There's this ongoing issue with the Tether "stablecoin" that insiders have known about for a long time that's only just starting to get more widespread attention lately. This issue with Tether has wide reaching consequences for the entire cryptocurrency ecosystem and is something I think would benefit from some explanation. This has got a lot more attention now that the SEC has started investigating Tether but there's value in talking about why stablecoins matter and what their role is in the broader crypto sector.
I've put this article in the monetary policy series because I think there's a very interesting lesson to be learned about the mechanics of trying to ped a currency exchange rate that can be learned from looking at the way in which Tether ties to make 1 USDT equal to $1 USD.
What is a stablecoin
When you have a crypto currency you have a currency that's distinct from any of the national currencies that are in use. These systems are often fully distributed and depending on the user base and economics of the coins can have very large fluctuations in value over time. There's no central bank involved trying to pull strings to make the purchasing power of the currency stable over time.
This variability in value makes some of these cryptocurrencies hard to use for daily use. If you wanted to purchase some items, unless they are priced in terms of the cryptocurrency then you'll have to make some conversion to some fiat currency at some stage in order to make that purchase. Given that cryptocurrencies can be quite volatile in terms of exchange rate to fiat currencies this can be quite an impediment to actually using the currency to buy goods and services.
At some point the notion of a stablecoin was introduced. What this does is give you a cryptocurrency that's got a pegged exchange rate with some other currency. The idea here is that you want ot try to give people some of the conveniences of the cryptocurrency and decentralized finance ecosystem without exposing people to as much volatility on the pricing. This of course comes with some downsides, in particular it introduces the need for a centralized organization to hold assets in order to back the coin and reduce the volatility of the offering. In order to peg an exchange rate you need to have enough capital reserves to do so. This is much like any other currency.
Tether has been in the news lately because it has persistently has had issues with the way it manages reserves. There has always been a transparency issue here and in recent times this has raised questions about if they have enough reserves available to actually support the system. Because Tether is not a bank there are significant legal issues with having less than a 1-1 backing of each coin. But perhaps more important than this is that there's a significant cultural mismatch going on here, the crypto world for the most part is a culture that assumes that 1-1 backing is the only way things should work, so things like Tether stand out for being against the grain.
Why are stablecoins popular at all?
Something I've come across frequently (at least in the developed world) is a misunderstanding of why stablecoins are such a big deal.
People who are crypto maximalists tend to be of the opinion that all fiat currency is a scam and that goods and services should be priced in crypto currency terms. With this worldview why would you use a crypto system of all things to price things in fiat?
People who are not in favor of crypto say, why not use the banking system to do transactions in fiat currency since that system already exists for that purpose? Exposing yourself to the risks of a cryptocurrency seems like a lot of potential downside compared to putting your money in a bank that you think has legal protections like deposit insurance that will protect your money in the case something happens to the bank1.
If you are in a country with good access to banking it can seem like a bit of a stretch as to why there's significant demand to use a cryptocurrency to conduct transactions denominated in fiat currency, after all there's a banking system that's quite efficient and established to move fiat money around locally.
And this gives us hints at why stablecoins are a big deal, a lot of people in the world just don't have access to good banking and many have no access to banking at all. This was something that I remember talking to people about a few years back when we were shifting towards a more cashless society over in Australia because we were wondering "what happens to the people who don't have a bank account?" when more and more businesses were starting to accept card payments only. This was a shocking blind spot for a lot of people as many people just didn't even stop to think about it or the extremely big consequences of going in a fully cashless direction.
If you think about this on a broader global scale there are a lot of people that are unbanked, this is the thing that if you've spent time in Western nations or in Asia it's harder to see this due to the much higher availability of banking services in those places.
Also a lot of transactions that are international are a pain to make via the banking system. For example the other day I needed to send some money to another country, in the bank wire I didn't even get a clear indication of how much fees I'd pay or even what the exact exchange rate would be for the person receiving it. I didn't even know when the person would get the payment. All of this adds up to a significant number of frictions for people engaged in commerce. In this day and age I have to say this is just crap, all of this could be done so much better. And that example was a country that is, relatively speaking, easy to make payments to as well! In some countries making a transfer is especially difficult, this is why we have extortionate fees for services like Western Union that would charge absurd amounts to anyone wishing to say send a remittance payment back to their family in another country. Much like how the expansion of the telephone networks and the internet finally killed off Western Unions telegram service1 decentralized finance will kill off their money transfer service that's used for remittances too. It's just a simple matter of cost gravity, the overpriced service of old just simply can't compete with these new services that are not only cheaper but are faster and more secure.
