Post by anenro on Oct 27, 2021 23:46:05 GMT 4
Warning: Stablecoins Like Tether Could be at the Heart of the Next Financial Crisis
Tether is about as stable a stablecoin as it is transparent
Whether or not you trade in cryptocurrencies, be forewarned: Stablecoins like tether could be at the heart of the next financial crisis. Industry leader, Tether Limited (owned by parent Tether Holdings Limited), may one day be in the eye of the hurricane. Here are six questions you need to have answered:
What are stablecoins and why do they matter?
How stable is tether?
What is Tether Limited’s checkered past?
What did a study find about the connection between bitcoin and tether
What do we know about Tether’s reserves?
Should we be concerned about tether and other stablecoins?
You may be surprised and even shocked by some of the answers. And spoiler alert: The answer to the last question is a resounding “yes!”
What is a stablecoin and why does it matter?
Stablecoins are cryptocurrencies that are designed to have relatively stable prices by pegging their value to an outside asset like fiat money such as the U.S. dollar, or a well-established reserve asset like gold, and are primarily used as payment mechanisms. Examples of stablecoins include tether, USD Coin, Binance USD, TrueUSD, Dai, Pax Dollar, and Gemini Dollar. Currently, close to $130 billion of stablecoins have been issued, with tether by far the largest at over $70 billion. The coins are meant to be fully backed by “safe” assets.
Stablecoins offer many potential benefits including a low-cost, real-time, competitive payments system and the potential to connect many currently unbanked segments of the population to the financial system. But without suitable regulation, there is also a risk they could cause turmoil akin to bank runs as well as the “breaking of the buck” in money market mutual funds in 2008.
According to a recent and influential paper by Gary Gorton and Jeffrey Zhang, stablecoin issuers are essentially unregulated banks. As such, just like any bank, the solvency of stablecoins matters given the increasing interconnectivity beyond the cryptocurrency world, into banking and general, and the broader economy.
They key is for stablecoins to have the backing of trusted reserves. According to Tether Limited, “Every Tether token is always 100% backed by our reserves, which include traditional currency and cash equivalents and, from time to time, may include other assets and receivables from loans made by Tether to third parties, which may include affiliated entities (collectively, “reserves”). Every Tether token is also 1-to-1 pegged to the dollar, so 1 USD₮ Token is always valued by Tether at 1 USD.” Sounds reassuring, doesn’t it? Well…maybe…
How stable is tether?
Given the premise behind a stablecoin like tether that is tied to the U.S. dollar, and the assurance from Tether Limited that tether “is always valued by Tether at 1 USD” you would expect to see a graph of tether prices in U.S. dollars to be a flatline, right? Well, you’d be wrong! Here’s what it actually looks like:
to see the chart please click on the link at the end of this post. tether price chart
This once-a-day price chart actually masks some more extreme intraday fluctuations. The chart shows a fair amount of variability, from a low of $0.91 to a high of almost $1.08. (On October 14, 2018 on the crypto exchange Kracken, tether momentarily dropped to $0.85.) The annualized standard deviation of price changes is 9.5 percent — roughly half of the volatility of a U.S. stock index, but still quite substantial, particularly so for a stablecoin. This chart begs the question: what was causing many of the downward and upward price spikes?
What is Tether Limited’s checkered past?
To say that Tether (and its affiliated Bitfinex exchange) has had a checkered past is an understatement. The company, its business associates, its customers, and its executives have been associated with counterfeiting, money laundering, and lawsuits.
Tether Limited was created in 2014 by former child actor Brock Pierce, as well as Reeve Collins and Craig Sellars. They teamed up with Phil Potter who was an executive at Bitfinex, a bitcoin exchange, a direct link that was only revealed through the Paradise Papers. Trading began in 2015 with three types of tether tokens tied to different currencies: the U.S. dollar, the euro, and the Japanese yen.
Potter’s boss at Bitfinex was Giancarlo Devansini, a former plastic surgeon and the current chief financial officer of Tether. Not much is known about him but a Bloomberg reporter noted that the only reference to him in Italian newspapers was that he was previously fined for selling counterfeit Microsoft software.
