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Time for Defi to reduce $USDT exposure

It’s been a week since the $UST collapse — a black day in crypto that wiped out value for millions of retail investors. In these past 7 days, $USDT, the largest stable-coin in crypto has been making some strange maneuvers.

In this article, I highlight some unusual activity in $USDT and its potential implications.

On 11'th May, $USDT, a stable-coin issued by Tether, showed first signs of a de-peg and went all the way down to 0.9935. After a couple of hours, it recovered ground and hit 0.9989.

And then, a few hours later, on 12'th May, in a matter of 6 hours, $USDT went all the way down to 0.95 before coming back to 0.99. It was interesting to note that $USDC and $BUSD were trading above par during this time. Investors were probably dumping $USDT for $USDC and $BUSD.

At the time of writing this article, $USDT has still not recovered its peg completely and is trading at 0.998 levels.

USDT de-peg and recovery. Note that $USDT is consistently below peg for over a week. (Source: Coinmarketcap)

The first de-peg was attributed largely to investor panic in the aftermath of $UST collapse. But continued weakness of $USDT means that there are more people looking to dump USDT than to hold it. This is unusual and disconcerting. Let me explain why..

If we look at the market cap chart of $USDT over the past 7 days, we see a ‘vertical drop’ every day. $USDT tokens between $1-$2 billion are being pushed out of circulation on a daily basis. Since $USDT is a centralized stable coin backed by US dollars, the only way to burn $USDT is by handing it over to Tether (the company that mints USDT) and redeem US dollars in exchange.

Drop in USDT supply (Source: CoinMarketCap)

As you can see in the above chart, there is a drop in supply of ~8 billion USDT. That is ~10% supply reduction in just over 5 days. Also, note the vertical drops each day highlighted in red circles.

If we zoom-out a bit and look at the entire life of $USDT, we will notice a sharp spike in USDT during the 2021 boom but even the rate of growth during that period is slower than the rate of fall over past 5 days.

Rate of change of USDT is the highest in past week. Source: CoinMarketCap

A persistent, high burn rate right after the $UST de-peg is unusual when we look at the entire lifecycle of $USDT

Protos did an investigation into $USDT last year (report available here). One of the key findings of this report was that just two market makers, Alameda Research and Cumberland Global, contributed to 2/3'rd of $USDT issuance. Combined, they accounted for $49.2 billion (71%) of new $USDT issuance. In all, Tether issued ~90% of USDT to market makers and individuals (small transactions) only accounted for 2.3% of USDT issuance (so much for decentralization..).

For people who don’t understand who market makers are, market makers are professional investors who understand markets much better than retail investors. They create liquidity in markets by placing bid/offer rates to buy and sell various crypto assets.

In short, money deployed by market makers can be termed ‘smart money’ whereas most retail investors money is euphemistically categorized as ‘dumb money’. ‘Smart money’ owners know the exact risks before deploying capital, ‘dumb money’ owners (usually) are driven by emotions and hype.

90% of Tether issuance is made to market makers (Source: Protos.com)

Now, add the three facts above:

  1. USDT has still not recovered peg after 5 days
  2. Sharpest USDT withdrawals happened in the past 1 week
  3. Most people deploying USDT are professional investors

We can make a reasonable conclusion that smart investors are likely dumping $USDT in exchange for US dollars or other stable coins. Question is WHY? What are market makers seeing that retail investors aren’t? Is this a slow bleed before a ‘tsunami’ and a major $USDT de-peg? These are natural questions that come to mind specially after $UST collapse.

Most people (including CTO of Tether, Paolo Ardoino obviously) think that such movements are perfectly normal and $USDT is well capitalized to absorb short term liquidity squeeze events.

Source: https://twitter.com/paoloardoino

Common logic given to us to explain such events is:

  1. This temporary de-peg is because of investor panic after $UST collapse
  2. A broader risk-off environment where investors across stocks, bonds, crypto are dumping risky assets in exchange for US dollar

While this might be partially true, this logic can be countered by a few questions:

  1. Why doesn’t this logic apply for USDC & BUSD, the second and third largest stable coins? If investors are scared in a risk-off environment, shouldn’t these two also see redemptions? But they haven’t.
USDC supply over past 7 days (Source: CoinMarketCap)

2. Market makers love volatility — higher the volatility, greater is the potential for a market maker to make money. In such a high volatility environment, it makes no sense for market makers to give up leverage (capital is leverage) by dumping $USDT for dollars. In fact, it is the opposite — in such circumstances, traders and market makers want more $USDT to make more bets.

