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What Will Happen If Our Worst Fears On Tether Came True? Perhaps Not What We Think.

Summary

The market has already taken into account various aspects of the Tether controversy, which will culminate in a hearing on the 6th of February 2018 by the CFTC.

The market's worst fear is the possibility that Tethers were issued without having been backed by USD, and were instead used to purchase Bitcoin.

Despite this, the value of Tether relative to USD has managed to hold up near a dollar at the time of writing.

It has been postulated that Tether's unravelling could lead to a panic in the cryptocurrency market, leading to a drastic fall in Bitcoin's value together with every other cryptocurrency.

Are these fears overblown? What is the more likely scenario? What are the possible long-term implications?

In recent days, the cryptocurrency market has been rocked by accusations that Tether's promise to back USDT with USD is not as good as gold, the details of which have already been covered extensively by blogs such as Bitfinexed, which I shall not delve into in this article. What this article focuses on are scenarios that could occur after February 6th 2018, and their implications on the cryptocurrency markets in general. This article does not focus on the safety or value of any cryptocurrency in general, including Tether (USDT).

Devaluation or Collapse?

Much of mainstream media have highlighted the possibility that a collapse of Tether could lead to a flood of Tether owners rushing for the exits, which in turn leads to contagion where the loss of liquidity also creates a flood of cryptocurrency owners rushing for the exits to convert their holdings for fiat currency, thereby precipitating a disastrous collapse of the cryptocurrency market capitalization, and of the market itself, hence leading to the end of the tulip bubble.

First of all, let's examine the immediate reaction of Tether owners in response to a realization that Tether was backed by less US dollars than was previously thought, or that instead of US dollars, Tether was holding Bitcoin. For this, we have plenty of examples in the history of fiat currencies to take reference from, ranging from the 1997 Asian Financial crisis which led to multiple currency devaluations, to the hyperinflation in Venezuela and Zimbabwe to the demonetization in India.

In cases where currencies were devalued or even debased to the point of hyperinflation, holders of the debased currency most certainly lost value, but transactions using the devalued currencies continued to take place in daily life. A devalued Indonesian Rupiah note in 1997 would have bought you less bread, but because it could still buy you some bread, people grudgingly kept the currency they possessed, accepted the loss of purchasing power or in some cases displayed their displeasure publicly, but they continued using the currency. Of course, they tried to reduce their currency holdings if it were possible, but people were clear that the currency's value was reduced, and both buyers and sellers adapted by accepting and demanding more units of the currency for goods or services.

In the event of India's demonetization (the collapse scenario), the government specifically provided a timeline beyond which the currency would be effectively worth zero. This sparked long lines where people rushed to the banks to exchange their old notes for new notes and transactions were impaired. Subsequent to demonetization, the notes were no longer accepted, they had zero value and could not be used to facilitate any transaction, and holders of the old currency could dispose of the notes with no semblance of regret.

The crucial distinction lies between whether the currency eventually retains some residual value, or possesses absolutely no value at all. In the latter, a market would cease to exist for the currency, whereas in the former, a market exists but would have to undergo repricing. The reader is best left to decide for oneself whether the events of February 6th 2018 will see Tether markets devalued to some extent, with the subsequent implication that every other cryptocurrency would undergo repricing with respect to Tether, or whether a complete collapse of Tether sparking a chain reaction of collapse in all cryptocurrencies would take place.

Personally, if I found out that the government backing my currency holdings held significantly less gold than was previously claimed, it is unlikely that my immediate response would be to flush my currency holdings down the toilet bowl.

A "Bank Run" on Tether

For the scenario where a bank run takes place on Tether, and Tether owners show up at the door demanding instant and non-negotiable redemption of US Dollars, it would be helpful to look at the reserve requirements of the US Federal Reserve. Funds in reserve are an indication of how much US dollars a depository institution has on hand to provide US dollars to people who wish to redeem US Dollars.

I am in no way indicating that Tether is a licensed depository institution, something that Tether would have to answer for itself, but it is helpful to look at some of the best practices adopted by mature financial institutions in preparation for precisely such a scenario. Reserve requirements are the amount of funds that a depository institution must hold in reserve against specified deposit liabilities. Within limits specified by law, the Board of Governors has sole authority over changes in reserve requirements. Depository institutions must hold reserves in the form of vault cash or deposits with Federal Reserve Banks.

Reserve Requirements by the US Federal Reserve (as of 3rd Feb 2018)

For depository institutions with Net transaction accounts between $0 to $16.0 million, the amount of required reserves is 0%. For depository institutions between $16.0 to $122.3 million, the amount of required reserves is 3%. For depository institutions greater than $122.3 million, the amount of required reserves is 10%.

It is also important to examine the major holders of Tether. At present, Tether is primarily held by cryptocurrency exchanges with little access to fiat currency, on behalf of their retail investors. Should retail investors of USDT decide to sell their USDT because they think it is overvalued, and be allowed to do so, it is likely that the cryptocurrency exchanges would be left holding the bulk of USDT. Bitfinexed advised in the article "Tether exchanges: How to avoid being 'Tethered'" that it would best serve the interests of the exchanges to demand USD from Tether in exchange for their USDT holdings. In essence, Bitfinexed is advising the cryptocurrency exchanges to conduct the equivalent of a disorderly bank run on Tether, pre-emptively and unilaterally.

In my opinion, cryptocurrency exchanges have a primary interest in maintaining the stability of the cryptocurrency markets. At the time of writing, USDT is being actively traded on 24 exchanges (less than the number of countries in the European Union), with a few exchanges accounting for a disproportionate amount of trading in USDT. It remains to be seen whether the major exchanges would heed the call for unilateral pre-emptive "bank runs" on Tether to the detriment of the entire cryptocurrency market, or they would co-ordinate their responses to prevent a disorderly unwinding of Tether, and contain any fallout within one or more coins.

Alternative Tether-like Coins

The cryptocurrency market has spent years searching for the right model for a "stablecoin" in the community, in order for users to cope with the volatility in cryptocurrency markets, and Tether was the first model which achieved some degree of acceptance amongst some, but not all users. It is likely that it will not be the last. If Tether is unable to survive this controversy, other coins may emerge in jurisdictions friendlier to cryptocurrencies with better transparency, and better auditing.

There are also coins claimed to be backed by assets such as gold or oil, that the cryptocurrency market might turn to for lack of better options. While this is purely speculative, in the absence of Tether, cryptocurrency users globally may even be driven towards coins such as the Petro as an unintended consequence, scheduled to be launched by Venezuela on Feb 20th 2018, in their pursuit of a "stablecoin". While this is not presently being seriously considered by the community, the price of oil is still quite stable RELATIVE to cryptocurrencies, and cryptocurrency users seeking stability on the time-scale of hours or days may still find this to be acceptable. While there might be legal implications for US citizens due to the US sanctions on Venezuela, the world is flat when it comes to cryptocurrencies.

Long-Term Implications

Of course, the long-term implications for the integrity of Tether could not be known at this point in time. However, it does provoke soul-searching amongst the cryptocurrency community, and should drive further innovation in "stablecoin" mechanisms.

Finally, this article in no way makes any recommendation on the value or safety of any particular cryptocurrency, but merely seeks to examine the various scenarios that could result from Tether's subpeona on February 6th 2018.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

Additional disclosure: I do not hold any USDT, nor do I have any plans to initiate any positions in USDT within the next few months.