According to Bloomberg, by March 2017, more than $50 million of tether was in circulation. In April 2017, the banks in Taiwan that Tether and Bitfinex had been using closed their accounts. Eventually Devasini’s executives found a startup in Puerto Rico that would work with them, Noble Bank International LLC, founded by John Betts. Around this time anonymous critics on Twitter questioned whether Tether had any backing of its coins. (As the chart above indicates, this is when tether traded far below a dollar.) Also in 2017, Tether was allegedly hacked and over $31 million of tokens were stolen.
According to The Wall Street Journal, between October 2017 and March 2018, tether-based trading increased 15-fold and at times tether trading volume represented as much as 80 percent of bitcoin trading versus 10 percent at the start of 2018. The same article quoted Ding’An Fei, a managing partner at Ledger Capital in Beijing who noted: “There are a couple of forces in this [cryptocurrency] market that if they failed, it would be catastrophic. Tether is one of them.”
According to Bloomberg, in June 2018, Potter disagreed with Devasini and the other partners who wanted to pull the firm’s money out of Noble and so he agreed to be bought out. Betts stepped down that month, Tether withdrew its deposits, and the bank failed soon afterwards.
In another crisis that Devansini faced that summer, Bifinex’s Panamanian money-transfer service, Crypto Capital Corp., refused to send $850 million of money, resulting in Bitfinex unable to pay customers who wanted to withdraw cash. It turned out that prosecutors in Poland had seized Crypto Capital’s accounts alleging money laundering. Instead of informing customers of Bitfinex’s insolvency, Devasini arranged for a loan from Tether’s reserves, leaving tether partially unbacked. The loans only became public in April 2019, when New York sued Tether. In May 2019, a group of major traders invested an additional $1 billion into Bitfinex.
Around that time, New York’s Attorney General filed a suit against Bitfinex for using Tether’s reserves to coverup its $850 million loss. In a February 2021 settlement, Bitfinex and Tether agreed to an $18.5 million penalty without admitting wrongdoing.
In May 2021, well-known Chinese crypto-trader who had ties to Bitfinex in which he held shares, Zhao Dong, pleaded guilty to China’s equivalent of money laundering $480 million for illegal casinos. In 2019, Zhao had helped to create Tether’s yuan-pegged stablecoin.
In October 2021, Tether reached a settlement with the Commodity Futures Trading Commission (CFTC) to pay a $41 million fine while not admitting any wrongdoing. The CFTC accused Tether of falsely claiming that each tether was backed by a U.S. dollar.
What did a study find about the connection between bitcoin and tether?
An academic research paper by John Griffin and Amin Shams published in August 2020 in the prestigious Journal of Finance titled Is Bitcoin Really Untethered? caused quite a stir. The paper investigated whether tether influenced bitcoin and other cryptocurrencies during a boom in prices in 2017.
The researchers note the appeal of the promise of cryptocurrencies with a decentralized leger with independently verifiable transactions, whose concepts emerged during the financial crisis, at a time of distrust of major banks. And yet they point out the irony of new large entities with vast control of the cryptocurrency world. As such, there study focuses on tether and bitcoin.
The researchers set out to test two alternative hypotheses for tether: whether it is demand-driven “pulled,” or whether it is supply-driven “pushed.” Under the pulled hypothesis, tether is driven by legitimate demand, while under the pushed hypothesis, “Bitinex prints tether regardless of the demand from cash investors, and additional supply of tether can create inflation in the price of bitcoin that is not due to a genuine capital flow.”
The researchers further noted that coordinating the supply of tether “creates an opportunity to manipulate cryptocurrencies.” Their extensive tests strongly support the “pushed” hypothesis. They find that over their sample period “one large player is associated with more than half of the exchange of tether from bitcoin at Bitfinex.” Furthermore, their results “are generally consistent with tether being printed unbacked and pushed out onto the market, which can have an inflationary effect on asset prices.” In other words, tether flows largely explained bitcoin prices in late-2017, and someone was gaming the market.
The fallout has been strong. Tether is facing a major class-action lawsuit that accuses it of contributing to “the largest bubble in human history” (quite an aggressive assertion given some major bubbles throughout history). The lawsuit alleges that a group of exchanges used tether to manipulate crypto markets by issuing tether without U.S. dollar backing, then selling the new tethers to Bitfinex. The case continues.