To digress, each trading firm has two teams — a market making team that adds risk to the company and a risk management team that makes sure that market makers are not taking excessive risks. Risk management teams would not flag transactions involving stable currencies (so long as they are stable) because stable currencies are supposed to have low (zero) volatility. Logic here is that a stable asset with zero volatility does not add risk to the firm (unless it stops being stable).

The fact that market makers are dumping huge amounts of stable currency in a high volatility environment is evidence that something isn’t right with $USDT

Tether has always been secretive about its reserves:

  1. Tether refuses to be audited by a big accounting firm. Audits also happen at irregular intervals. For a long time, Tether convinced everyone that each USDT is backed by dollar until they were forced to admit otherwise by the New York Attorney General
  2. Tether’s holdings state that ~37% of funds are locked in Commercial Paper & Certificates of Deposit (short term debt given to companies) and ~5% funds are locked in Corporate Bonds & Funds. We don’t know who the counter-parties for those bonds/commercial paper are & what would be the liquidity of these instruments if economy enters a recession (which is a likely scenario now).
Tether reserves (Source: Tether.to)

3. Tether’s CTO came out saying they have cut Commercial Paper holding by 50%. The fact that he had to come up with that statement in itself exemplifies the ‘risk’ to these reserves.

I personally cannot fathom the logic of investing reserves in anything except Cash, T-Bills and Money Market funds. Anything beyond this, regardless of credit ratings, should have been a strict NO NO. How in the world is the crypto community allowing this?

In a risky, recessionary environment where credit is squeezed and costly, it is absolutely ridiculous for the largest stable coin company to hold any asset beyond cash, t-bills and money market.

4. Does all the $USDT minted have a corresponding US dollar transferred back to Tether? Last year saw $57 billion $USDT added to circulating supply — do we really know that $57 billion US dollars were transferred by market makers to Tether? As someone who understands traditional markets, I think that not all of this $57 billion was in hard cash — there must be some non-cash instruments used by counter-parties involved(unfortunately, we will never know this)

Bernhard Mueller wrote a wonderful piece on ‘Tether Black Swan’ wherein he describes possible ways in which companies can issue ‘commercial paper’ of ghost companies and effectively print $USDT that is not backed by US dollars (stable coins printed out of thin air). While we don’t have proof for this, the fact that all this critical data is hidden from scrutiny makes it discomforting. Tether issued $4.4 billion USDT to its parent company iFinex — this surely is discomforting — how are we to know that actual US dollars were transferred from iFinex to Tether for this transaction..

USDT issuance by Tether to its parent entity iFinex was $4.4 billion (Source: Protos.com)

Stable coins have been a boon to the Defi ecosystem — only with a vibrant stable coin ecosystem can Defi run its pooling, farming, trading and portfolio management services. This is kind of obvious now — $USDT supply has grown from $21 billion to $78 billion while the TVL across Defi platforms has increased from $18 billion to $235 billion.

Defi TVL increased from 18 billion to 235 billion. Source: DefiLama

Even after a sharp drop in Defi TVL (thanks to Anchor Protocol wipeout and ton of liquidations triggered after $BTC dropped to 24k on May 12), Glassnode shows that ~20% of USDT tokens are still locked in smart contracts.

That is roughly $15 billion worth of $USDT, almost 12% of the Defi TVL ($ 112 billion at the time of writing).

~20% USDT locked in smart contracts (Source: Glassnode)

I see the following risks to the ecosystem

  1. Chain is as strong as its weakest link

Platforms such as dY/dX, Aave, Uniswap, Curve, Lido etc have built extensive exposure to USDT.

Tons of smart developers, retail investors are putting in their time, effort and capital to build new, fair, transparent, secure and decentralized applications. It would be tragic if all these apps are taken down because of excessive trust placed by the ecosystem on one opaque, lying and centralized entity that refuses to subject itself to a comprehensive, periodic audit.

