Money 2.0 Stuff: Yes, another Tether column

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Note: Nothing written in this column is financial advice. If you are taking financial advice from this column, there are probably bigger issues to discuss.

At the time of this writing, $USDT is trading at ~$0.98, after some heavy volatility following last week’s news of a NY State-pursued lawsuit pushed it to a range between $0.96 and $1.06. 

Some questions still remain: Why is the price still $1? How could this change in the future? What, if any, systematic risks does this pose?

To answer these questions, it’s important to understand exactly what Tether is. Tether is a digital token issued by a centralized company which maintains reserves in excess of the tokens issued. It was first created as “Realcoin” by former Mighty Ducks star Brock Pierce in 2014 and rebranded as Tether later that year. During the rebrand, the principals behind the company changed as well — incidentally, to Bitfinex CEO Jan Ludovicus van der Velde and CFO Giancarlo Devasini.

The core use case behind Tether then is the same motivation behind today’s fiat-coins: to provide an easy way for exchange customers to move and store dollars on a blockchain. This is particularly useful for a number of “crypto-native” exchanges that don’t have consistent fiat banking rails (choosing instead to rely on Tether’s on-again-off-again correspondent banking). 

Despite looking something like a bank, this isn’t to suggest that Tether is a “fractional reserve bank” like some defenders have claimed after spending 5 minutes on Wikipedia. Banks have intense regulatory scrutiny and credit risk limits that allow them to operate that way in addition to being subject to normal business stuff like audits. Tether is an asset coming from a central issuer with a set of guarantees about its backing.

From then to now, a bunch of things happened. Bitfinex was hacked in 2016 to the tune of ~$75 million. Bitfinex socialized their losses and offered customers $BFX tokens, tradable representations of $1 worth of Bitfinex equity. These tokens were later bought back in full and destroyed. Conspiracy theorists, most notably anonymous troll Bitfinex’ed advanced a number of theories around potential spoofing, the use of USDT to “pump” the cryptocurrency spot market, and other inane theories. Bitfinex’s wild ride, while tangentially related to their relationship with Tether, is not too relevant today outside of indicating some of the creative business and accounting processes of the management.

After the crash, amidst widespread speculation, last week’s legal filings definitively shut the door on many crypto-optimists’ arguments that USDT tokens were backed 1:1 by US-dollar or other currency deposits after revelations that USDT was partially backed by receivables for a loan at 6.5%, collateralized equity in iFinex, Bitfinex’s parent company. 

What we know for sure:

  1. Tether was definitely fully backed by dollar reserves at one point in 2018, consistent with its historic claim that Tether is backed by “traditional currency held in [their] reserves”.
  2. After swapping banks regularly, Bitfinex chose to do business with an intermediary called Crypto Capital. Crypto Capital subsequently got tied up with their own legal issues, causing them to lose track of $850 million.
  3. The Bitfinex/Tether team attempted to resolve the situation by facilitating a loan from the right hand to the left.
  4. At some point, their public claims changed to specify that Tether is backed by “[their] 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.” This was updated after the loan facilitated in (3)

It’s important to note here that Bitfinex and Tether are still distinct entities. This is significant for a number of reasons foremost of which that the long-term sustenance of Bitfinex, while relevant, is a less important factor in determining whether Tether holders can be made whole or not. Liabilities flow in one direction: solvent or otherwise, Bitfinex is still on the hook for the $900 million borrowed from Tether.

Whether extending this loan was a “good idea” for Tether holders is a separate question. When it was extended, it was likely expected that the missing funds were recoverable within a reasonable time frame. Bitfinex’s exchange business was very strong—one of the top exchanges in the world—without any risk of going away any time soon. Considering these circumstances, a loan for dollar deposit at a rate of 6.5% is quite reasonable, particularly given a large claim by Tether holders on Bitfinex equity (which the company itself is heavily incentivized to avoid.)

So the question now: why is Tether still trading at a dollar?

The simple explanation is that size holders of USDT who have astutely assessed the risk of holding the asset have determined that either:

  1. Bitfinex has the ability to pay down the loan through its exchange business and will remain open. In last week’s filings, the NY State AG strongly indicated that the interest of the office was consumer protection and that they would allow Bitfinex to operate in light of this. The fates of Bitfinex and Tether are intricately linked.
  2. Cooperating with authorities, Bitfinex can access the funds currently held by authorities from the United States, Spain, and Portugal.
  3. In the event neither (1) or (2) are possible, the value of the equity and assets Bitfinex is a sufficiently strong backstop to the shortfall in Tether’s currency reserves. Though they likely have some dollars and crypto-assets on their balance sheet, it’s unclear what the firm would be worth in the event trading was to be suspended.

Large holders have likely all known that uncertainty was afoot since Tether’s ToS was updated earlier this year. In spite of this, Tether has continued to trade at approximately its redemption value signaling that large holders are confident in their abilities to be made whole (or at the very least, confident enough not to meaningfully reduce their exposure).

However, there’s an additional wrinkle. The largest holders of Tether are exchanges. As of this writing, Binance has ~$700 million worth of exposure. While some large portion of this may be client holdings, it’s an open secret in the industry that a number of exchanges have used USDT to park profits.

Even if only half of Binance’s USDT exposure is off their balance sheet, they are aligned with Bitfinex and Tether’s stability whether they like it or not. This means that the largest exchanges in the ecosystem provide a seemingly permanent bid on USDT up to $1, lest the peg unravels before Bitfinex is able to pay down their loan.

On the face of it, shorting USDT presents an extremely appealing set up: the potential to be short squeezed is minimal which means there is an asymmetric payoff if the USDT peg does break. Structurally, execution of this is harder than it appears. It is extremely difficult, if not impossible to borrow USDT in size. Borrow rates even at small sizes can exceed 15–20%. There are two types of trades that can be executed:

1. A directional short, which works at any size. Outside of Bitfinex shutting down, it’s unlikely to present a profitable set up given the systematic support for Tether and interest in seeing it escape de-pegging.

2. The Soros trade, where one (or multiple) traders literally sell enough USDT to exhaust existing cash reserves in an attempt to break the peg.

At the face of it, given the difficulty of facilitating a sizable borrow suggests that the Soros trade is exactly what large holders are worried about. There’s no other easily explainable reason why someone holding a sizable amount of USDT wouldn’t want to profit from extremely enticing 20% borrow rates. If they are excessively concerned about a price collapse in USDT, there is minimal appeal in holding USDT given the existence of alternative fiat-coins. 

The strongest argument against shorting Tether is “too big to fail”: because of its’ systematic importance, exchanges and other large holders who don’t have the luxury of de-risking their exposure are forced longs who are willing to subsidize the peg (as is likely happening right now). In its’ current state, Tether presents a kind of Prisoner’s Dilemma game: all large exchanges with exposure likely want to sell but none can defect—if any one does (perhaps with the use of any privacy feature OMNI presents), the sell pressure that would hit ~$1 bids is immense.

Given the current trading price of $1 and the unlikely event of USDT trading at a material premium (i.e., > $1.10) to its’ redeemable price, it’s very ripe for a sufficiently capitalized trader to apply leverage and put on a large short position. Whether or not this will be successful will likely come down to one factor: the solvency of Bitfinex and whether they are able to either (1) maintain the illusion of sustainability long enough to recoup and pay down their debts, by the good graces of NY state regulators or (2) raise alternative financing, which they appear to be in a frenzy to facilitate, potentially via IEO.

What does this mean?

Bitfinex is seemingly unstoppable, a cat with nine lives that’s able to recover from hacks and bad business deals with the strength of Justin Bieber’s post-DUI rebranding. Even if Tether isn’t backed by the cash reserves everyone wants them to have, they are backed by the faith and confidence of the crypto community that has seen them on their comeuppance, during which they’ve (almost) always attempted to do right by their customers in addition to the exchanges’ Prisoner’s Dilemma described above.

A large faction of the community has always thought that Bitfinex has embodied the ethos of the ecosystem, providing free-market solutions to all sorts of business problems. The same group of people steadfastly against the bank bailouts could support a Bitfinex IEO-powered bailout (where this time, we get equity), enabling them to remain a core part of the industry for another day.