What do we know about Tether’s reserves?
For years there have been questions regarding whether or not Tether actually had reserves to back its stablecoin. To make its case that it had solid reserves, on November 1, 2018, Tether announced a relationship with Bahamian bank Deltec, and claimed that Deltec was holding $1.8 billion on its behalf, which at the time was enough money to cover the amount of tether in circulation. The attestation letter below became infamous for its illegible squiggle signature with no name attached (my musings: given the illegible writing, maybe it was signed by a physician?).
Source: tether.to tether.to/wp-content/uploads/2018/11/Tether-Letter.pdf (to see the letter)
Prior to February 26, 2019, Tether’s website indicated that “Every tether is always backed 1-to-1, by traditional currency held in our reserves. So 1 USD₮ is always equivalent to 1 USD.” However, on February 26, 2019, Tether first admitted that tether tokens weren’t exclusively backed by cash, but rather that “from time to time, may include other assets and receivables from loans.”
After the New York State settlement on February 23, 2021, Tether’s reserve disclosure did improve — somewhat. Tether was required to post quarterly transparency reports. The first report issued on May 13, 2021 was a pie chart showing a breakdown of its $42 billion in crypto reserves as of March 30, 2021. I recreated the pie charts below, and also created corresponding ones for its $63 billion in reserves as of June 30, 2021.
We’ll unpack what these charts tell us, but first note that they are only quarterly snapshots, and as such don’t tell us what was happening in-between the quarters. (The academic research by Griffin and Shams suggested some interesting end-of-month bitcoin return patterns related to tether issuance, possibly suggesting “window dressing.”) Prior to February 26, 2019, Tether gave the impression that its reserves were 100 percent cash (i.e., U.S. dollars) or cash equivalents (i.e., riskless and liquid Treasury bills). The top-left chart as of March 31, 2021 showed that only three-quarters of reserves were “cash and equivalents.” The remaining quarter included secured loans, corporate bonds, precious metals (like gold), and other investments (like bitcoin).
The top-right chart drills down on the “cash and equivalents” pie slice. Together, cash (U.S. dollars) and Treasury bills are less than 7 percent of “cash and equivalents.” Reverse repo notes make up another 3.6 percent, and although not described by Tether, as best as I can tell these securities appear to be reasonably safe and liquid. Fiduciary deposit accounts are owned by one person but managed by another. I’m really not sure how liquid or risky these types of accounts are.
The biggest chunk of “cash and equivalents” at 65 percent is commercial paper, which is unsecured short-term borrowing, typically by large banks or companies. It isn’t clear which firms issued the commercial paper bought by Tether. While commercial paper is generally liquid and low-risk, there are important exceptions. During the 2007–2009 financial crisis, there were times when the commercial paper market dried up. There have been famous defaults on commercial paper including Penn Central in the 1970s, Johns Manville in the 1980s, and Olympia & York in the 1990s.
The chart on the lower-left shows Tether reserves as of June 30, 2021. The “cash and equivalents” slice has increased from just over 75 percent, to just over 85 percent, which implies less risk exposure. The bottom-right chart shows a substantial increase in cash, Treasury bills, and reverse repo notes, collectively totaling 42 percent. However, the remaining 58 percent is still invested in commercial paper. For the June 30, 2021 report, Tether also provided information on both the quality and duration of the commercial paper, as shown in the next two charts.
According to Standard & Poor’s for its short-term credit ratings, an issuer with an A-1 rating has “strong capacity to meet its financial commitments” and those with a “+” are “extremely strong”; those with an A-2 have “satisfactory capacity” but are “somewhat more susceptible to the adverse effects of changes in circumstances and economic conditions”; those with A-3 have “adequate capacity” but are “more likely” to be weakened by adverse conditions; and those with B are “vulnerable” and have “significant speculative characteristics.” Combined, the A-3 and other categories made up 7 percent of Tether’s commercial paper holdings, while a further 45 percent were in the A-2 “satisfactory” category. While the overall picture looks satisfactory form a riskiness perspective, that could change dramatically and quickly during an adverse event like an economic downturn.
In this chart above, we see the breakdown of commercial paper by duration of maturity: 34 percent within 90 days, 21 percent between 91 and 180 days, and 45 percent longer than 180 days but less than a year. If there was a liquidity crisis and Tether needed to turn the commercial paper into cash rather than wait for maturity, they might not get the full amounts.
In response to Bloomberg ’s critical article, Tether responded by claiming that “all tether tokens are fully backed” (but it didn’t specify that the backing wasn’t 100 percent U.S. dollars) and “the company has taken a leadership position in transparency” (which is an interesting perspective given the low bar for transparency).
Should we be concerned about tether and other stablecoins?
We should be concerned with the true stability of tether and other stablecoins because they play such an important role in the cryptocurrency infrastructure. Let’s take a look at the phenomenal growth in tether’s trading volume.
This chart is in log scale, which means that it shows a tenfold increase in volume between each horizontal line. There appear to be two trendlines: one up to 2018, and the other since then. Average daily volume rose from 21,146 per day in April 2015 to over 2.24 billion per day in March 2018 — an increase of 4,632 percent per year. Then between March 2018 and September 2021, volume grew at an annual rate of 326 percent, with September 2021 average daily volume of almost 84 billion shares. On some days, volume exceeded 200 billion. Recently, the circulating supply of 70 billion tether coins has been over twice as large as USD coin, the second largest circulating stablecoin. The bottom line is that stablecoins matter, and among stablecoins, tether matters.
Let’s dig deeper in terms of Tether’s reserve policy, and why it matters. According to Tether’s terms of servicesection 3, “Tether Tokens are 100% backed by by [sic] Tether’s Reserves… Tether reserves the right to delay the redemption or withdrawal [emphasis added] 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.”
I purposely left in the “by by” direct quote on the Tether website. This may seem like an innocuous typo, but I see it differently. I remember when an accounting colleague I was teaching with flagged a firm’s financial statements because the firm hadn’t properly included a double-underline. His interpretation was that it was a red flag if the firm didn’t pay attention to details. I think the same applies to Tether. But the section that is worth noting is that Tether has the right to delay withdrawals.
Furthermore, according to Section 1.1.32 of the terms of service, “Reserves means traditional currency and cash equivalents and, from time to time, may include other assets and receivables from loans made by Tether to third parties, which may include affiliated entities [emphasis added].” Effectively, Tether is admitting that there could be conflicts of interest related to its reserves.
Why does all this matter? Most of the time, it probably doesn’t. But it’s the exceptional times or the tails that matter. While growth in tether trading volume is still at a phenomenal rate, that growth is slowing. Imagine a case when trading volume peaks and then declines, and correspondingly traders look to liquidate their tether holding. Compound this with an external event, akin to what happened during the financial crisis, that caused investors to liquidate some of their investments, including crypto, and the result might be ugly. Bitcoin’s price could collapse.
Or even worse, imagine a crypto-related event whereby investors lost trust with some part of the crypto infrastructure — say a major hack, or a steep decline in a prominent cryptocurrency like bitcoin. It’s possible that this could lead to the crypto equivalent of a bank run, or the “break the buck” crisis that occurred among some money market funds during the financial crisis. If you think this is implausible, such a bank run has already occurred. In a 24-hour period, the Iron Titanium token dropped from an all-time high of near $65 to near zero in June 2021. The Iron Titanium token was created to provide some of the reserves backing the Iron stablecoin.
Here’s what you should take-away before using stablecoins, and tether in particular:
Stablecoins are at the heart of the cryptocurrency world, and so what happens with stablecoins matters not only within the crypto-world but beyond, as money flows to and from cryptos and cash.
Stablecoins such as tether aren’t as stable as one might have expected. Moves away from one-to-one tether-for-dollar tracking should raise eyebrows.
Tether has a history of opaqueness and continues to be involved in litigation, which should raise red flags.
Tether’s reserves aren’t backed 100 percent by cash. If crypto-traders lost confidence in tether and caused a “bank run” on the coin, enough money to allow tether-for-dollar conversion might not immediately be available.
What’s needed, and probably inevitable, is what many crypto-traders detest: and that’s regulation, like full and transparent token-for-dollar reserves for stablecoins. But the concern is that it may take a crisis before that happens. Until then, caveat emptor.
