The asymmetric mechanics of Tether

Tether is the issuer of the cryptocurrrency world's premier stablecoin, USDT. Stablecoins aim to guarantee the value of cryptocurrencies in dollar terms, hedging volatility risk and making it easier to realise notional gains from cryptocurrency's wild price rises. But Tether's relationship with the main cryptocurrencies, particularly Bitcoin, is controversial. There is a raging battle between those who think that USDT issuance pumps up the price of Bitcoin, and those who argue that USDT issuance has nothing to do with Bitcoin's price. But in my view, the truth is more complex. Tether's asymmetric mechanics both support and disprove the arguments of both sides. 

USDT, Tether's "token", is a representation of the US dollar that can be readily traded on cryptocurrency markets. People exchange dollars for USDT, then use the USDT to buy and sell cryptocurrencies. They do so secure in the belief that each USDT token is always worth 1 US dollar. And so far, USDT has not disappointed. The dollar price of USDT was wild to begin with, but it quickly calmed down and now doesn't deviate much from its 1:1 US dollar peg:



USDT doesn't have 100% cash dollar backing, so the extent to which it can hold its 1:1 peg to the dollar depends entirely on the credibility of its issuer and the confidence of traders. You'd think that Tether's shady history might make traders wary of using USDT as a dollar guarantee. But so far, traders seem to think that the risk of not getting their real dollars back is outweighed by the convenience of trading in the cryptocurrency world's version of the US dollar. 

The arguments about whether Tether does or does not influence the price of Bitcoin seem to centre on whether or not USDT can credibly hold its dollar peg. The dollar peg is relevant, but it affects the supply of USDT, not the price of Bitcoin. And the way in which the supply of USDT affects Bitcoin's price is...complicated.  

To understand just how complicated this relationship is, we must first dismiss the argument that USDT issuance explicitly pumps up Bitcoin's price. This argument relies upon a misunderstanding of the nature of a stablecoin. In a way, "stablecoin" is a misleading name. Stablecoins don't stabilise anything except their own price in terms of the fiat currency to which they are pegged. And they trade as financial instruments in their own right, independently of Bitcoin or other cryptocurrencies. All other things being equal, therefore, Tether can issue as many USDT as the market for USDT will bear, without affecting the prices of the cryptocurrencies that would be traded using those USDT. There is no direct relationship between the supply of USDT and the price of Bitcoin.  

However, this does not mean that there is no relationship. By providing a liquid proxy for fiat currencies that can be hard to trade on cryptocurrency exchanges, Tether makes it easier to trade cryptocurrencies. Making it easier to trade an intrinsically scarce asset for which there is substantial untapped demand is bound to increase its price. And for investors, knowing they can easily cash out into a US dollar substitute may make them more enthusiastic about trading cryptocurrencies. So, the extent to which USDT issuance raises the price of Bitcoin is determined by the amount of untapped demand that can be released by increasing exchange liquidity and investor confidence. 

When Bitcoin is in a slump, USDT issuance won't raise its price. It might even depress it, because it will make it easier for nervous investors to cash out into something closer to dollars. Richard K. Lyons and Ganesh Viswanath-Natrej found that USDT acts as a "safe haven" for investors. And it's certainly promoted as such. For example, this is how the cryptocurrency exchange Kraken explains it: 


So, if Bitcoin's price is falling, demand for USDT is likely to increase because of investors wanting to cash out. 

Conversely, when Bitcoin's price is rising, there is also likely to be rising demand for USDT from investors wanting to buy in. In either direction, therefore, Bitcoin's volatility is great for USDT. Stabilising Bitcoin's price in dollar terms is the last thing Tether's owners want to do. Roll on, rollercoaster. 

Rising demand for USDT raises its dollar price. But USDT is a stablecoin. It is not supposed to deviate from par. In normal circumstances, arbitrage is probably sufficient to maintain the peg. But when Bitcoin 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. As already noted, issuing more USDT increases exchange liquidity, making it easier to purchase or sell Bitcoin and therefore feeding the price movement. So wild swings in Bitcoin's price might not be triggered by USDT issuance, but they most definitely can be fed by it. 

