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The Tether controversy, explained

How stable are stablecoins?

What if a digital currency wipeout could injure — or even destroy — the entire cryptocurrency ecosystem? Lately, there’s been a focus on stablecoins, the quiet power players of the cryptocurrency space.

Questions about stablecoins, particularly one called Tether, have been knocking around in financial circles for months: are they as stable as they ought to be? A vocal group of people — including the likes of Jim Cramer, Nouriel Roubini, podcasters Bennett Tomlin and Cas Piancey, and pseudonymous blogger Bitfinex’ed — have raised questions about Tether as a possible systemic risk to the cryptocurrency ecosystem. On August 9th, Tether put out an attestation about its reserves, a way of reassuring users that the most popular stablecoin is, well, stable.

The attestation seems unlikely to reassure Tether’s most vocal critics, some of whom fear that its real use is to keep the price of Bitcoin high. The company has also been investigated by the New York attorney general for claims around its backing and settled with the NYAG earlier this year. As part of the settlement, Tether is prohibited from doing business in New York state, the capital of the US financial world.

Fears around stablecoins aren’t just limited to Tether. After months of hemming and hawing from regulators, chair of the US Securities and Exchange Commission Gary Gensler has now clearly asked for more authority to regulate cryptocurrency. “We have a role as a nation to protect those investors against fraud.” Janet Yellen, the Treasury secretary, met with the President’s Working Group on Financial Markets to discuss stablecoins specifically.

Right now, there’s no standardized way for stablecoins to disclose the assets that back them. It seems like an obvious target for regulators, but there’s also a way to do an end run around the needs for stablecoins at all. In fact, the way to get rid of stablecoins might just be… the dollar but digital.

What is a stablecoin?

These digital currencies, which are pegged to other assets such as the US dollar or the Euro, are primarily used as payment mechanisms. Stablecoins’ name reflects the idea that the peg makes them less volatile than cryptocurrencies such as Ethereum or Bitcoin, which can vary widely in value. Typically, when someone sets up a stablecoin, there’s a reserve for the assets, which are held as collateral.

Some stablecoins are centralized, as well. With cryptocurrency such as Bitcoin or Ethereum, if you’re hacked and lose money, well, sorry, you’re fucked. This isn’t the case for some stablecoins; when $600 million was stolen from PolyNetwork, Tether simply froze the $33 million of its tokens that were included in the heist. That rendered those funds useless to the attacker.

What do people use stablecoins for?

Payments, says Bruce Mizrach, an economics professor at Rutgers. The real competitors for stablecoins such as Tether (USDT) are things like Venmo and PayPal. Most of the time, the fees they charge for transactions are relatively low, Mizrach found; Tether’s fees are usually less than a dollar, while out-of-network ATM fees are about $3.08. (About 1 percent of transactions have fees higher than $25, though.) The same is true of USDC, another stablecoin.

They’re also used as a place to store value when investors exit cryptocurrency trades, says Richard Li, CEO of 4K, an NFT marketplace. Imagine an investor — we’ll call him Mars Vulrich — wants to lock in some profit he made in Bitcoin. Now, our friend Mars can exit the trade back into US dollars and send that to his bank account, but it’ll take a couple of days. Some of that delay is that Mars has to comply with anti-money laundering laws to exit cryptocurrency back into the US dollar. During that time, if Mars sees a cool opportunity to get into another cryptocurrency investment, he won’t be able to reach that money.

Now, he could instead exit his Bitcoin trade into a dollar-pegged cryptocurrency. The relatively quick transaction would mean that his funds would be available to go into another investment right away. If Mars is trying to do rapid trading, he might choose to do this instead of moving back and forth between the traditional banking system and cryptocurrency.

Stablecoins can also be used for margin trading. Our buddy Mars can borrow money from an exchange such as Kraken, which will use its own funds to help execute the trade. But Mars has to put up some collateral for the loan, and stablecoins can be useful for that. Margin trading is risky — it can lead to very big losses.

This seems like something that would interest government regulators, like the Securities and Exchange Commission.

