Tether's Credibility And Its Impact On Bitcoin (Cryptocurrency:BTC-USD)

6.21K Followers

Summary

Tether represents a significant risk to the cryptocurrency ecosystem and if Tether is significantly underfunded it could damage the reputability of cryptocurrencies.
Tether has been underfunded as the result of reserve mismanagement, but more concerning are claims of unbacked Tether being issued to speculate on cryptocurrencies.
Studies indicate that unbacked Tether may have been used to drive up the prices of cryptocurrencies in the past but it is uncertain if this is ongoing.
There have been problems with Tether that should concern investors but evidence of outright fraud is weak.

Tether represents a risk to cryptocurrency prices as there are serious concerns about its reputability and it is one of the primary means of buying Bitcoin (BTC-USD) globally. Tether and the Bitfinex exchange are both controlled by iFinex and have a well documented history of problems but it is not clear whether these issues have been due to mismanagement, a lack of access to the traditional financial system or are more nefarious. The questions surrounding Tether are likely to come to a head in coming months as the New York Attorney General (NYAG) investigates claims of losses.

Tether

Tether is a stablecoin (a cryptocurrency designed to maintain a constant exchange rate with a fiat currency) which was first introduced as RealCoin in 2014. RealCoin was later renamed Tether and began trading on the Bitfinex exchange in 2015. Stablecoins have seen fairly widespread adoption in the cryptocurrency industry as they are easier to transfer between exchanges and help circumvent the traditional financial system. Tether aims to maintain a peg against the USD by using cash and cash equivalent reserves equal in value to the total amount of Tether issued. Concerns have persisted over the legitimacy of this process for a number of years, although these concerns have not resulted in Tether trading at a discount for a significant length of time.

Figure 1: Tether Price

(source: Created by author using data from coingecko)

These concerns were at least partially validated in March 2019 when the claim of each Tether being backed by 1 USD was modified to include loans to affiliate companies. Then in April 2019 Tether's lawyer claimed that each Tether was backed by only 0.74 USD in cash and cash equivalents. Speculation about the credibility of Tether’s reserves has been further exacerbated by a lack of transparency and auditing of reserves, although this is at least partially due to the fact that most auditors are unlikely to want to take on this type of risk. The lack of transparency could also be related to regulatory problems with financial institutions, not because of a lack of reserves.

Legal Issues

New York’s Attorney General has accused Bitfinex of using Tether's funds to cover up 850 million USD in losses. It is claimed these losses are due to a Panamanian payment processor known as Crypto Capital Corp. having funds seized in a number of countries. Tether hopes to recover these funds at some point in the future but given the claims against Crypto Capital Corp. it would be fair to assume the money is gone. Tether is issued by Tether Limited, which is owned by Hong Kong-based iFinex. iFinex also operates the Bitfinex cryptocurrency exchange and possibly commingled client and corporate funds to cover these losses. The attorney general has filed a case against iFinex and has court ordered the company to submit documentation by January 15, 2021. After reviewing the documents, the Attorney General’s office will make a decision about how to proceed. Bitfinex also faces other charges, including market manipulation.

Underfunding

At the time that Tether admitted to each USDT only being backed by 0.74 USD in reserves there was approximately 2.1 billion Tether issued, implying a shortage of approximately 550 million USD. There are now approximately 24.4 billion USDT outstanding and if the Tether issued since April 2019 had full backing, Tether would now be approximately 98% backed by cash and cash equivalents. Tether has potentially grown out of its previous reserve issues, particularly if Bitfinex is making contributions to reserves. It is also possible that Tether has bolstered reserves from the 0.1% fee they charge any time USD is converted into Tether, or converted from Tether to USD. Tether's reserves could also presumably earn a small return through investment in liquid assets (cash equivalent). It is difficult to know what the status of Tether's reserves currently is without transparency, but the inappropriate use of Tether reserve funds to cover Bitfinex losses is a separate issue to whether Tether is being issued correctly in the first place.

Market Manipulation

There have been suggestions that USDT has been minted without backing and used to drive Bitcoin’s price higher during the 2017 and 2019 bull markets. A previous study suggested that at least half of the 2017 rise in bitcoin prices was due to coordinated price manipulation. Tether was allegedly used to buy bitcoin at key moments when the price was declining, which resulted in sizable price increases. The patterns observed were speculated to be consistent either with one large player purchasing Tether with cash at Bitfinex and then exchanging it for Bitcoin, or Tether being printed without cash backup. The study showed these flows were attributable to one entity, clustered below round prices, induced asymmetric autocorrelations in Bitcoin and suggested insufficient Tether reserves before month-ends. While this analysis appears credible it is difficult to draw conclusions without visibility into Tether’s reserves and even if this were the case, it is not clear that it is ongoing.

The high correlation between the issuance of Tether and Bitcoin's price is often cited as evidence of fraud, but this alone is meaningless. Tether is used to purchase Bitcoin and an increase in the supply of Tether merely shows demand for Bitcoin. Claims of fraud would also require evidence that a significant portion of the Tether being issued is unbacked.

Figure 2: Bitcoin Price and Stablecoin Market Capitalization

(source: Created by author using data from coingecko)

If unbacked Tether were the primary driving force behind Bitcoin’s recent price increase it raises the specter of a significant decline in prices once that buying pressure dissipates. Claims of market manipulation are not new to Bitcoin, with the 2013 bull market largely being attributed to market manipulation on the Mt. Gox exchange.

Stablecoins

Tether is the largest and most liquid stablecoin, but it is far from the only widely adopted one. Tether’s dominance has decreased over the past 12 months as the popularity of alternative stablecoins has increased.