So coming back to the US dollar, this is the global reserve currency, which is so in practice because a lot of international trade is conducted in US dollars even in locations completely outside the United States. This has given rise to an entire system known as the eurodollar system which allows people to do banking in United States dollars in locations that are not in the United States. In practice there are a lot of people who want to do trade in US dollars across the world, but there's a lot of locations where banking is substandard. Creating a coin like USDT that has an advertised backing of one to one with real US dollars that can be transacted easily is an extremely compelling offering to a lot of people out there. If you are entirely unbanked then this might even be your best option to trade in US dollars.
Why does the situation with Tether persist despite the backing for the currency being in such a dubious state
Looking at the situation from the perspectives of people who have some sort of utilitarian approach to this is important.
Wealth is created by commerce not by currency. If for example I run a business then for the most part all I really care about from a foreign currency point of view is if it will allow me to conduct the transaction I need it for. The longer I hold a foreign currency the more risk I have with regards to foreign exchange fluctuations, if I can quickly convert my money then exchange it quickly for the goods and services I want then I don't take on so much risk with regards to that foreign currency. In the case of something like Tether if it helps me do business and I'm able to make my transactions quickly then I can get some very significant gains from that. In essence I can be acting in my short term interests by using a currency that's really got no backing at all. This is effectively a large part of why fiat currencies not only exist but thrive in the right circumstances, if people have enough confidence in them to trust them and transact in them they then have defacto power as a unit of exchange.
Where things do become a bit weird is if I have to hold my money in any currency for an extended amount of time. The longer I have to hold it the more I care about the stability of purchasing power of that currency. In the case of Tether the situation is that you are essentially holding a token that effectively is supposed to give you the right to exchange it 1-1 for some amount of USD. If enough people are to withdraw their holdings then if there's not enough reserves backing the circulating Tether tokens then some people will be left with nothing. This is in effect the same sort of dynamic that people talk about with "runs on the bank".
Now in a regular situation if I had say 100 tokens and $100 USD of reserves for those tokens I think it's reasonable to say that these tokens are backed one for one. However if I have say 100 tokens but only $74 USD of reserves then things get a lot more weird, if this information were known and this was on the market it would be reasonable for each token to trade at 74 cents each. However another approach is just to keep selling as though there were full reserves in which case if there's a run on the tokens 74 people get $1 and the rest get nothing. In the case of Tether it seems they have gone for the option of not discounting the token based on the reserves. As long as few enough people attempt to exchange those tokens for USD this situation with insufficient backing could continue for a potentially long time. Some commentators out there think that's the exact situation we are seeing with some of the stablecoins.
Why $74 in that previous example? According to Tethers own lawyers in a document released a while back Tether admitted they only had 74 cents per dollar for backing their coins. A few years is a long time in crypto though so quite a bit might have changed in the interim. How this ends up playing out will be very interesting and will have broad impacts on the crypto market if only because BTC is frequently priced in USDT and not the real deal USD. Even without considering the potential impacts this has on the pricing of the much bigger market cap BTC there are still enormous amount of money moving around with Tether. This issue is a particularly big deal and is worth keeping a close eye on if you are interested in the crypto space.
Unfortunately the banking system has rolled back many of these protections very quietly over the last few years. People still have this rock solid confidence in their bank accounts being covered by deposit insurance despite the push in all G20 countries to introduce bank bail in laws that effectively circumvent the deposit insurance in the sorts of liquidity events where you actually would need it the most. But yet due to ignorance towards the regulatory changes in the banking sector most people just think nothing has changed. ↩↩
Worth noting that I'm talking about the old system of being able to send telegrams, not the new phone messing app of the same name. This system existed for a very very long time, even after widespread usage stopped. This system of communications had been around for a long time and in a lot of places, for example in India the telegram system started in 1850 and operated all the way up until it was decommissioned 163 years later in 2013 ↩
This post is part 5 of the "MonetaryPolicy" series: