Stablecoin Primer — Tether USDT shallow dive
This article is part of the Stablecoin Primer article series Section 4. If you are interested in reading the other articles in the series, check out this post.
Shallow dive format is as follows: Protocol -> Token(s) -> Design Principles -> Key Metrics -> Why use or mint USDT?
USDT stablecoin is issued and managed by Tether Holding Limited based out of Cayman Islands (originally based out of Hong Kong.) Founded in 2014, USDT is the first stablecoin to reach mass adoption. Tether’s idea of creating a price-stable cryptocurrency, as stated in its whitepaper, was two-fold:
1- Blockchain is a better transaction and settlement layer for fiat currencies since its cryptographic proof capabilities reduce the need for all the intermediaries that make fiat systems slow and costly.
2- Existing cryptocurrencies like bitcoin are still too volatile and technically complex to be used in mainstream transactions.
So in order to retain the best of both worlds, Tether simply created the blockchain version of the US dollar. Each USDT is basically backed by an equal amount of US dollars in Tether’s reserves. Put another way, a user has to deposit $1 to Tether to create 1 USDT. While whether Tether really holds users’ deposits intact in its reserves is a hot topic of discussion, the company conducts regular proof-of-reserve audits by third parties. So far, these audits highlight that the cash, cash equivalents and other assets in Tether’s reserves are greater in value than the USDT in circulation.
If you can’t already tell, Tether is more like a traditional reserve bank with a blockchain twist rather than a decentralized protocol. Users are not the custodian of their own assets but Tether is. Given its traditional design, I like to think of Tether more like a box-office that is midway on an imaginary bridge between the fiat and the crypto economies where USDT is the ticket purchased with fiat money to enter the crypto wonderland. Two analogies for you right there.
USDT is a stablecoin token that is 1-to-1 pegged to the US dollar and is fully backed by the US dollar in Tether’s reserves. The simplicity of Tether’s 1-to-1 backing implementation makes it more approachable for non-technical users and thus plays a key role in its mainstream adoption.
Behind the scenes there are two types of USDTs: 1- Issued and 2- Authorized but not issued. Issued USDTs have been sold to users in return for their deposit, are in circulation in the open market, and are included in USDT’s market cap. Authorized but not issued USDTs are tokens that have been created on a blockchain, have not been sold to users, and are sitting in Tether’s reserves. While Authorized but not issued tokens may make it seems like Tether is printing money out of thin air, Tether’s FAQ page suggests that the reason for having the second group of tokens is a measure of security (more on this later).
DESIGN PRINCIPLE— STABILITY
When discussing USDT’s stability, we need to keep in mind various aspects Tether Limited and it’s reserve structure:
- Reserve Mechanism: In order to maintain accountability and ensure stability, Tether uses a reserve mechanism. Every USDT in circulation is backed by cash, cash equivalents and other types of assets in Tether’s reserves. By itself, a USDT stablecoin token does not really have any value. It’s just like a piece of code sitting on a blockchain. The fact that there is cash in Tether’s reserves corresponding to each token is what gives USDT stablecoins their value. Since Tether promises a 1-to-1 backing to the US dollar, 1 USDT’s price is equal to $1, which also means that Tether is only as stable as the US Dollar.
- USDT Burn: A user who wants to take their cash back from Tether’s reserves can deposit their USDT to Tether. Tether then either burns or takes these USDTs out of circulation by listing them as Authorized but not issued. This is done so that there isn’t an oversupply of USDT in the open market for which Tether doesn’t have backing for. Remember, USDTs biggest stability indicator is its backing.
- Reserve Types: This is an area where Tether receives lots of criticism. Yes, Tether openly states that its reserves are not composed of only cash but also cash equivalents, other assets, and receivables from loans made. But, it also uses the 1-to-1 backing narrative quite often on its website. So while the average user may think that there are 86 billion $1 bills in Tether’s reserves (or 860 million $100 bills), that’s not really the case. In reality, Tether’s reserves only include 10% cash, and include other riskier financial assets like commercial paper (44%) and corporate bonds (5%) — see their transparency page. This simply shows that the management team of Tether believes that a large number of users will not want to redeem their cash deposits from Tether’s reserves at once, which could be very problematic for Tether and the crypto industry.
- Bank-run Possibility: While unlikely, a bank-run on Tether Limited may only happen if enough investors asked for their dollars back at once. In that scenario, Tether would need to immediately liquidate some of the non-cash assets in its reserves(e.g., corporate bonds) at a discount. This in return would make the remaining USDT in circulation not 100% backed but, say, 70%. This would make even more investors ask for their dollars back, believing that Tether will go bankrupt. And this downward spiral would make Tether even less collateralized. That’s why, critics suggest that holding assets other than cash in reserves is an extremely risky bet that could spike instability in USDT’s price and could go as far as impacting the whole crypto economy.