It is! SEC chairman Gary Gensler has suggested that stablecoins might actually fall under the SEC’s authority, in remarks at the Aspen Security Forum. Specifically, he said that stablecoins “also may be securities and investment companies. To the extent they are, we will apply the full investor protections of the Investment Company Act and the other federal securities laws to these products.”

Okay, but that hasn’t happened yet?

Nope. Cryptocurrency regulation is kind of a hot topic right now, though, and Gensler used to teach courses on cryptocurrency during his last gig at MIT.

Why might the SEC want to get involved?

Well, stablecoins are huge. The most popular one, Tether, launched in 2014 and is pegged to the dollar. It’s got a market capitalization of more than $60 billion. USDT tokens are involved in half of worldwide Bitcoin trades. And there have been questions about whether movements in Tether have created price manipulation in Bitcoin. One academic study found that a particular player on the Bitfinex exchange uses newly printed Tether to purchase Bitcoin when Bitcoin prices fall, to support Bitcoin’s price. Apparently, this works.

Didn’t Tether get into trouble recently?

Why don’t we just go through a quick history? If you want a less abridged version, journalist Amy Castor has put together an exhaustive timeline; this Men’s Journal article also gives you some of the history.

The biggest question right now — which has been in play for a moment — is what’s backing Tether. In 2014, it was originally called Realcoin, and the idea was that it would be backed by the US dollar on a one-to-one basis. For some time, the website read: “Every tether is always backed 1-to-1, by traditional currency held in our reserves.”

In February 2019, this text changed to: “Every tether 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’).”

If “affiliated entities” raised your eyebrows, well, you’re not alone. See, in 2014, Tether also announced a partnership with cryptocurrency exchange Bitfinex. In 2017, the leak of the Paradise Papers established that the same people control both Bitfinex and Tether.

“Tether and Bitfinex are two different businesses and groups with two different objectives,” a Tether spokesperson told me when I asked about the relationship between the two.

In 2019, New York state Attorney General Letitia James said, “Our investigation has determined that the operators of the ‘Bitfinex’ trading platform, who also control the ‘tether’ virtual currency, have engaged in a cover-up to hide the apparent loss of $850 million dollars of co-mingled [sic] client and corporate funds.” Tether’s lawyer admitted that Tether was only 74 percent backed.

Anyway, Tether settled the case with New York state. In the settlement agreement, the office of the attorney general found that Tether had no reserves to back the stablecoins in circulation for periods of time. On November 1st, 2018, it published a “verification” of its cash reserve at Deltec Bank & Trust Ltd. of the Bahamas, saying Tether was fully backed by cash. The very next day, though, that money began moving from Tether’s accounts to Bitfinex’s.

Tether declined to comment on why money moves between Bitfinex accounts and Tether accounts.

The settlement agreement, by the way, bars Tether from doing business with anyone in New York. Bitfinex and Tether did not admit wrongdoing but paid an $18 million fine; Tether must also provide quarterly reports on its reserves for the next two years.

Oh, wow. So, Tether said it was backed, and the New York attorney general found that wasn’t true?

Yep. Here’s how Attorney General James put it: “Tether’s claims that its virtual currency was fully backed by U.S. dollars at all times was a lie.”

Meanwhile, on August 9th, Tether tweeted “Tether has always been fully backed.”

Yikes. Has Tether provided that quarterly report it promised?

Mmmmmmm, well, the first move was pie charts! As of March 31st, about 76 percent of Tether was backed by cash and cash equivalents, including unspecified commercial paper, which is a kind of short-term debt issued by companies. The “cash and cash equivalents” are composed of 4 percent cash; most of the rest of it is commercial paper, which represents about half of Tether’s collateral, or about $30 billion.

The recent attestation is more detailed. According to it, about half of the $62.8 billion in assets are held in commercial paper and certificates of deposit. A quarter of the assets are in Treasury bills, a significant increase from the last report — which may reassure some people, since T-bills have a reputation as very safe assets. According to the accounting firm Moore Cayman, Tether has more money in its reserves than is required for redemption.

Is that a normal report?

We don’t know whose commercial paper Tether is holding, and that’s a little weird. I asked the company directly and the spokesperson’s written response was, “We are a tech company and we closely guard our counter-party relationships. At this time, we do not disclose the make-up of our commercial paper holdings.” That is… unusual.

