Earlier this week, on May 12th 2022, Tether (also commonly called USDT), the most used and largest stablecoin by market capitalization briefly lost its peg to the US dollar, trading at lows of $0.95. Tether’s wobble sent yet another shockwave across the cryptocurrency community, which is still reeling from the recent implosion of algorithmic stablecoin Terra USD and its associated token LUNA. At the time of writing, LUNA is down over 99% from all-time highs.
This was Tether’s most significant de-pegging from the dollar since the “covid crash” in March 2020. However, the systemic risks associated with Tether are far greater now than they were just over two years ago. Since 2020, Tether’s market capitalization grew from just over $6 billion to around $80 billion today. In fact, Tether is the third biggest cryptocurrency by market cap – only third to Bitcoin and Ethereum.
Tether is also consistently the most traded cryptocurrency, with daily volumes exceeding even Bitcoin and Ethereum. This is because traders and investors use stablecoins like Tether as a “safe haven”, and to trade the volatility inherent in the crypto market.
The centrality of Tether to the crypto ecosystem has caused many to question its stability. In particular, what is Tether actually backed by, and does its claim that “all Tether tokens are pegged at 1-to-1 with a matching fiat currency and are backed 100% by Tether’s reserves” hold up to scrutiny?
What is Tether backed by?
Every quarter or so Tether publishes an “Independent Accountant Report” which sets out details of the reserves backing USDT and its other fiat pegged stablecoins. (Note that Tether began publishing these reports after being ordered to do so by the New York Attorney General, who found that Tether had been less than transparent about its holdings up until that point).
The latest report was published in December 2021 and gives a breakdown (some might say more of a summary) of the reserves that back Tether.
The largest portion of Tether’s reserves (about 83%) is held in “Cash & Cash Equivalents & Other Short-Term Deposits & Commercial Paper”. This consists of:
- Commercial Paper and Certificates of Deposit (36.68%)
- Treasury Bills (52.41%)
- Cash & Bank Deposits (6.36%)
- Money Market Funds (4.55%)
Note that Tether CTO Paolo Ardoino recently stated that the company has reduced its holdings of commercial paper over the past six months. However, there is currently no documentation supporting this that we could find. Ardoino said that Tether will publish an updated report within a few weeks.
The remainder of Tether’s reserves (about 16%) consists of the following:
- Secured Loans
- Corporate Bonds, Funds and Precious Metals; and
- “Other investments” including digital tokens
Who is the issuer of Tether’s Commercial Paper?
One of the things that still raises a lot of eyebrows regarding Tether’s reserves is that no one is quite sure who the issuers of the commercial paper, a type of unsecured short-term debt, are.
Representatives of Tether have been asked on many occasions about the source of its commercial paper, and each time have declined to provide additional transparency. For example, in an interview with CNBC Tether’s CTO and General Counsel refused to disclose anything more about the issuers of their commercial paper.
A 2021 article published by Bloomberg claimed that Tether’s reserves included “billions of dollars of short-term loans to large Chinese companies”. However, it was not clear who these companies were. Tether maintains that the commercial paper they hold is sufficiently high quality.
Also in 2021, the US Commodities Futures Trading Commission fined Tether $41 million for misleading statements regarding its reserves. The CFTC found that Tether’s claim that its stablecoin was “100% backed by corresponding fiat assets, including U.S. dollars and euros” was misleading.
The CFTC finding stated that:
Tether held sufficient fiat reserves in its accounts to back USDT tether tokens in circulation for only 27.6% of the days in a 26-month sample time period from 2016 through 2018. The order also finds that, instead of holding all USDT token reserves in U.S. dollars as represented, Tether relied upon unregulated entities and certain third-parties to hold funds comprising the reserves.
In response to the fine, a spokesperson for Tether said that “there is no finding that tether tokens were not fully backed at all times—simply that the reserves were not all in cash and all in a bank account titled in Tether’s name, at all times.”
How important is Tether to crypto?
As we outlined above, USDT is used for a disproportionate amount of crypto trades and daily volumes exceed both Bitcoin and Ethereum. In fact, data suggests that since 2019 around 50-60% of Bitcoin trades for USDT. This means that Tether is a huge part of the cryptocurrency ecosystem. So, what would the outcome for the crypto market be if Tether had a TerraLuna-style implosion?
In a report published in 2021, JP Morgan looked at what could happen if there with issues with the use of Tether and concluded that it would likely cause a “severe liquidity shock” to the crypto markets.
USDT (Tether) is engaged in a classic liquidity transformation along the lines of traditional commercial banks, but is not subject to the same strict supervisory and disclosure regime, and certainly does not have anything like deposit insurance… were any issues to arise that could affect the willingness or ability of both domestic and foreign investors to use USDT, the most likely result would be a severe liquidity shock to the broader cryptocurrency market.
JP Morgan: Digital transformation and the rise of fintech: Blockchain, Bitcoin and digital finance 2021
Regulatory scrutiny and stablecoin risks
Tether, and stablecoins more generally, have been subject to a high degree of regulatory scrutiny.
Regulators have expressed their concerns about the potential risks of stablecoins. In November 2021, US Treasury Secretary Janet Yellen said that the “absence of appropriate oversight [for stablecoins] presents risks to users and the broader system“.
A summary of some of the key concerns regulators have in respect of stablecoins is set out in a President’s Working Group report from 2021. The report highlights risks that stablecoins may pose for crypto markets, as well as the “real economy”.
In particular, the report refers to the risk of stablecoins failing to maintain their stable value, causing a run, which in turn could have an impact on financial stability.
The working group recommended that issuers of stablecoins should be “insured depository institutions” and subject to appropriate supervision and regulation.
Some regulators have already begun to address this issue. For example, the proposed European regulation for cryptocurrencies, MiCA, sets out rules for issuers of stablecoins, requiring them to have adequate capital to insulate them from such risks.