normal circumstances, arbitrage is probably sufficient to maintain the peg. But when BTC is experiencing high volatility – in either direction – demand for USDT can increase far faster than arbitrageurs can bring it down. To prevent the dollar peg breaking, therefore, Tether must respond to this extra demand by issuing more USDT. And issuing more USDT increases exchange liquidity, making it easier to purchase or sell BTC and therefore feeding the price movement. So wild swings in BTC’s price might not be triggered by USDT issuance, but they… can be fed by it.

Conclusions

If Bitfinex and Tether follow through on their commitment to be more transparent about Tether’s reserves, rumors about USDT being backed by flaky assets may be put to bed, although questions remain around possible Tether BTC pumping. Also, it is a big if! However, the NYAG settlement does reduce a major crypto market black swan risk if, as Bryce Weiner believes, the market plumbing absolutely depends on USDT, making it effectively too big to fail.