Link to original article: sfoerster-5338.medium.com/warning-stablecoins-like-tether-could-be-at-the-heart-of-the-next-financial-crisis-1edf1cd076b4
Tether is about as stable a stablecoin as it is transparent
Whether or not you trade in cryptocurrencies, be forewarned: Stablecoins like tether could be at the heart of the next financial crisis. Industry leader, Tether Limited (owned by parent Tether Holdings Limited), may one day be in the eye of the hurricane. Here are six questions you need to have answered:
What are stablecoins and why do they matter?
How stable is tether?
What is Tether Limited’s checkered past?
What did a study find about the connection between bitcoin and tether
What do we know about Tether’s reserves?
Should we be concerned about tether and other stablecoins?
You may be surprised and even shocked by some of the answers. And spoiler alert: The answer to the last question is a resounding “yes!”
What is a stablecoin and why does it matter?
Stablecoins are cryptocurrencies that are designed to have relatively stable prices by pegging their value to an outside asset like fiat money such as the U.S. dollar, or a well-established reserve asset like gold, and are primarily used as payment mechanisms. Examples of stablecoins include tether, USD Coin, Binance USD, TrueUSD, Dai, Pax Dollar, and Gemini Dollar. Currently, close to $130 billion of stablecoins have been issued, with tether by far the largest at over $70 billion. The coins are meant to be fully backed by “safe” assets.
Stablecoins offer many potential benefits including a low-cost, real-time, competitive payments system and the potential to connect many currently unbanked segments of the population to the financial system. But without suitable regulation, there is also a risk they could cause turmoil akin to bank runs as well as the “breaking of the buck” in money market mutual funds in 2008.
According to a recent and influential paper by Gary Gorton and Jeffrey Zhang, stablecoin issuers are essentially unregulated banks. As such, just like any bank, the solvency of stablecoins matters given the increasing interconnectivity beyond the cryptocurrency world, into banking and general, and the broader economy.
They key is for stablecoins to have the backing of trusted reserves. According to Tether Limited, “Every Tether token is always 100% backed by our reserves, which include traditional currency and cash equivalents and, from time to time, may include other assets and receivables from loans made by Tether to third parties, which may include affiliated entities (collectively, “reserves”). Every Tether token is also 1-to-1 pegged to the dollar, so 1 USD₮ Token is always valued by Tether at 1 USD.” Sounds reassuring, doesn’t it? Well…maybe…
How stable is tether?
Given the premise behind a stablecoin like tether that is tied to the U.S. dollar, and the assurance from Tether Limited that tether “is always valued by Tether at 1 USD” you would expect to see a graph of tether prices in U.S. dollars to be a flatline, right? Well, you’d be wrong! Here’s what it actually looks like:
to see the chart please click on the link at the end of this post. tether price chart
This once-a-day price chart actually masks some more extreme intraday fluctuations. The chart shows a fair amount of variability, from a low of $0.91 to a high of almost $1.08. (On October 14, 2018 on the crypto exchange Kracken, tether momentarily dropped to $0.85.) The annualized standard deviation of price changes is 9.5 percent — roughly half of the volatility of a U.S. stock index, but still quite substantial, particularly so for a stablecoin. This chart begs the question: what was causing many of the downward and upward price spikes?
What is Tether Limited’s checkered past?
To say that Tether (and its affiliated Bitfinex exchange) has had a checkered past is an understatement. The company, its business associates, its customers, and its executives have been associated with counterfeiting, money laundering, and lawsuits.
Tether Limited was created in 2014 by former child actor Brock Pierce, as well as Reeve Collins and Craig Sellars. They teamed up with Phil Potter who was an executive at Bitfinex, a bitcoin exchange, a direct link that was only revealed through the Paradise Papers. Trading began in 2015 with three types of tether tokens tied to different currencies: the U.S. dollar, the euro, and the Japanese yen.
Potter’s boss at Bitfinex was Giancarlo Devansini, a former plastic surgeon and the current chief financial officer of Tether. Not much is known about him but a Bloomberg reporter noted that the only reference to him in Italian newspapers was that he was previously fined for selling counterfeit Microsoft software.
