Blame it on multiple open tabs. Or on a lizard brain.
In the post on Tether’s reserves day before yesterday, I forgot to mention the most important risk facing the stablecoin: a debt default.
Unlike past years, the prospect of a debt default by the US government is a very real threat this year. Both sides of the aisle have dug into their positions and a bipartisan deal by the X-date – the date on which the government stops paying its bills – seems unlikely. Treasury Secretary Janet Yellen has warned that it could be as soon as 1 June.
More than half of the reserves backing Tether’s current circulating supply consist of Treasury Securities. A default, even if temporary, could wreak havoc on securities markets and, consequently, on the stablecoin’s reserves. Its peg could go awry. Circle’s USDC will not be spared either.
Analysts at The Brookings Institute say a default this year could result in “severe disruption” of the Treasury securities market with “acute spillovers” to other markets. The primacy of the US dollar and financial instruments denominated in the currency in the global economy will ensure that those effects are far-reaching.
Again, Brookings’s analysts say a default will also affect the cost and availability of credit to households and businesses in America. Credit is the engine of American economy and a decline in its value will tip the country into a recession. They are not the only ones sounding out warnings about a debt ceiling crisis.
Investment firm Goldman Sachs’s asset management arm is reported to be “minimizing” the number of short term treasuries in its portfolio.
Tether’s competitor Circle’s USDC is already taking steps to safeguard itself. The company’s chief executive officer Jeremy Allaire told Politico this week that it is curtailing exposure to a default by not holding treasuries that mature beyond early June.
Tether’s Risky Reserves
Whether the catastrophic scenario outlined by analysts comes to pass remains to be seen. However, the composition of Tether’s reserves ensures that the stablecoin will suffer massive problems even if there is a mild disruption to financial markets.
About $68.7 billion of its reserves are locked up in government-related securities. Out of that figure, slightly more than $53 billion is held in Treasury securities with a duration of less than 90 days. It is this tranche of securities that will be most affected by market turmoil during a debt default.
The Federal Reserve’s hikes in the last year converted short term treasuries into a lucrative investment option. While the high rates multiplied Tether’s revenue, they also injected interest rate and duration risk into its reserves.
Volatility in financial markets magnifies those risks. Borrowing the script from recent bank failures, the value of previously high yielding bills in the stablecoin’s current reserves will crash during a debt default, making Tether’s guarantee of a 1:1 backing for its tokens unsound.
Previously, such events have triggered large scale redemptions by token holders, resulting in a loss of its peg. Tether will have to sell its existing pile of securities for big losses in such an event to make investors whole. Already the T-bill market, where the yield on short term securities, such as six-month bills expiring in August, is signaling danger ahead.
Not Much Recourse
Tether does not have recourses to make up for the losses due to its exposure to treasuries. The stablecoin has invested in gold bars for its reserves, but the precious metal constitutes only $4 billion of its $81.8 billion in reserves. That figure is hardly sufficient if a stampede comes calling. This is not an unlikely scenario: the stablecoin claimed to have redeemed investors to the tune of $20 billion in a month last May.
Bitcoin accounts for $1.5 billion in the reserves. While its price has risen this year, the cryptocurrency reversed course this past month and has been in a downward spiral due to mounting illiquidity in its ecosystem.
Tether has not disclosed details about the $140 million worth of corporate bonds backing those reserves. But we do know that they have residual average maturity of less than 210 days, meaning they are also afflicted by the same risk as its Treasury portfolio. Finally, there’s the $5.3 billion in secured loan on its books. Those loans, however, are subject to margin calls and liquidation mechanisms.
What About Other Stablecoins?
Other stablecoins are susceptible to the same risks as Tether because they claim to be adequately backed by liquid treasuries. Of special mention here is Circle’s USDC. It had a market capitalization of $44.6 billion at the beginning of this year. It is $29.9 billion, as of this writing, because it was the subject of a run in March.
While CEO Allaire has outlined the stablecoin’s investing strategy in the Politico piece, he has not proposed a mitigation strategy for handling redemptions in such an event. After all, it was the stablecoin’s exposure to Silicon Valley Bank that slashed USDC’s market capitalization.
A hedge to the risk presented by short term treasuries is putting money into their long-dated counterparts. But that would mean compromising on liquidity and hoping that a mass redemption, of the sort that destabilized its peg in March, does not recur.
A USDC Depeg
Traders in decentralized finance (DeFi) markets are already anticipating a loss of peg for the coin. According to statistics from DeFiLlama, there’s $124.5 million riding on bets that the stablecoin will lose its peg once again within 20% of its current price.
That’s up from $111 million at the start of this month. About $70 million is placed on its peg going all the way down to $0.90. Considering that the stablecoin’s peg went all the way down to $0.87 last time, that shouldn’t be a difficult target. The danger with USDC is that it is extensively used in DeFi collateral, meaning a loss in its peg will ripple through DeFi markets.