Notes 3/31: Tether Attestation Report, Stablecoins as Free Banking, and The Banality of Another DeFi Hack

Tether, the algorithmic stablecoin that straddles all of crypto, released an attestation report for its second quarter this morning. As usual, it is a sham and a mishmash of meaningless statistics and assertions. The report does not provide much clarity about its finances though it does bring to light some of the underlying risks.

According to the report, Tether has U.S. Treasuries worth $72 million, a figure that it claims rivals Mexico’s holdings of the same asset, on its balance sheet. It had $850 million in net profits in the second quarter and more than $1 billion in operating profits. It also has a vague statement about shares buyback for $115 million to “further strengthen the shareholder group.”

As of this writing, Tether has a market capitalization of roughly $84 billion, its highest on record.

An Exercise in Obfuscation

Earnings reports are exercises in obfuscation. Attestation reports are even more so because they represent a stablecoin’s balances at a point in time, instead of over the quarter. In Tether’s case, they are works of fiction because it does not really need reserves for its operations.

Still, the stablecoin indulges in wordplays in its reports. The latest edition of its attestation attempts to confuse readers with a new term – excess reserves. Initially, they are explained as a reference to Tether’s profits. And so, the company claims that it had “excess reserves” of $850 million in the second quarter. This should mean that it had net profits of $850 million in that period.

In the succeeding sentence, however, the definition changes. Tether states that it has record “total excess reserves” of $3.3 billion. How is that possible? As it turns out, this figure is the difference between its circulating supply in crypto markets and the total number of its tokens present on all blockchains.

Not all Tether tokens minted are traded; some of them simply reside on chain, waiting to be deployed as ammunition for future hikes in bitcoin prices. Such tokens are worthless and risky because of the danger to Tether’s peg.

However, the conflation of “excess reserves” with profits enables the stablecoin to assert that its excess reserves reached an “all-time high”.

What About Bitcoin?

Tether had promised to make purchases of bitcoin with up to 15% of its net profits last quarter. It holds $1.67 billion worth of bitcoin on its balance sheet as of this writing.

It is worth remembering here that the second quarter was a challenging time for crypto. Trading volumes fell. Liquidity dwindled. And a raft of scandals and regulatory crackdowns continued to hammer away at its innards. Tether also lost its peg twice during the quarter. As a result, Bitcoin price rose only by 8% during the quarter.

The situation is not going away anytime soon. Bitcoin has traded in a tight range for most of last month. Depending on your source, bitcoin whales are either exiting their holdings through exchanges or holding on dear life (HODL). Either way, bitcoin liquidity has reached its lowest level since early 2021.

That means the risk to Tether’s portfolio has multiplied. But the stablecoin’s runway to prop up bitcoin price is limited because the cryptocurrency multiplies risk in the stablecoin’s portfolio. The main trading venue for the pair is Binance, an exchange that has been rapped repeatedly by regulators worldwide. Its token is also being shorted by investors.

What happens when Tether is no longer able to bolster bitcoin and loses its peg? The stablecoin and the cryptocurrency both crash.

Stablecoin Regulation

On the subject of stablecoins, the latest attempt to regulate them by the U.S. Congress turned into an acrimonious battle between Democrats and Republicans last week. The stablecoin bill was passed by a 34-16 vote in the House and is now up for consideration by the Senate.

But it faces a difficult road ahead because it has not received support from ranking member Rep. Maxine Waters (D-CA). She said the bill promoted “a race to the bottom” by creating 58 different licenses for stablecoins.

Stablecoins as Free Banking

The main point of contention in the bill is the power accorded to states to regulate stablecoins. The last time this happened was during the free banking era that preceded the civil war.

Back then, banks were allowed to issue private notes if they had a state license. The number of private currencies multiplied and banks resorted to dubious tactics to increase their circulating supply and profits. The resulting chaos led to many bank closures and currencies going out of circulation.

Previous studies have shown that these bank closures were not related to regulatory arbitrage. In fact, regulations for state banking licenses were “similar” in Michigan, a state that recorded the highest number of failures, and New York, which had among the lowest. Rather, it was liquidity – the ability to exchange notes at par – that contributed to bank failures in a state.

For example, the Suffolk Bank System (SBS) in Massachusetts, another state with a low failure rate, was considered among the sturdiest in the banking system. It was a precursor to the current Federal Reserve in that it was a grouping of many banks that exchanged each other’s notes at par. Wildcat banks in Michigan operated as lone rangers and did not have many such arrangements.

The current crop of stablecoins resemble the Michigan setup. Even with adequate reserves, they will find it difficult to survive without liquidity or demand for their coins.

Flashbots Funding

A story on CoinDesk encapsulates the problem with crypto. Venture firms pumped $129 million into crypto firms last week. Flashbots, a firm that works in Maximal Extractable Value (MEV), led the funding sweepstakes with a share of $60 million of the total. MEV is in danger of being deemed illegal by the European Union’s MiCA regulation.

Curve Finance Hack

There was another hack at a decentralized finance (DeFi) platform over the weekend and worthless tokens with arbitrary valuations were stolen. Meanwhile, market depth for the said token has plunged and there is a desperate bid to boost liquidity. Transaction volumes have surged and MEV rewards have hit a new record. Oh, but ether’s price remains unaffected by the hullabaloo.

This is a familiar set of events, sort of like a DeFi karmic cycle. There is nothing new to see here.

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