Jun 1, 2021
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Some thoughts about stablecoins like Tether

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Stablecoin issuer Tether has published the composition of the reserves by which the USDT stablecoin is backed. The percentage of real dollars is surprisingly low. But whether that is as damning as critics gleefully account for is hard to say.

The stablecoin Tether (USDT) has long been criticized. That’s because the dollar token, which has now reached close to $60 billion, is a mainstay of crypto markets — and has long been suspected of manipulating markets with insufficient backing.

The full Tether story would be far too long at this point. What is relevant here is that Tether was recently required by the New York Attorney General’s Office to disclose on a semi-annual basis the composition of the reserves through which the company covers the stablecoin. Tether has now complied — by publishing two pie charts on its website showing the reserves as of March 31, 2021.

These pie charts first show that “cash or cash-like” funds do not account for the full coverage, but just under 76 percent. The other funds consist of:

12.55 percent secured loans (Secured Loan). What the loans are backed by is unclear, as is to whom they are made. It would be conceivable that the borrowers are other exchanges flooding their markets with liquidity through the tethers, and those other cryptocurrencies back them. But that’s speculative.

9.96 percent “corporate bonds, funds, and precious metals.” This group is extremely vague and squishy; anything could be hidden behind it. One could assume that the bonds of the sister company Bitfinex, which Tether received for a loan, fall into this group.

1.64 percent “other investments,” including digital tokens. These tokens are exclusively bitcoins, according to Bitfinex.

Most importantly, however, is admittedly the category of cash and cash-like funds. If one takes the designation seriously, these should be dollars or paper that can be exchanged for dollars quickly, in large quantities, and without friction. If this part of the reserves is sound, the reserves should be more than sufficient to maintain dollar parity. If they are not, the dollar peg threatens to wobble.

Dollars themselves, i.e., cash in the strict sense, play only a minor role of 3.87 percent in cash-like reserves. That would be 2.94 percent of all tether dollars, or $1.7 billion. That won’t be much more than a bonus.

By far, the largest share is in so-called commercial paper, 65.39 percent of cash-like reserves. That’s 49.6 percent of total reserves, or $28.85 billion. This category is critical, even war-critical. But what is it all about?

Commercial paper is a member of the money market paper family. These are, according to Wikipedia, financial instruments “that can be liquidated into central bank money at short notice,” and that is why they even count as part of the M3 money supply. Commercial papers represent “short-term, unsecured bearer bonds of the U.S. money market” through which “first-class industrial and commercial companies” obtain liquid funds quickly. Defaults on these securities are rare but played a role, for example, in the Lehman bankruptcy, which famously triggered the financial crisis in late summer 2008.

One can be divided about the quality of Tethers Commercial Papers. If they are indeed solid papers with very low default risks — as they should be by definition — the risk should be low. However, even an investor like Caitlin Long, who is almost a friend of Tether and Bitfinex, is critical of the papers: they introduce credit risk, which, even if low, could cause Tether to decouple from the dollar price.

In particular, Caitlin Long sharply criticizes the selection of assets in reserve. After all, if the goal was to minimize risk and maximize confidence in Tether dollars, government bonds and other securities that could be liquidated in the short term would have been better. But Tether deliberately chose commercial paper to earn on the interest, he said. At just one percent on reserves, Tether would earn $582 million a year. Stablecoins can be profitable.

Bitcoin critics naturally take an even more negative view of the coverage. While David Gerard is surprisingly mild about the commercial papers, saying that the papers are only worth what their rating says and Tether should urgently show it, Amy Castor speculates that Tether issued the tokens for its big customers — crypto exchanges — and is footing the bill as commercial paper. And Stephen Diehl, an extreme bitcoin critic who has been trending for several months, says that the commercial paper is a pure accounting trick as long as it is unknown who issued it.

The second-largest part of the cash-like reserves comprises so-called “fiduciary deposits” with just under eight billion dollars. These are, explains David Gerard, more or less “money in some bank,” which is further used by the bank. On which bank Tether leaves open, it is again difficult to make any statement about the risks.

Overall, the composition of Tether’s reserves, David Gerard quotes bitcoin skeptic Frances Coppola, “is reminiscent of banks’ balance sheets before Lehmann. A run on asset-backed commercial paper in August 2007 after BNP announced it could not price in the mortgage-backed securities that covered the commercial paper. This was the primary reason for Northern Rock’s collapse.”

In other words, uncovered commercial paper played a role in the concoction of the 2008 financial crisis. In some ways, this reduces the criticism of Tether’s reserves to being somehow reminiscent of bank balance sheets before 2008. This is much less dramatic than first thought, indeed quite positive. But it also, and more importantly, shows how difficult the lack of transparency makes it for critics to make informed criticisms of the reserves. The pie charts don’t give enough away to make any meaningful point at all.

Fintech investor Caitlin Long is nevertheless critical of the lineup. She usually defends Tether against its critics, she says. But given how important the stablecoin is, she says she has to criticize the choice of assets in the reserves themselves. Tether, she said, acts less like an issuer of a stablecoin than like a hedge fund earning returns on the money entrusted to it. The incentives are classically toxic: Tether pockets the profits but offloads the risks onto the users. Not just the users of Tether — but the users of all cryptocurrencies.

In fact, we may have all already paid for Tether’s profits. Because now, Caitlin Long explains, if risk managers start to take a 5–10 percent haircut on Tether dollars in the portfolio — which is already happening in some DeFi protocols — traders would have to sell some of the other assets — especially cryptocurrencies — to rebalance the portfolio. If already done, this would explain the plunge in prices of just over 10 percent.

A fiercer assessment comes, as expected, from Stephen Diehl: with the commercial papers, each tether is backed “by a huge pile of promissory bills to strangers.” Ignoring the eight billion dollars in bank deposits, Diehl claims that only 2.9 percent of the reserves consist of “real dollars in a bank account.” “So: for every USDT, only 0.03 real dollars exist”. Because bitcoin and other cryptocurrencies are priced in dollars but paid for with USDT, he says, pricing is “entirely synthetic,” and crypto markets are “not significantly different than a Ponzi scheme.” It is inevitable, he said, that Tether will implode — and so will the crypto markets.

That, of course, is an unrestrainedly overly negative judgment from someone who is predictably and presumably intentionally unrestrainedly overly negative about the crypto markets. Still, the effort at transparency that Tether demonstrates here turns out to be rather unsatisfactory. The company has missed the opportunity to dispel doubts and the open question of why? It tends to reinforce skepticism.

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