Figure 3: Tether Share of Stablecoin Market

(source: Created by author using data from coingecko)

USD Coin

USDC is based on open standards and public smart contracts and is governed by Centre, a membership-based consortium that sets technical, policy and financial standards for stablecoins. It is issued by regulated financial institutions, backed by fully reserved assets, and is redeemable on a 1 to 1 basis for USD. USDC’s reserves are attested to each month by an accounting services firm and the report published. Coinbase was a founding member of USDC and this is likely one of the reasons that they do not support Tether.

DAI

DAI aims to maintain a 1 USD exchange rate through an automated system of smart contracts on the Ethereum blockchain. DAI is maintained and regulated by MakerDAO, a decentralized autonomous organization composed of the owners of its governance token, MKR, who may vote on changes to certain parameters in its smart contracts in order to ensure the stability of DAI.

DAI is created from an overcollateralized loan and repayment process utilizing Ether, with the collateralization ratio for Ether currently set at 150%. By repaying a loan and its accrued interest, the returned DAI is automatically destroyed and the collateral is made available for withdrawal. DAI is open source and public providing transparency and giving users confidence in reserves. Ether is a far more volatile reserve asset than fiat currencies though, which is at least partially accounted for using overcollateralization.

Other relatively large stablecoins include:

Binance USD
True USD
HUSD
Paxos Standard
TerraUSD

While it has been speculated that Tether is issuing unbacked USDT and speculating on cryptocurrencies, driving prices higher, it is also possible if not likely that the increase in issued USDT is simply the result of demand for cryptocurrencies. An increase in the number of issued tokens has been observed across all stable coins, including USDC and DAI, which have verified reserves. There have been credible claims that unbacked Tether have been issued to manipulate Bitcoin’s price in the past but when the same trend is present across all stable coins this thesis loses credibility.

Figure 4: Tether and USD Coin Market Capitalization

(source: Created by author using data from coingecko)

Fraud Incentives

Investors must also consider what would incentivize iFinex to commit a massive long-term fraud through the issuance of unbacked Tether. While it may appear obvious, as this is essentially a license to print money, it also risks destroying the value of Tether and Bitfinex. It is likely that iFinex stands to gain more from the successful ongoing operations of Tether and Bitfinex (without risking jail time) than they would from committing fraud.

Coinbase is one of the largest cryptocurrency exchanges globally, with 35 million customers and an 8 billion valuation when last reported in 2018. It is currently preparing for an IPO and pre-IPO shares that trade on crypto exchange FTX have soared, currently implying a 70 billion USD valuation. Although this is impacted by the current cryptocurrency bull market and investor appetite for IPOs and it has been suggested that fair value is closer to 28 billion USD. It is difficult to say how much Bitfinex would be worth due to a lack of data, but based on trading volumes relative to Coinbase, it could be up to 10 billion dollars. In addition to this, iFinex earns income from Tether fees which could be worth hundreds of millions of dollars. A Tether fraud risks making Bitfinex and Tether worthless and the cost of that probably outweighs the benefit of any ill-gotten gains from fraud.

If the legal action against iFinex does reveal a significant shortage in reserves it could raise questions about the suitability of cryptocurrencies for institutional investors and raises the specter of increased regulations. In the short-term it would likely result in a significant amount of negative sentiment, which could drag down cryptocurrency prices significantly. Tether is part of the cryptocurrency infrastructure, which creates systemic risk. The size of this risk is dependent on to what extent exchanges are holding a large amount of Tether. Given the ongoing concerns with Tether it would be unwise for exchanges to hold large amounts of Tether on an on-going basis.

If it is revealed that Tether isn’t fully backed, it is not clear at what point the market would panic, as there was little reaction when Tether announced they only had 74% backing. Tether will likely, or is already, encountering problems related to regulation and this should be the primary long-term concern for Tether holders.

I would avoid exposure to USDT if at all possible and be prepared for a buying opportunity if further issues with Tether’s reserves are revealed. Overall, I do not find the current evidence against Tether particularly convincing and do not believe Tether represents a serious risk to the cryptocurrency market. Given Tether knew there was a deadline for revealing their full financial situation to the NYAG, it would be reasonable to assume they would try and rectify any issues before that date. With the large run-up in cryptocurrency prices over the last 12 months, it should also have been easy for them to correct any discrepancies. In addition, it is not even clear that committing fraud would be financially attractive due to the value of Tether and Bitfinex as ongoing concerns.

This article was written by

Richard Durant

6.21K Followers

Richard Durant is the leader of Narweena, an asset manager focused on finding market dislocations that are the result of a poor understanding of a businesses long-term prospects. Narweena believes that excess risk adjusted returns can be achieved by identifying businesses with secular growth opportunities in markets with barriers to entry. Narweena’s research process is focused on company and industry fundamentals with the goal of uncovering unique insights. Narweena has a high risk appetite and a long-term horizon, in pursuit of stocks that are deeply undervalued. Coverage tilts towards smaller cap stocks and markets where competitive advantages are not obvious.Investments are driven by a belief that an aging population with low population growth and stagnating productivity growth will create a different opportunity set to what has worked in the past. Many industries are likely to face stagnation or secular decline, which counter-intuitively may improve business performance if competition decreases. Conversely, other businesses are likely to face rising costs and diseconomies of scale. In addition, economies are becoming increasingly dominated by asset light businesses, and the need for infrastructure investments is declining over time. As a result, a large pool of capital is chasing a limited set of investment opportunities, which is driving up asset prices and compressing risk premia over time.Durant has undergraduate degrees in engineering and finance from the University of Adelaide (Honors) and an MBA from Nanyang Technological University (Dean’s Honors List). He has also passed the CFA exams.Durant also publishes musings on technology and its long-term impact on economic development on Substack (http://richarddurant.substack.com).

Analyst’s Disclosure: I am/we are long BTC-USD. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

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