The surge in market capitalization for Tether always brings the stablecoin’s many mysteries into the spotlight. Who runs it? Who are its bankers? And, most important of all, where are its reserves?
Tether claims to be a fiat-backed stablecoin. This means that its circulating supply should be bolstered by an equal amount of fiat currency in reserves. At the stablecoin’s current market cap of more than $83 billion, we are not talking about chump change. It is a portfolio that could move entire markets.
But Tether has refused to submit its balance sheet to a comprehensive audit from accounting agencies. There are also no public records of its transactions or dealings with brokers.
How is it able to maintain such vast reserves and remain anonymous in trading markets?
That question presumes Tether has reserves, even if they are inadequate, to satisfy client redemptions. But what if the fiat-backed stablecoin is actually an algorithmic entity which does not need reserves to maintain its peg?
The idea is provocative although not entirely impossible. Tether functions as a supranational entity that operates outside the scope of regulatory jurisdictions. It is difficult, actually impossible, to verify its assertions about reserves It is possible, however, to make deductions based on its operating history and price action.
Operating An Algorithmic Stablecoin
The setup for an algorithmic stablecoin does not require reserves. Instead, an alternate token is used to maintain the stablecoin’s peg. The alternate token – let’s call it T2 – trades in crypto markets and its supply is calibrated based on market conditions. Thus, the total amount of T2 in circulation contracts when the stablecoin’s peg rises above $1 and it is increased when the peg falls below $1.
Swaps or the exchanges occurring between T2 and the stablecoin by traders ensure price stability. Arbitrageurs use the fluctuations in price for both tokens to make money. When the stablecoin token trades below its peg, they exchange it for $1. And they make money by buying T2 when the stablecoin token is above its intended peg. To ensure that the system works, the supply of both tokens must be balanced to match buy and sell offers in the market.
An example of this mechanism at work was the infamous Terra Labs ecosystem. UST, the stablecoin, maintained its peg through arbitrage with Luna – the ecosystem’s native token. Luna had a fixed supply of one billion and was traded in crypto markets. During periods of expansion, when its supply exceeded demand, Terra burned Luna’s excess supply to bring it back in line.
From Terra’s whitepaper:
When TerraSDR’s price < 1SDR, users and arbitrageurs can send 1 TerraSDR to the system and receive 1SDR’s worth of Luna.
When Terra SDR’s price >1SDR, users and arbitrageurs can send 1SDR’s worth of Luna to the system and receive 1 TerraSDR.
The Tether Algorithmic Stablecoin
On the face of it, at least, Tether seems to function in isolation, without an alternate token to maintain its peg. However, some of its biggest trading volumes occur against bitcoin.
The pair have a relationship that is nearly a decade old. Tether’s beginnings were on the Omni Layer, a side chain protocol on bitcoin to create custom contracts and cryptocurrencies. But bitcoin’s many problems, including scaling, meant that the stablecoin failed to gain traction. It was only after Tether introduced an ERC-20 token on Ethereum that its token took off.
A 2018 study authored by researchers at the University of Texas alleged that Tether instigated bull runs in crypto markets and manipulated bitcoin price by inflating its token supply. The charge is not surprising considering that Tether markets are the most liquid pathways to conduct a bitcoin trade.
According to the paper, the stablecoin creates the illusion of demand at crypto trading venues by pumping out fresh Tether supplies. The new tokens, which are not backed by reserves, are lapped up by traders who use them to purchase bitcoin. The price of bitcoin rises.
Tether also gets in on some of the ensuing trading action by cashing out its considerable seigniorage – the the cost of printing tokens – by selling its bitcoin holdings for US dollars at a relatively unknown crypto exchange. The choice of venue is deliberate and minimizes the trade’s effect on bitcoin price, and profit taking, occurring at prominent exchanges like Binance.
The Connection Between Tether and Bitcoin
One can substitute bitcoin and Tether in the Terra/Luna setup. Like Luna, bitcoin has limited supply and trades in crypto markets. Tether is the stablecoin whose peg is intrinsically linked by design to bitcoin.
For the scheme to work, however, there must be demand for both tokens. Crypto’s many failings – illiquidity, scams, and lack of regulation are just some – means that traders and consumers are not willing to carry the risk of trading it. Therefore, Tether manufactures “demand” by printing fresh tokens. In many instances, the tokens are also used to revive bitcoin’s sagging price.
The seigniorage accruing to Tether from its contrivances is substantial. Consider that the stablecoin is nothing but a block of code replicated across supported exchanges. Its cost of production is nearly zero and the exit roads during a bull run sparkle with crypto riches. For example, bitcoin touched a high of nearly $69,000 in November 2021.
