Tether Arbitrage & The Dollar Peg

(This article is a subsection of “King Tether and the Stable Coin Wars”, presented here stand-alone to allow for more arbitrage examples, and to provide a resource for readers looking to understand how stable coins maintain their pegs to fiat currencies — article was written in Oct/2018, while the arbitrage process changed in Nov/2018, when USDT became redeemable at Tether directly, rather than at Bitfinex via fiat withdrawals).

Tether is a cryptocurrency issued on the bitcoin blockchain. It is a stable coin, where each tether in circulation is meant to be backed one-to-one by fiat currency held in deposit. Tether (USDT) maintains its peg with the US dollar due to two factors:

1. On deposit, Bitfinex credits users’ accounts with 1 USD for every USDT deposited.
2. When the price of USDT-USD deviates considerably from $1, arbitrageurs bring it back in-sync.

Arbitrage example 1: USDT-USD drops to 97 in Kraken. A trader would buy USDT (using USD) in Kraken, transfer the USDT to Bitfinex, convert to USD at $1.0, withdraw USD, transfer the USD back to Kraken, and generate 3% in gross revenue. Arbitrageurs would perform the arbitrage trade whenever the spread would justify the operational costs and perceived risks, and, by doing so, would put upwards pressure on USDT-USD, pushing it towards $1.

Arbitrage example 2: USDT-USD drops to 97 across exchanges. Consequently the premium between BTC-USD in Coinbase and BTC-USDT in Binance widens to 3% in favor of BTC-USDT. A trader would buy BTC (using USD) in Coinbase, transfer the BTC to Binance, sell the BTC for USDT, transfer the USDT to Bitfinex, convert to USD at $1.0, withdraw USD, transfer the USD back to Coinbase, and generate 3% in gross revenue. By doing so, arbitrageurs would put upwards pressure on USDT-USD, pushing it back towards $1.

Arbitrage example 3: USDT-USDT increases to 1.03 across exchanges. Consequently the discount between BTC-USD in Coinbase and BTC-USDT in Binance widens to 3% in favor of BTC-USD. A trader would sell BTC and buy USD in Coinbase, transfer the USD to Bitfinex, convert to USDT at $1.0, transfer the USDT to Binance, buy BTC, transfer the BTC back to Coinbase, and generate 3% in gross revenue. By doing so, arbitrageurs would put downwards pressure on USDT-USD, pushing it back towards $1.

It is the work of traders performing arbitrage that keeps the value of an asset trading closely to its underlying value. Arbitrage consists of various legs (minimum of two). To perform the arbitrage, traders need a gateway to close the last leg of the arbitrage — in this case, a Bitfinex with a working banking relationship, allowing for fiat withdrawals.

Arbitrage traders are not making free money, they make profits by taking on four risks:

• Market risk — in the first example, the price of BTC may drop while the trader is transferring the BTC to Binance. Market risk can be eliminated almost entirely by hedging the BTC long exposure on a derivatives market such as Bitmex or the CME e.g. by temporarily shorting XBT.
• Execution risk — related to bid-ask spreads, falling under operational costs, yet unpredictable.
• Liquidity risk — related to delays in closing the last leg of the trade, which affect profitability given opportunity costs and the time value of money.
• Credit risk — of Bitfinex and/or Tether in the case of USDT. If either were to become insolvent before the trader processes the fiat withdrawal, the trader couldn’t redeem the USDT for USD.

Tethers could lose the peg and deviate considerably from $1 in the event of an increase in perceived liquidity risk and/or credit risk. In other words, if trust in Bitfinex or Tether diminishes, or if Bitfinex experiences banking issues, USDT would move lower.

In a fully efficient market, for as long as USDT is fully backed by USD, and that is known by all, and the Bitfinex withdrawals process is perfectly efficient, the USDT’s market price would remain close to $1 regardless of any buying or selling, due to the work of arbitrage traders. It is, of course, not a fully efficient market, particularly so because of bottlenecks in fiat deposits/withdrawals i.e. banking issues.

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