Bloomberg’s Matt Levine made a helpful comparison: this is what JP Morgan discloses on one of its money market funds, and it’s a lot more detailed than what we got from Tether. You can see the issuer, the specific identification code, how much money is invested, and the market value, among other things, for each holding.

There’s another stablecoin of comparison, and it’s USDC, which is also pegged to the dollar. It’s the second-largest stablecoin, actually! Anyway, USDC’s parent company, Circle, is attempting a SPAC. So we got an attestation to its assets: 61 percent in cash and cash equivalents and 9 percent commercial paper. But USDC has its own issues; Coinbase had been promising that there was $1 in a bank account backing each token. The attestation showed that wasn’t true.

Of the top 10 stablecoins, the most transparent is Gemini, says Mizrach. It’s completely backed by dollars in FDIC-insured accounts. “That’s the model of transparency,” he says. Tether, naturally, would disagree. “We are the most transparent stablecoin issuer,” the spokesperson told me.

But Tether’s still worth a dollar?

More or less, yeah. Most people who own Tether bought it from someone else, and they’re probably not going to try to redeem it — they’re just going to sell it, instead. There could, theoretically, be a run on Tether, though, like if the economy suddenly tanks or there’s another, more damaging government investigation or something.

Is there another investigation?

Yeah, according to Bloomberg. It’s about bank fraud, with possible criminal charges.

This investigation doesn’t particularly worry Alan Konevsky, the chief legal officer of tZERO, a security token trading platform. “This was a company that was trying to figure out how to get off the ground in a fairly hostile financial services climate where they couldn’t even open a bank account,” he says. “A lot of crypto companies have had difficulty trying to open bank accounts.” Some of the problems Tether has experienced may be due to regulatory uncertainty, he says.

Has anyone tried just asking Tether what’s up?

Actually, yes. CNBC’s Deirdre Bosa had CTO Paolo Ardoino (who is also the CTO of Bitfinex) and general counsel Stuart Hoegner (who is also the general counsel of Bitfinex) on for a bizarre half-hour interview during which almost nothing was actually said.

This is worth watching in full if you’re curious, but the highlights are: Tether won’t say more about their commercial paper (due to nonexistent “privacy” concerns), won’t deny the commercial paper is Chinese, and say they’ve never denied a customer who wanted a redemption. The market trusts Tether, Ardoino says, because it’s popular. “We think the market has spoken,” he said. “We believe the market has voted with its feet.”

Also, “we are working toward getting financial audits,” Hoegner said.

Why didn’t the CEO show for this interview?

Here’s what Ardoino had to say about it: “So, our CEO [Jan Ludovicus van der Velde], and our CFO Giancarlo [Devasini] are two great businessmen. They are working as hard as they can, they are super hard workers. They are really deeply involved with our businesses and they handle day to day operations, and they also are extremely available to our customers.”

Van der Velde and Devasini are also the CEO and the CFO of Bitfinex, respectively.

Did you ask Tether about any of this?

I did, and I didn’t get any further than Bosa. “At this time, we do not disclose the make-up of our commercial paper holdings,” Tether’s spokesperson said. I also asked if the commercial paper was Chinese. Tether declined to comment on that.

What happens if it makes other people nervous and Tether goes to zero?

To be honest, I don’t know. But a lot of other stablecoins have failed! For instance, of all the stablecoins created in 2015, 80 percent failed, according to Mizrach’s research. And 25 percent of those created in 2018 also failed. That makes the failure rate of stablecoins comparable to other digital assets.

So let’s say that Tether holders start getting cold feet. A bunch of people decide to redeem their tokens. Our friend Mars Vulrich is among them. Now, per Tether’s terms of service, he might not get his money back right away — or he might find himself holding some of the mysterious commercial paper Tether says it’s backed by instead of US dollars. Now Mars has previously sued tech companies that have mistreated him, but Tether’s terms of service say that they can’t be held liable. And, as the TOS clearly spells out, Tether’s tokens aren’t “subject to Federal Deposit Insurance Corporation (“FDIC”) or Securities Investor Protection Corporation protections.”