If collusion by some market makers & a stable coin entity pulls down a ton of open-source, transformational projects, then the real question to ask is, how is this different from the world of traditional finance where central banks, commercial banks, hedge funds screw the economy. We are back to the ‘win is mine, loss is yours’ culture of traditional finance (only the players are different this time)

It would be tragic if the entire Defi ecosystem of developers, entrepreneurs, investors are taken down by one entity; Defi stakeholders should evaluate systemic risk of a $USDT collapse and actively reduce leverage & exposure.

2. Give Governments a stick to beat Defi

I’ve always felt that stable coins are the Trojan Horse for Governments and Central Banks to control and subdue crypto markets. They must be silently giggling at the fact that crypto community has created a systemic dependency on centralized stable coins. It is like a ‘Achilles Heel’ that can be openly attacked by people who wield power. And the one thing we know about people with power is that they will use it, sooner rather than later. Central Bank Digital Currencies (CBDCs) and a wave of regulations will be a weapon of choice to attack stable coins.

As things stand today, entire Defi can be brought to its knees if US Treasury makes one phone call to 3 entities — Binance, Circle, Tether. So much for decentralization, security and immutability…

Crypto space over the past 18 months has chosen ‘growth’ over ‘security’ — that choice has resulted in massive $USDT minting and circulation within the entire Defi ecosystem.

While all of us loved those juicy 400% APYs, it’s time to step back and take a long term view of things (specially after the $UST debacle). Short term greed can potentially kill long term growth.

Key questions to ask are:

  1. Is this an organic movement or controlled by a few powerful players who control everything from VC funding, to exchanges to OTC market making?
  2. Are Alameda, Jump, Binance ushering innovation or pushing us to reckless risks that will come back to haunt us with stifling regulations?
  3. The only 2 blue-chips people believe in today are Bitcoin and Ethereum — both grew organically and weren’t at the mercy of market makers to survive. Tokenomics, governance and growth need to be thought from a long term perspective (not a VC perspective)
  4. Is simply having transactions on-chain a metric for immutability and transparency? Why is the capital behind these transactions not transparent? Why isn’t anyone raising a voice against it?
  5. Are we robust to survive a Fed QT, rising interest rates and persistent inflation? If no, what are the most likely points of failure? Have the best brains collectively analyzed these risks?

Some corrective measures needed to make Defi sustainable:

  1. All key crypto founders Hayden Adams (Uniswap), Rune Christensen (Dai), Michael Egorov (Curve) etc need to collectively brainstorm and come up with a white-paper on systemic risks to Defi. This needs to be widely circulated to retail investors who can understand the risks properly.
  2. Every Defi protocol should accept $USDT as collateral only if they commit to transparency and periodic audits. Otherwise, investors and governance token holders should ban $USDT as a possible collateral.
  3. Defi entrepreneurs should not raise capital in $USDT. Investors should fund crypto startups in US dollar or stable coins that stick to minimum transparency standards
  4. Innovate around stable coins. I know we failed with $UST Terra but atleast we know what doesn’t work. Projects such as OlympusDAO, MakerDAO, Frax Finance Community and many more need to come up with variations of a ‘decentralized stablecoin’. And yes, stable coin projects should have good risk management, low leverage and should scale gradually —super fast growth creates high leverage, loose risk controls and potential failures.

$USDT is making unusual movements & smart investors seem to be selling the largest stable coin. Crypto community has sacrificed longevity for short-term profits and 2021 bull market has created huge ‘centralized’ entities that have spread their tentacles across the Defi ecosystem.

As a Defi maximalist, I hope all Defi stakeholders realize the risks we are building by increasing $USDT exposure. Its high time that every protocol reviews their stable coin exposure and actively cuts down $USDT exposure.

In the end, what matters is to protect what we built so far & take measured risks to improve what we have and focus on long term sustainability.

I hope Defi ecosystem saves itself from the fate of ‘Troy’.

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Defipi Guy

Defi investor and researcher. Macro analyst. Believe in first principles thinking. Believe in humility, open-mindedness and long term positive sum games.