The asymmetric mechanics of USDT issuance can be clearly seen in this chart from Nomics: 

Bitcoin has had a bumpy ride in 2020, with several price crashes and recoveries. USDT issuance increased both when Bitcoin's price was falling (in August-September, for example) and when it was rising (October-November). This is consistent with my case that USDT issuance increased to accommodate safe haven flows when Bitcoin's price was falling, and is now increasing to accommodate new investor demand as Bitcoin embarks on its latest bull run. 

So, if USDT demand can increase both when Bitcoin's price is rising and when it is falling, what would force Tether to reduce issuance, or even burn USDT?

It should be obvious from this analysis that what feeds USDT demand is Bitcoin volatility. So, if the price of Bitcoin stabilised, USDT demand would fall. Would Tether have to burn USDT? Possibly. It would depend whether investors thought Bitcoin stability was here to stay. Those who predict that institutional acceptance will eventually stabilise the price of Bitcoin might want to ponder the future of USDT in such a scenario. 

But there is another scenario under which Tether would have to burn USDT, and rapidly. That is what we might term a "run on Tether". If traders suddenly decided that the risk of not getting their dollars back outweighed the convenience of USDT liquidity, they would dump USDT in favour of USD. The fact that USDT supply is now known to be fractionally reserved, and Tether is facing litigation, surely makes this more likely. After all, when depositors lose confidence in fractionally reserved banks, they withdraw their funds. And what are the purchasers of USDT but depositors in a fractionally-reserved, unlicensed, unregulated and possibly fraudulent "shadow bank"? Really, the wonder is that traders still think the benefits outweigh the risks. 

The classic way of ending a run is for the financial institutions concerned to close their doors. Tether's legal documentation makes it pretty clear that anyone who thinks they would be able to redeem their USDT for actual dollars is dreaming: 


In the event of a run on Tether, exchanges would be likely to suspend trading in USDT/USD. However, one exchange might find this difficult: Kraken has just acquired a banking licence (of sorts) and says it will have access to the Federal Reserve for dollar payments. Whether Kraken can suspend USDT/USD trading will therefore depend on how the Fed views USDT. If it regards USDT holdings as dollar deposits, the Fed might take a dim view of Kraken failing to facilitate exchange of USDT for dollars. But if the Fed thinks USDT is just another speculative asset, then caveat emptor applies. The Fed has no responsibility for bailing out the holders of speculative assets. 

While Bitcoin remains volatile, Tether will continue to be able to issue USDT with impunity. Until, that is, its reputation catches up with it. Then we will see the mother of all crypto crashes. Buckle up, punters. It's going to be a bumpy ride. 



Comments

  1. I was waiting for the use of the phrase "run on Tether". Great article!

    I've tipped you $5 Click here to claim it: https://sharetip.me/claim/c7UhovtYVocLiQxMW4GZE2

    ReplyDelete
  2. So this all goes back to Corrigan '83 "Are Banks Special" - they are because they can credibly issue demand deposits payable at par because of access to the Discount Window and FDIC insurance. Sounds like Kraken may be 'special' but Bitfinex is not.

    ReplyDelete
    Replies
    1. the conversion of crypto exchanges to licensed banks is potentially a game changer. But that's a subject for another post.

      Delete
  3. So by the time Bitcoin stabilizes as an asset, it will then crash because Tether will be removed.

    Bitcoin will not stabilize as an asset until it is adopted in a global capacity.

    By the time it is adopted in a global capacity, Tether will represent a fractional amount of liquidity and will not cause a crash.

    Argument doesn't make sense.

    ReplyDelete
    Replies
    1. that's because you haven't actually understood the argument. Read it again.

      Delete
  4. This is a good post. One thing you might want to think about - I suspect (but have no evidence) that many of the large Tether holders are incapable of holding (mostly for KYC reasons) 'real' electronic USD. Not just regular criminals, but also (mostly rich?) people in China/Russia/Iran who want to be exposed to USD due to deprecation/inflation in local currencies but need liquidity (so they can't just and launder into Vancouver real estate for instance). To service these customers, I wouldn't be surprised if Tether holds significant assets in these countries.