According to Bloomberg, by March 2017, more than $50 million of tether was in circulation. In April 2017, the banks in Taiwan that Tether and Bitfinex had been using closed their accounts. Eventually Devasini’s executives found a startup in Puerto Rico that would work with them, Noble Bank International LLC, founded by John Betts. Around this time anonymous critics on Twitter questioned whether Tether had any backing of its coins. (As the chart above indicates, this is when tether traded far below a dollar.) Also in 2017, Tether was allegedly hacked and over $31 million of tokens were stolen.
According to The Wall Street Journal, between October 2017 and March 2018, tether-based trading increased 15-fold and at times tether trading volume represented as much as 80 percent of bitcoin trading versus 10 percent at the start of 2018. The same article quoted Ding’An Fei, a managing partner at Ledger Capital in Beijing who noted: “There are a couple of forces in this [cryptocurrency] market that if they failed, it would be catastrophic. Tether is one of them.”
According to Bloomberg, in June 2018, Potter disagreed with Devasini and the other partners who wanted to pull the firm’s money out of Noble and so he agreed to be bought out. Betts stepped down that month, Tether withdrew its deposits, and the bank failed soon afterwards.
In another crisis that Devansini faced that summer, Bifinex’s Panamanian money-transfer service, Crypto Capital Corp., refused to send $850 million of money, resulting in Bitfinex unable to pay customers who wanted to withdraw cash. It turned out that prosecutors in Poland had seized Crypto Capital’s accounts alleging money laundering. Instead of informing customers of Bitfinex’s insolvency, Devasini arranged for a loan from Tether’s reserves, leaving tether partially unbacked. The loans only became public in April 2019, when New York sued Tether. In May 2019, a group of major traders invested an additional $1 billion into Bitfinex.
Around that time, New York’s Attorney General filed a suit against Bitfinex for using Tether’s reserves to coverup its $850 million loss. In a February 2021 settlement, Bitfinex and Tether agreed to an $18.5 million penalty without admitting wrongdoing.
In May 2021, well-known Chinese crypto-trader who had ties to Bitfinex in which he held shares, Zhao Dong, pleaded guilty to China’s equivalent of money laundering $480 million for illegal casinos. In 2019, Zhao had helped to create Tether’s yuan-pegged stablecoin.
In October 2021, Tether reached a settlement with the Commodity Futures Trading Commission (CFTC) to pay a $41 million fine while not admitting any wrongdoing. The CFTC accused Tether of falsely claiming that each tether was backed by a U.S. dollar.
What did a study find about the connection between bitcoin and tether?
An academic research paper by John Griffin and Amin Shams published in August 2020 in the prestigious Journal of Finance titled Is Bitcoin Really Untethered? caused quite a stir. The paper investigated whether tether influenced bitcoin and other cryptocurrencies during a boom in prices in 2017.
The researchers note the appeal of the promise of cryptocurrencies with a decentralized leger with independently verifiable transactions, whose concepts emerged during the financial crisis, at a time of distrust of major banks. And yet they point out the irony of new large entities with vast control of the cryptocurrency world. As such, there study focuses on tether and bitcoin.
The researchers set out to test two alternative hypotheses for tether: whether it is demand-driven “pulled,” or whether it is supply-driven “pushed.” Under the pulled hypothesis, tether is driven by legitimate demand, while under the pushed hypothesis, “Bitinex prints tether regardless of the demand from cash investors, and additional supply of tether can create inflation in the price of bitcoin that is not due to a genuine capital flow.”
The researchers further noted that coordinating the supply of tether “creates an opportunity to manipulate cryptocurrencies.” Their extensive tests strongly support the “pushed” hypothesis. They find that over their sample period “one large player is associated with more than half of the exchange of tether from bitcoin at Bitfinex.” Furthermore, their results “are generally consistent with tether being printed unbacked and pushed out onto the market, which can have an inflationary effect on asset prices.” In other words, tether flows largely explained bitcoin prices in late-2017, and someone was gaming the market.
The fallout has been strong. Tether is facing a major class-action lawsuit that accuses it of contributing to “the largest bubble in human history” (quite an aggressive assertion given some major bubbles throughout history). The lawsuit alleges that a group of exchanges used tether to manipulate crypto markets by issuing tether without U.S. dollar backing, then selling the new tethers to Bitfinex. The case continues.
What do we know about Tether’s reserves?