DESIGN PRINCIPLE — DECENTRALIZATION
While reviewing Tether’s decentralization, we want to understand if there is a single point of failure within the system and how transparent its monetary policy is to the users.
- Multiple Authorization Keys: Tether relies on Multiple Authorization Keys to create new tokens. This means that multiple parties authorize that an X amount of USDT can be minted on Y blockchain (USDT is available in 9 different blockchains). This way, the system doesn’t have a single point of failure, which can authorize the minting of new tokens and minting money out of thin air.
- KYC Verification: Unlike decentralized protocols like Maker, which allows any user regardless of their age and nationality to mint new stablecoins, Tether is a bit more traditional. To be able to mint new USDTs via Tether’s website, a user has to go through a potentially lengthy due diligence and risk rating process. As such, Tether is NOT trustless, permissionless, and, real-time — lacking some of the biggest decentralization related promises of cryptocurrencies.
- Custodianship: Tether Limited acts as a centralized custodian of users assets. For example, Deltec Bank in the Bahamas holds ~$15 billion cash and low risk bonds as part of Tether’s reserves. In that sense Tether’s does have a single point of failure.
- Transparency: For any stablecoin to reach mainstream adoption, transparency is key. Tether publishes daily record of bank balances as well as quarterly proof-of-reserve audit reports on their Transparency page. However, one should be cognizant that transparency alone is not sufficient. Because what good does a transparent monetary policy make if all users can see how risky the underlying assets are? (maybe transparency does make a big difference — Tether is still the stablecoin with the largest market cap.)
DESIGN PRINCIPLE — CAPITAL EFFICIENCY
- Fiat deposit = Stablecoin: If a user wants to mint 100 USDT, they need to deposit $100 plus a small fee. This is a more efficient structure than to crypto-backed stablecoins, which often require more overcollateralization (see DAI shallow-dive).
- Traditional settlement channels: Depositing and withdrawing cash from Tether is a lengthy process as Tether relies on traditional settlement channels. In certain circumstances, when the demand of the crypto economy exceeds what the fiat economy can provision, Tether becomes capital inefficient. For example, at the height of the Ukraine — Russia war, Ukrainian citizens flocked to the local crypto exchange Kuna to demand USDT. Since Kuna had a limited supply of USDT available at hand, USDT ended up trading at premiums up to 4%.
These metrics can be regarded as the high-level vital signs of Tether and the USDT stablecoin.
- USDT Supply: Currently at $85 billion, USDT supply experienced its first peak during the DeFi boom of 2020. USDT’s supply growth never stopped though. Since USDT is a significant liquidity source for the overall crypto economy, the more the crypto economy grows, the more demand for USDT. While new stablecoins are able to take a piece from the stablecoin pie, as more users are onboarded to crypto the pie keeps on growing and USDT remains to be the champion.
- USDT Peg Variance: Regardless of the composition of Tether’s reserves and all the controversy it attracts, the demand for USDT remains to be consistently increasing. This in return helps USDT to preserve its price closely pegged to at $1.
- Tether Reserves Composition: Straight from Tether’s Transparency page, this diagram shows the composition of Tether’s reserves. As you can see, only 12.42% of Tether’s reserves are composed of cash.
WHY USE OR MINT USDT?
There are three types of players in the Tether ecosystem: Individuals, merchants, and exchanges. If you recall our Consumer vs. DeFi participant breakdown in Section 3 for stablecoin users, you will recall that not every type of player interacts with a stablecoin in the same way. Along those lines, for USDT, individuals and Merchants tend to use USDT while exchanges mint USDT.
Use (more applicable to Consumers)
- Individuals: As we discussed in length in Section 2, individuals use USDT in many ways including peer-to-peer transactions and store of value. Given the ease of purchasing USDT from secondary markets like crypto exchanges, individuals rely less on minting new USDTs via Tether.
- Merchants: USDT allows for faster, international, and cost-effective payments for merchants.
Mint (more applicable to DeFi Participants)
- Exchanges: Most exchanges earn income from trades, so more trade volume entails more income. Increased trade volume can only happen if exchanges can attract more customers. Since most customers carry USDT, lots of exchanges offer USDT-based trades (e.g., selling BTC for USDT.) To be able to offer USDT trading pairs, exchanges need a lot of USDT in their reserves or liquidity pools at all times. So minting new USDT is an essential liquidity source for exchanges.
STABLECOIN PRIMER article series
Stablecoin Primer — Intro: Rower and slow cooker
Stablecoin Primer — Section 1: Path to stablecoins
Stablecoin Primer — Section 2: Stablecoin landscape
Stablecoin Primer — Section 3: Stablecoin types
Stablecoin Primer — Section 4: Stablecoin shallow dives — USDT (you are here), DAI, UST, and more
Stablecoin Primer — Section 5: Stablecoins’ future
Stablecoin Primer — Bonus section: Anything missed
Enjoy! Happy to chat further via comments, Twitter, or Linkedin
Special thanks to NEAR Team Grants for making this research possible.
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