Bitcoin production parallels Tether issuances to maintain parity in buy and sell offers for both coins. For example, the hash rate, or the total number of systems devoted to mining bitcoin, and network difficulty – a measure of the difficulty level to mine bitcoin – fell in June 2021 along with Tether’s market cap. [The market capitalization of a stablecoin is equal to its circulating supply and a lower market cap means that there were fewer Tether available on blockchains].
Bitcoin price also fell from a high of roughly $41,000 at the beginning of June to $31,000 by the middle of July. All three parameters rose in August 2021 and bitcoin set a price record in November of that year.
All Roads Lead to Tether
Tether emerged as the connecting strand between many crypto tokens and exchanges that were launched after the bull run of 2017. By the summer of 2018, it accounted for as much as 80% of overall crypto trading volume.
One of the benefits of garnering such a massive share is shared liquidity. In an illiquid crypto ecosystem, a Tether trade provides some semblance of a counterparty guarantee. Thus, when bitcoin price collapses, traders can quickly shift their funds using atomic wallets to another coin that is on an upswing because both tokens trade against Tether.
In fact, the narrative of an altcoin ecosystem, led by Ethereum’s native token ether, took root around the same time that Tether’s popularity skyrocketed in 2018. Prices for this ecosystem move in a direction opposite to that of bitcoin, enabling more choice and hedges in cryptocurrencies.
For Tether, this arrangement means that it has multiple levers to accumulate profits and control the direction of crypto markets. While new stablecoins like USDC and BUSD have eaten into Tether’s share in recent years, it still accounted for more than 50 percent of all trades occurring in crypto markets last year. More importantly, it is still the biggest trading partner for bitcoin and ethereum, the two biggest cryptocurrencies by market capitalization.
The Tether Economy
Howsoever elegant a stablecoin’s design may be, it is still underpinned by demand. The hefty seigniorage Tether earns from its operations has spawned an economy. As with everything else, there is not much publicly-available information about the Tether treasury. But the company reported profits of $1.1 billion recently.
What does a company, with minimal production costs, do with that kind of money? It looks for new avenues to make money.
Most crypto startups use their treasury funds to fund applications for their blockchain. But Tether does not have a blockchain; its profits are derived from its use as a trading pair against other tokens at crypto exchanges. More coins and more exchanges, therefore translate to more profits for Tether.
The stablecoin has funded a smorgasbord of crypto ventures – tokens, exchanges, and mining ventures – to propagate Tether’s use and maintain its peg.
Consider the company’s recent announcement of investing in a crypto mining venture in Uruguay. A steady and predictable supply of bitcoin is important to maintain Tether’s peg because bitcoin mining and Tether supply must correspond for efficient operations of an algorithmic stablecoin.
With regulators in the United States – the biggest center for bitcoin mining in the world today – threatening to clamp down on the activity through taxes, Tether’s latest investment is a defense play to maintain its peg. Its move to shore up liquidity for bitcoin by using its profits is a similar move during a time when investors are exiting the crypto ecosystem.
The Importance of Burning Tokens
Another key feature of the Tether economy are redemptions. It is difficult to redeem Tether and there is no public record of redemptions or Tether holders. But the event itself is important to understand Tether’s role as a algorithmic stablecoin.
Two things happen when Tether ‘redeems’ investors after losing its peg.
First, the stablecoin’s overall supply in crypto markets goes down because it burns tokens out of existence. Considering that Tether greases most transactions in crypto, the decline in its supply translates to an overall swoon in crypto markets.
Not surprisingly, most losses of peg for Tether have occurred following a crypto bull run or, at the very least, a surge in prices for the top cryptocurrency tokens. It may be delayed but the loss in peg is sure to occur. As an example, Tether’s peg went awry a month after bitcoin set a price record in 2021. The stablecoin also lost its peg in May 2022 following Terra’s implosion.
Another point to note during a Tether redemption event is bitcoin price action. A loss of peg for Tether is always accompanied by volatility in bitcoin price. When Tether trades below its peg, bitcoin price jumps. When Tether is above its peg, bitcoin price falls.
On Jan 22, 2019, Tether lost its peg and traded at $0.001 per USD at OKCoin. Bitcoin price rose from $3,540.38 on Jan 20 to a peak of $3587.77 on Jan 22. The situation reversed itself on March 12, 2020. Tether traded at a premium on March 13, 2020 at Bittrex and FTX, two crypto exchanges. Bitcoin price fell from a peak of $5962.64 on March 12, 2020 to $5142.62 in 24 hours.
This dissonant choreography in prices is typical of the workings of an algorithmic stablecoin. Another token, in this case, bitcoin, absorbs volatility emanating from the stablecoin.
There have been attempts to create stablecoins earlier. Basis was a proposed algorithmic stablecoin that failed to make it past regulators. Terra’s implosion demonstrated the inherent fragility of such a setup. Will Tether, another algorithmic stablecoin, last?