For years there have been questions regarding whether or not Tether actually had reserves to back its stablecoin. To make its case that it had solid reserves, on November 1, 2018, Tether announced a relationship with Bahamian bank Deltec, and claimed that Deltec was holding $1.8 billion on its behalf, which at the time was enough money to cover the amount of tether in circulation. The attestation letter below became infamous for its illegible squiggle signature with no name attached (my musings: given the illegible writing, maybe it was signed by a physician?).
Source: tether.to tether.to/wp-content/uploads/2018/11/Tether-Letter.pdf (to see the letter)
Prior to February 26, 2019, Tether’s website indicated that “Every tether is always backed 1-to-1, by traditional currency held in our reserves. So 1 USD₮ is always equivalent to 1 USD.” However, on February 26, 2019, Tether first admitted that tether tokens weren’t exclusively backed by cash, but rather that “from time to time, may include other assets and receivables from loans.”
After the New York State settlement on February 23, 2021, Tether’s reserve disclosure did improve — somewhat. Tether was required to post quarterly transparency reports. The first report issued on May 13, 2021 was a pie chart showing a breakdown of its $42 billion in crypto reserves as of March 30, 2021. I recreated the pie charts below, and also created corresponding ones for its $63 billion in reserves as of June 30, 2021.
We’ll unpack what these charts tell us, but first note that they are only quarterly snapshots, and as such don’t tell us what was happening in-between the quarters. (The academic research by Griffin and Shams suggested some interesting end-of-month bitcoin return patterns related to tether issuance, possibly suggesting “window dressing.”) Prior to February 26, 2019, Tether gave the impression that its reserves were 100 percent cash (i.e., U.S. dollars) or cash equivalents (i.e., riskless and liquid Treasury bills). The top-left chart as of March 31, 2021 showed that only three-quarters of reserves were “cash and equivalents.” The remaining quarter included secured loans, corporate bonds, precious metals (like gold), and other investments (like bitcoin).
The top-right chart drills down on the “cash and equivalents” pie slice. Together, cash (U.S. dollars) and Treasury bills are less than 7 percent of “cash and equivalents.” Reverse repo notes make up another 3.6 percent, and although not described by Tether, as best as I can tell these securities appear to be reasonably safe and liquid. Fiduciary deposit accounts are owned by one person but managed by another. I’m really not sure how liquid or risky these types of accounts are.
The biggest chunk of “cash and equivalents” at 65 percent is commercial paper, which is unsecured short-term borrowing, typically by large banks or companies. It isn’t clear which firms issued the commercial paper bought by Tether. While commercial paper is generally liquid and low-risk, there are important exceptions. During the 2007–2009 financial crisis, there were times when the commercial paper market dried up. There have been famous defaults on commercial paper including Penn Central in the 1970s, Johns Manville in the 1980s, and Olympia & York in the 1990s.
The chart on the lower-left shows Tether reserves as of June 30, 2021. The “cash and equivalents” slice has increased from just over 75 percent, to just over 85 percent, which implies less risk exposure. The bottom-right chart shows a substantial increase in cash, Treasury bills, and reverse repo notes, collectively totaling 42 percent. However, the remaining 58 percent is still invested in commercial paper. For the June 30, 2021 report, Tether also provided information on both the quality and duration of the commercial paper, as shown in the next two charts.
According to Standard & Poor’s for its short-term credit ratings, an issuer with an A-1 rating has “strong capacity to meet its financial commitments” and those with a “+” are “extremely strong”; those with an A-2 have “satisfactory capacity” but are “somewhat more susceptible to the adverse effects of changes in circumstances and economic conditions”; those with A-3 have “adequate capacity” but are “more likely” to be weakened by adverse conditions; and those with B are “vulnerable” and have “significant speculative characteristics.” Combined, the A-3 and other categories made up 7 percent of Tether’s commercial paper holdings, while a further 45 percent were in the A-2 “satisfactory” category. While the overall picture looks satisfactory form a riskiness perspective, that could change dramatically and quickly during an adverse event like an economic downturn.
In this chart above, we see the breakdown of commercial paper by duration of maturity: 34 percent within 90 days, 21 percent between 91 and 180 days, and 45 percent longer than 180 days but less than a year. If there was a liquidity crisis and Tether needed to turn the commercial paper into cash rather than wait for maturity, they might not get the full amounts.