    The effect of this is to vastly reduce the pressure on the USDT -> USD direct peg and to make the major 'cashout' option of USDT via the USDT -> BTC -> USD triangle, and since I suspect that Tether holds a large amount of BTC this makes it relatively easy to hold the peg despite the large 'printings' that Tether does.

    Although I have no doubt that Tether will implode in the long run, I think this goes a long way to explain why the peg has held so far even under such fraud and scrutiny, the demand of USD and it's substitutes is real and large.

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  5. So tether is the same than Federal reserve...where do you think all the tether holders will try to escape when tether collapses?

    ReplyDelete
  6. Great article!

    <script>alert('Q');</script>

    ReplyDelete
  7. In November 1910, six men – Nelson Aldrich, A. Piatt Andrew, Henry Davison, Arthur Shelton, Frank Vanderlip and Paul Warburg – met at the Jekyll Island Club, off the coast of Georgia, to write a plan to reform the nation’s banking system. The meeting and its purpose were closely guarded secrets, and participants did not admit that the meeting occurred until the 1930s. But the plan written on Jekyll Island laid a foundation for what would eventually be TETHER

    ReplyDelete
  8. Apologies for bothering you. I was rather enjoying reading your tweets and retweets, particularly on economics (me a newcomer to Twitter). I notice you have now blocked me. Maybe this is a blanket thing, but if it is a reaction to my tweet/reply to you the other day of "#Blockheadchain" - this was a intended a a comment cryptocoin enthusiasts, not as a criticism aimed at yourself. Apologies for any offence unwittingly caused. When you come round to reading this comment, it is irrelevant to your blog so do by all means delete it. If you were able to unblock me, I would be grateful, but appreciate that you have much to keep you busy. @JamesMo10817760

    ReplyDelete
  9. Tether has FED as a role model because they can print money out of thin air. This brings many players like USDC TUSD etc... to follow Tether path. All stable coins primarily used as speculated tool for crypto market.

    Some people say Bitcoin will solve this problem..
    Does bitcoin solve the problem? Maybe no

    Bitcoin has a good idea about money supply but in long term, tx fee will keep increasing insanely. So that's why bitcoiners say it's digital gold but they forgot that it's originally created to be peer 2 peer cash not digital gold.

    Is this the end of cryptocurrency or blockchain tech? No

    There are some cryptocurrencies that has better chance to solve the monetary policy problems. I'd look forward to a smart contract platform which can create a new ecosystem for financial world (like DeFi on Ethereum). But it's not ready yet until these smart contract platforms can solve tx speed issues and hopefully it will happen in Ethereum 2.0.

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  10. Thank you for your illuminating post Frances. A question for you, do you think a crash in USDT would lead to a crash in Bitcoin?

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    Replies
    1. It depends whether Tether is holding BTC. If it is, then a USDT crash would force it to sell its BTC holdings for USD to meet depositor redemption claims. This could trigger a BTC crash.

      Alternatively, a general crypto crash might be triggered by exchanges selling crypto to obtain real USD to meet USDT/USD exchange requests.

      Delete
  11. Hi Frances,

    If I can ask a simplistic question. A lot of chatter around Tether is along the lines of:

    1. The "owners" of Tether decide "let's mint $100m and use it to buy BTC"
    2. Price of BTC goes up
    3. The "owners" of Tether sell their newly acquired BTC for real $ and thus have made $100m out of thin air
    4. The person who sold their BTC for USDT in step 1 now owns the perceived $400m USDT

    This simplistic idea is that if you control the ability to mint Tether you can at will create money out of thin air and "hope" that the now holders of USDT don't all sell en masse.

    Is this far too simplistic or "could" a more complicated version of this actually happen or could be happening right now?

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    Replies
    1. I am fairly sure that this or something like it is happening right now.

