Let’s talk about Tether (Part 2)

We had previously in Part 1 provided a quick summary on yesterday’s events. In Part 2, we will do a deeper dive to consider the legal complexities behind Tether’s turmoils of late.

But first, by way of context…. Tether, the grandfather of all asset-backed stable-coins, was the very first in its kind, meant to be backed 1:1 to the USD held in its bank account. USDT served a simple function, and a simple need, as a trading hedge against its more volatile counterparts.

Per its whitepaper, USDT was backed by its Proof-of-Reserve. It was a simple onchain-offchain function, where Tether, as the issuer, would publish monthly audits and verifications of its bank account. There were always questions abuzz, and despite allegations that SEC had subpoenaed its accounts, an audit was never completed.

In June 2018, with much speculation ongoing about its solvency, Tether issued a Transparency Report in conjunction with law firm Freeh, Sporkin & Sullivan LLP. The report had some weight from the legal perspective, attesting that Tether had in fact sufficient unencumbered assets to match the USDT in circulation, but this was not a full audit of its accounts. Further, the reports also provided no firm guarantee that Tether was not operating a fractional reserve.

Taking a step back, even if Tether had a proof-of-reserve, of solvency, then what? Fundamentally, the way Tether was legally structured seemed problematic.

Tether functioned simply; a User simply exchanges his USD to USDT. This USD was then transferred to Tether’s centralised bank account. There were 2 potential key problems:

1. Given that the bank account was controlled by Tether, there was every risk of the company absconding with the assets therein.
2. Further, as per the Transparency Report, it was very clear that the underlying USD were assets belonging to Tether. In the event of an insolvency, the holders of USDT could very well be nothing more than unsecured creditors ranked last in the hierarchy.

These deep-rooted problems, coupled with the opaqueness that Tether had functioned on, accelerated and exacerbated fear, uncertainty and distrust. And as soon as Tether’s bank partners were shoved into the spotlight, with rumours that Noble Bank was going bankrupt, this was sufficient to trigger many investor’s flight-to-safety instincts.

To rehash, on 15 October 2018, at the peak, USDT was trading at a 15% discount below its par value of US$1 whilst its stablecoin counterparts, such as TUSD and PAX, were trading at a premium of 20% above its par value of US$1. Over a span of 9 hours that day, TUSD had seen its market cap increase from 141 million to 163 million, while PAX market cap had doubled from 24.8 million to 51 million. USDT had seen its market cap reduced from 2.4 billion to 2.25 billion. Accordingly, USDT’s circulating supply had decreased from 2.5 billion to 2.3 billion. TUSD circulating supply increased from 135 million to 159 million. PAX circulating supply doubled from 23.9 million to 50.5 million. While it might not be significant in the grand scheme of things, it was a good indication of where the market was heading.

The rise of the stablecoins — a summarised case study

To understand an investor’s flight-to-safety response, we have to understand the difference between USDT and the rest of the stablecoins available on the market.

Based on a simple comparison between Tether and the rest of the stablecoins, the differences were quite apparent:

1. USDT operates without a licensed overseer, as compared to TUSD, which purportedly employs a legal trust with an independent licensed trustee, or GUSD or PAX, both which were supervised by licensed custodian fiduciaries.
2. Despite being around the longest, USDT which has been unwilling to publish any audited reports (assuming any audit was completed), TUSD on the other hand has proceeded to publish regular independent attestations by Cohen & Co. Audit reports by GUSD and PAX’s are also due soon.
3. Where TUSD, GUSD and PAX have partnered with credible U.S. banks backed by FDIC, USDT’s banking relationships have been uncertain at best. This had increased uncertainty amidst speculation.

The key to this, is transparency. While USDT and its partners are still shrouded in mystery, the rest of its stablecoin counterparts have been very clear from the beginning. While USDT has remained reluctant to publish any form of audited reports, its counterparts have been transparent about their banking relationships as well as the proceeds in their trust accounts. This has lent credibility in a volatile market where there is a real need for a proper trading hedge.

This was coupled with the fact that USDT functioned on a primitive legal framework; in the event that USDT did go insolvent, USDT holders would no longer be guaranteed 1:1 redemption given that it was likely that they might be construed as nothing more than unsecured creditors of Tether. The various successors of USDT had provided various solutions to this problem, including the imposition of a licensed fiduciary to oversee its accounts in order to reduce the risk of an improper use of reserves, or embezzlement, thereby reducing the risk of insolvency. There is a further fix to this issue, by implementing a full legal trust model, where even in insolvency, these assets are protected purely for the benefit of the token-holders, as has been contemplated by Rate3’s tokenization protocol.

What’s next for stablecoins?

Stablecoins are still very much in the infancy of their development. So long as most users remain hard-wired in measuring the value of mediums-of-exchange in terms of fiat currency — as is the case currently, it is an imperative for stablecoins to provide confidence assurance measures to buyers by transparently guaranteeing redeemability for fiat, for example through a legal trust model. Such guarantees form a fundamental primitive that is necessary to facilitate user trust and adoption, enabling applications — and subsequently an ecosystem — to develop and build on top of it.