In response to Bloomberg ’s critical article, Tether responded by claiming that “all tether tokens are fully backed” (but it didn’t specify that the backing wasn’t 100 percent U.S. dollars) and “the company has taken a leadership position in transparency” (which is an interesting perspective given the low bar for transparency).
Should we be concerned about tether and other stablecoins?
We should be concerned with the true stability of tether and other stablecoins because they play such an important role in the cryptocurrency infrastructure. Let’s take a look at the phenomenal growth in tether’s trading volume.
This chart is in log scale, which means that it shows a tenfold increase in volume between each horizontal line. There appear to be two trendlines: one up to 2018, and the other since then. Average daily volume rose from 21,146 per day in April 2015 to over 2.24 billion per day in March 2018 — an increase of 4,632 percent per year. Then between March 2018 and September 2021, volume grew at an annual rate of 326 percent, with September 2021 average daily volume of almost 84 billion shares. On some days, volume exceeded 200 billion. Recently, the circulating supply of 70 billion tether coins has been over twice as large as USD coin, the second largest circulating stablecoin. The bottom line is that stablecoins matter, and among stablecoins, tether matters.
Let’s dig deeper in terms of Tether’s reserve policy, and why it matters. According to Tether’s terms of servicesection 3, “Tether Tokens are 100% backed by by [sic] Tether’s Reserves… Tether reserves the right to delay the redemption or withdrawal [emphasis added] 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.”
I purposely left in the “by by” direct quote on the Tether website. This may seem like an innocuous typo, but I see it differently. I remember when an accounting colleague I was teaching with flagged a firm’s financial statements because the firm hadn’t properly included a double-underline. His interpretation was that it was a red flag if the firm didn’t pay attention to details. I think the same applies to Tether. But the section that is worth noting is that Tether has the right to delay withdrawals.
Furthermore, according to Section 1.1.32 of the terms of service, “Reserves means traditional currency and cash equivalents and, from time to time, may include other assets and receivables from loans made by Tether to third parties, which may include affiliated entities [emphasis added].” Effectively, Tether is admitting that there could be conflicts of interest related to its reserves.
Why does all this matter? Most of the time, it probably doesn’t. But it’s the exceptional times or the tails that matter. While growth in tether trading volume is still at a phenomenal rate, that growth is slowing. Imagine a case when trading volume peaks and then declines, and correspondingly traders look to liquidate their tether holding. Compound this with an external event, akin to what happened during the financial crisis, that caused investors to liquidate some of their investments, including crypto, and the result might be ugly. Bitcoin’s price could collapse.
Or even worse, imagine a crypto-related event whereby investors lost trust with some part of the crypto infrastructure — say a major hack, or a steep decline in a prominent cryptocurrency like bitcoin. It’s possible that this could lead to the crypto equivalent of a bank run, or the “break the buck” crisis that occurred among some money market funds during the financial crisis. If you think this is implausible, such a bank run has already occurred. In a 24-hour period, the Iron Titanium token dropped from an all-time high of near $65 to near zero in June 2021. The Iron Titanium token was created to provide some of the reserves backing the Iron stablecoin.
Here’s what you should take-away before using stablecoins, and tether in particular:
Stablecoins are at the heart of the cryptocurrency world, and so what happens with stablecoins matters not only within the crypto-world but beyond, as money flows to and from cryptos and cash.
Stablecoins such as tether aren’t as stable as one might have expected. Moves away from one-to-one tether-for-dollar tracking should raise eyebrows.
Tether has a history of opaqueness and continues to be involved in litigation, which should raise red flags.
Tether’s reserves aren’t backed 100 percent by cash. If crypto-traders lost confidence in tether and caused a “bank run” on the coin, enough money to allow tether-for-dollar conversion might not immediately be available.
What’s needed, and probably inevitable, is what many crypto-traders detest: and that’s regulation, like full and transparent token-for-dollar reserves for stablecoins. But the concern is that it may take a crisis before that happens. Until then, caveat emptor.
Link to original article: sfoerster-5338.medium.com/warning-stablecoins-like-tether-could-be-at-the-heart-of-the-next-financial-crisis-1edf1cd076b4