Here I was thinking I was going to write another post about how the market is getting quite overvalued and for folks to keep pushing into international stocks which are more reasonably priced. Yet what really grabbed my attention and sent me into an hours long rabbit hole was the saga of Tether and where it’s cash sits.

Bloomberg recently featured an article which asked Anyone Seen Tether’s Billions? I will leave the details of the origin story to that article which in itself is very interesting. What caught my attention is how tether is linked into the whole crypto echo system and how it is an integral cog in the machine of the crypto universe despite its dodgy reputation.

What Are Stable Coins and Why Are They Important?

So first it helps to understand what a stablecoin is and why it matters to the crypto world. Stable coins like USD Coin, Binance USD, Dai and Tether are all supposed to be backed by real dollars in real accounts. These operate in practice very similar to how a money market fund or currency board operates. Cash and bank deposits earn nothing so these funds make their living by issuing shares in return for cash. They then take this cash and invest it in short term securities and make a bit of interest off of it. In the US, due to past market disruptions and runs on funds, money market funds are expected to hold high quality, very liquid securities such as commercial paper issued by banks and high quality corporates as well as T-bills and other cash like instruments.

On a larger scale, a currency board is very similar. Argentina had a currency board prior to its 2001 default where they pegged the peso 1 to 1 to the US dollar and the central bank claimed every peso in the economy was backed by a dollar. Sound familiar? That ended in catastrophe after rumors gained momentum that there weren’t enough dollars to back pesos, which were being printed im abundance to be used for whatever the government wanted (paying their friends, insiders or any project it deemed of importance). People rushed to exchange their pesos for dollars and it became obvious there were not enough. This toppled the government and the one to one peg was abandoned, the peso was floated and within a few days was trading at 3 to a dollar, a 66% decline. Argentina is still feeling the repercussions of this and the peso currently trades at 100 to the dollar.

Stablecoins matter because they offer the plumbing of the crypto world that had previously been missing. It’s easiest to show why through an example.

Let’s say you are a crypto trader and you’ve seen that there is an arbitrage opportunity. An early and famous example of this was FTX founder Sam Bankman-Fried who was taking advantage of the price of Bitcoin in yen in Japan versus the price in dollars in the US. This is known in the FX market as triangular arbitrage when it involves 3 different currencies and banks have been doing it for years. The issue was since banks can’t touch crypto, no one had been able to perform this trade at scale until Bankman-Fried came along. In an article in Yahoo Finance, Bankman described what he did:

After buying Bitcoin for $10,000 in the US, investors could send it to a Japanese exchange. There they could sell it for $11,500 worth of Japanese yen. At that point, they could convert the amount back to dollars.

Because of the trade’s global nature and the wire transfers involved, it would take up to a day to perform. ”But it was doable, and you could scale it, making literally 10% per weekday, which is just absolutely insane,” Bankman-Fried said.

Now the devil is in the details in the above, which is what Bankman-Fried mastered. He essentially did the dirty work of setting up foreign currency account in yen at Japanese exchanges and USD accounts at US centric exchanges. The issue with this is that with the movement of currencies as well as crypto, you would want to convert your Japanese Bitcoin to yen and then quickly to dollars as quick as you can. But this may involve the slow banking system where conversion to cash by a traditional account may be blocked or take days to clear. If there was a way that the exchange in Japan and the exchange in the US could transact with each other for the exact dollar amount of your trade without taking the risk of each other then you could send your profits back to the US with no issue. If only there was a crypto, pegged to the dollar, that allowed you to transfer your arbitrage profits from one exchange to another securely and quickly?

That is what stablecoins do. Their growth is due to the fact that they act as a link or a clearing house between exchanges. On the one hand this facilitates liquidity in Bitcoin and other crypto. It’s now easier to move crypto around the world to take advantage of arbitrage opportunities and exchanges can transact with each other securely. On the other hand, this is all resting on the belief that these stablecoins are actually that: stable.

Plumbing Gone Wrong

So the exchanges like Bitfinex and Binance, which are dependent on stablecoins to transact between each other, could have major issues were tether to not actually turn out to be very tethered to the dollar. This brings us back to the function of money market funds and currency boards. Their liabilities are stable and simple: they have one dollar and they give a Tether to the user who gave them a dollar. Then they go and take that dollar and invest it to make a spread just like a bank does. As long as not too many people at once ask for their dollars back, they are ok. Just like a bank they will keep liquid reserves on hand to cover the small amount of users that want their dollars back.

However, if they don’t keep enough liquidity on hand or a regulator we’re to freeze a significant portion of their assets, or a massive amount of people were to try and redeem their tethers at once, the scheme would collapse in classic bank run fashion. This matters for an entity that claims to hold about $70 billion in dollar assets.

This has already happened on a smaller scale as a bank in Panama called Crypto Capital, which was banking Tether, saw $850 million frozen by Polish authorities on account of fraud claiming the bank was working with Colombian drug traffickers in late 2019. Amazingly, this didn’t sink Bitfinex or Tether because crypto was still hot. Bitfinex just issued some nee crypto to plug the hole and went about business.

Acting According to Incentives

The exchanges have an interest in keeping the Tether bubble going. Even if Tether were to not have the funds to meet redemptions, the exchanges could offer it lines of credit to keep it afloat, especially at a time when they are minting money. It’s also in Tether’s interest to diversify into as many exchanges as it can and keep issuing Tethers to exchanges, even if it doesn’t have them, because this will make the currency so endemic in the system that is has to be bailed out by the exchanges if something goes wrong.

Add this to the pure profit that Tether can make on that spread. The less liquid the security, the higher the interest rate and with $70 billion, the owners could make $500 to $600 million on every $10 billion they invest if they are investing the funds at rates of 5% to 6% as the Bloomberg article claims. This could be why they are resisting any transparency or a third party audit. The goal is to make money on the spread for as long as they can, while at the same time spreading the beast as far and deep as they can into the crypto exchanges to make it indispensable.

Other currencies such as USD Coin and Dai have attempted to solve the issue of transparency. USD Coin has multiple independent auditors and is backed by firms like Goldman Sachs. Dai destroys and mints it’s stablecoin according to an algorithm so there is no discrepancy between supply and demand. Yet Tether may be achieving its goal of becoming critical to the crypto echo system just in time for the retail frenzy to begin with a Bitcoin ETF already having been launched this week.

As we have seen in the past, frauds like those of Bernie Madoff and Enron have gone on to make tons of money for many years before they were exposed. The Tether story is one I am keeping an eye on here.

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