We may have gotten a preview of what could happen with Tether in a run on a different stablecoin in June. The Iron Titanium token, an algorithmic stablecoin that was partially collateralized, fell from $60 to near zero in the space of a day. Mark Cuban lost his investment, telling Bloomberg, “The investment wasn’t so big that I felt the need to have to dot every I and cross every T. I took a flyer and lost.”

According to Tether, there’s no need to worry. “Tether has never refused a redemption to a customer — and stress-testing of Tether is not hypothetical,” a Tether spokesperson said. “In March of 2020, bitcoin dropped by half in just a couple of days. Just two months ago, we had one of the worst days in bitcoin’s history, with prices falling by 30 percent in a few days in May. During those events, the Tether peg remained solid, all redemptions were honored, and the price across exchanges remained stable. Tether has been stress-tested multiple times and passed with flying colors each and every time.”

Tether declined to comment on the in-kind redemptions.

Okay. So how much risk is there from Tether to other cryptocurrencies?

“Tether, being the largest, would jeopardize all but the most transparent of stablecoins,” Mizrach says. Gemini would likely benefit from a failure of Tether, though, and USDC could, too.

Tether is often used as a parking place for high-frequency traders, Mizrach says. It’s also used for leveraged cryptocurrency trading, Li points out. That means if Tether loses its peg, it can also tank Bitcoin and Ethereum. (Tether is involved in more Bitcoin transactions than the US dollar is.) “It can be construed as part of a systemic risk,” Li says. “But I think the risk is overblown relative to what most people think.” In his opinion, the real risks are people being out of jobs, and then unable to pay their mortgages — as well as the risks of climate change.

A report from JP Morgan in February pointed out that USDT does a lot of the same things in the cryptocurrency world that banks do in traditional finance, but without the same supervision and without deposit insurance. So if people were unwilling or unable to use Tether tokens, “the most likely result would be a severe liquidity shock to the broader cryptocurrency market,” which could lead to everyone trying to sell at once.

On the other hand, Konevsky tells me that he doesn’t think it would be as catastrophic as others fear. “It would be painful,” he says. “But I don’t think it will collapse crypto or stablecoins.” There are other available alternatives to Tether, he points out. Li agrees. “If Tether went to zero, I’m sure there would be panic in the markets,” he says. “But it’s probably not going to be an utter collapse.”

Are there broader consequences for finance outside of the cryptocurrency realm?

Yes, according to Fitch, one of the Big Three credits rating agencies. Let’s say there’s a run on Tether tokens, and Tether has to suddenly sell its commercial paper. That “could affect the stability of short-term credit markets if it occurred during a period of wider selling pressure in the CP market,” especially if other sell-offs were happening at the same time.

The other thing Fitch points out is that during a period of financial stress, Tether may not be stable.

It’s not just Fitch worried about the broader consequences to the financial system. Treasury Secretary Janet Yellen and Boston Federal Reserve president Eric Rosengren have also expressed concern.

So… what, uh, happens now?

Well, there’s a possibility that regulation of cryptocurrency changes — certainly the rumblings from the Treasury Secretary and the head of the SEC suggest that regulatory changes are coming.

But one way to make Tether unnecessary is to create a digital dollar, and some US lawmakers seem to be warming to the idea, including Senator Elizabeth Warren (D-MA). (China’s doing something like this already.) A digital dollar would drive out all of the dollar-pegged stablecoins, because that would mean zero counterparty risk, Mizrach says. “That’s the biggest risk to Tether,” he says.

Tether, naturally, disagrees: “We think it’s positive that governments are taking inspiration from private stablecoins, and especially Tether, as the most innovative, liquid, trusted, and popular stablecoin. We believe there’s room in the space for both CBDCs [central bank digital currencies, such as the digital dollar] and private stablecoins like Tether.”

Li views central bank digital currencies as inevitable. “I just hope they bring a level of transparency,” he says. He also wants lower fees on transactions. “It’s ridiculous that it’s 2021 and we still pay 2.9 percent fees to process transactions in the traditional world. It’s robbery.”

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