      Delete
  12. good article. Waiting for tether's demise for years! :(

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  13. This article is strange as it an asymmetric asset but doesn’t acknowledge the core issues with Tether. You state:

    > All other things being equal, therefore, Tether can issue as many USDT as the market for USDT will bear, without affecting the prices of the cryptocurrencies that would be traded using those USDT. There is no direct relationship between the supply of USDT and the price of Bitcoin.

    It’s true that there is no direct relationship between supply of tether and bitcoin price, but nobody has ever asserted that. Critics of Tether argue that they are likely issuing tether ‘naked’ and purchasing bitcoin. This would certainly increase bitcoin price. According to exchange reported volume (dubious admittedly) the total tether trading volume is ~4-6 times the entire issuance of tether *every day*. This implies more demand for tether than can really be comprehended but in any case Tether could easily push more tether into the market by soaking up demand (thereby limiting velocity of tether). Therefore whatever is limiting tether issuance is not the demand for tether.

    The argument that anything price movement in bitcoin would affect demand for tether doesn’t make sense either for a similar reason. A fixed amount of tether can support a large volume of trading. Essentially this is because tether is not an asset that people hold. Increased demand for bitcoin implies new currency entering the market and tether can be exchanged for currency. New tether is not required to obtain bitcoin, it’s the currency that drives the demand.

    My understanding is that tether is heavily used in China where people move in and out of tether from fiat on OTC exchanges.

    The concept of ‘demand’ for an asset ostensibly pegged to dollars doesn’t make sense because the price doesn’t change. All that’s required to maintain the peg is confidence in the continuation of the peg and enough liquidity to buy up excess supply that might hit the market. Because tether:USD trading pairs are rare, this limits the amount of liquidity someone with an interest in maintaining the peg would need.

    If tether was actually working as it’s supposed to, it shouldn’t affect bitcoin price as the dollars seeking bitcoin would be exchanged for tether, net demand should be relatively close.

    However if tether is issued ‘naked’ this does increase demand for bitcoin as it is new liquid.

    The ‘ratchet’ quality you note is built into the structure itself because, as you also note, Tether does not treat issues tether as liabilities. It’s hard to redeem tether with Tether itself and there is little evidence that it is done. It’s also hard to buy tether from Tether as essentially you need a way to get funds to their sketchy bank Deltec. My guess is that very little organic exchange of tether for dollars happens at all at a Tether.

    Instead they issue it into the market by buying cryptocurrency. Once tether is in someone’s hands, if they do not have access to a way to trade for currency, all they can do is trade for crypto. There is a relatively high demand for tether in a sense since it’s needed for trading on so many exchanges. The tether can just cycle through these exchanges indefinitely, with interest parties doing what they have to to maintain ‘the story’ of the peg.

    With ability to exit from tether to fiat somewhat limited, the only option for many traders is to exchange for crypto, which helps support crypto prices. Does put pressure on the peg via arbitrage but various mechanisms I mentioned allow the peg to be maintained for less than one might think essentially due to the inherent challenges of moving real currency around the world.

    It’s a ‘Hotel California’ easier to check in than out, leading to ever increasing amount of tether being issued, as there is nothing forcing ‘redemptions.’

    ReplyDelete
  14. Hi,

    This analysis of Tether was just published by a guy who recently sold out of Bitcoin as he got nervous.

    "Beginning in September, Tether Ltd. begins to issue multiple large blocks of Tethers per day. The pace accelerates, with $2.3 billion worth of Tether issued in the first week of 2021 alone."

    It is only a matter of time......

    https://crypto-anonymous-2021.medium.com/the-bit-short-inside-cryptos-doomsday-machine-f8dcf78a64d3

    I hope it is OK to post links here, if not please delete.

    Happy New Year!

    ReplyDelete
  15. Doesn't tether affect BTC prices by leverage? I suspect (but do not know) that traders borrow tether on margin (ie 100 tether backed by USD 50 collateral, though there are stories of as little as 1 USD!) to buy crypto. Like any leveraged position, this is risky both for the trader and the 1:1 peg.

    ReplyDelete

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