Episode 18: Tarred and Tethered

The Never-Ending Saga of Tether, the $3B Stablecoin

If you follow crypto, you may have heard rumblings over the past week that the New York Attorney General’s Office has some beef with Tether, Bitfinex, and their affiliated banks. Well, we are here to play a game of Fact or FUD on the matter and try to untangle it.

In this episode, we explore the good, the bad, and the ugly of collateralization, fractional reserve, and — everyone’s favorite no-return crypto asset — Tether.

Listen to Episode 19

Trollbox or not, don’t mess with ‘MURCAH

What is a Tether Anyways

Getting money into and out of bitcoin is HARD — how do you take fiat dollars and turn them into bitcoin when crypto and banking don’t connect

Before 2013, anyone who wanted to get their hands on bitcoin would have to resort to mining it themselves (not that difficult, but also not that easy), get on local bitcoins, or wire money to Mt. Gox in Japan. In 2013, the first retail brokerage platforms in US, Coinbase and Circle, made life a little easer. Of course, once you had your bitcoin, there were also the unregulated, or simply, less regulated crypto to crypto exchanges, like BTCe.

In January 2012, a bitcoin enthusiast named J.R. Willett described the possibility of building new currencies on top of the Bitcoin Protocol, through a cryptocurrency called “Realcoin.” The idea was to allow complex financial tasks on top of bitcoin, and to enable “smart assets” (via smart contracts) and a second layer that would be the capital markets layer for bitcoin. This project was re-named and launched in 2014 as “Mastercoin” by a group of founders including Brock Pierce, Craig Sellars, and Reeve Collins. These founders were part of an associated entity, the Mastercoin Foundation, which would use the funds from the Mastercoin ICO to promote the use of this new “second layer.”

The Mastercoin protocol would become the technological foundation of the Tether cryptocurrency, and the first “tokens” were issued in October 2014, via the Mastercoin protocol but anchored to the bitcoin blockchain. This was really the pre-cursor to 2017’s ERC-20 tokens.

In November of that year, these tokens were renamed as “Tether” as part of a new company, Tether Limited, whose leadership included executives from both Mastercoin and Bifinex. At that time, Tether was widely publicized to be backed 100% by its original currency, and to be redeemable at any time with no exposure to exchange risk. The company’s website states that it is incorporated in Hong Kong with offices in Switzerland, without giving details.

Then, in January 2015, the exchange Bitfinex enabled trading of Tether on their platform for the first time. While representatives from Tether and Bitfinex say that the two are separate, the Paradise Papers leaks in November 2017 named Bitfinex officials as responsible for setting up Tether Holdings Limited in the British Virgin Islands in 2014, and the Tether website currently lists Bitfinex executives as also being Tether executives. The CEO of both firms is Jan Ludovicus van der Velde. Bitfinex is one of the largest Bitcoin exchanges by volume in the world.

When Tether first launched, volume was small, since the bitcoin market was small.

• At the end of 2015, Tether’s “market cap” crossed the 1M for the first time
• 2016 ended with $7M of Tether in circulation
• In 2017, Tether exploded as the crypto market exploded, and at the end of the year, the total volume of Tether in the market was $1.3B. That was a straight run, in 12 months, from $7M to more than $1B.
• Today, the market cap sits around $2.8B, and hovers within a $500M range of that number.

A few final notes on Tether

Tether was originally built on top of Mastercoin, one of the first ICOs, which later re-branded to Omni. Omni currently has a market cap of about $2M. Here’s is a great example of value not accruing at the protocol layer, but in the instrument itself. This might (clears throat, sips tea) just be an important lesson about the future of Ethereum and the stablecoins built on top of it. At peak crypto mania, Omni only reached a $50M market cap, nowhere close to the billions the token issued on top of it, Tether, has reached.

Today, there are two constructions of Tether, Omni / Bitcoin and ERC-20, although Tron and other protocols are also looking to get Tether onboarded.

• Tether was originally created to use the Bitcoin network as its transport protocol — via “Omni — to allow transactions of tokenized fiat. This version of Tether therefore “inherits” the stability and security of the longest established blockchain network, Bitcoin.
• Tether on the Ethereum blockchain, as an ERC20 token, is a newer transport layer, which now makes tether available in Ethereum smart contracts or decentralised applications on Ethereum. As a standard ERC20 token it can also be sent to any Ethereum address.

Since Tether is currently built on top of two different protocols (Bitcoin and Ethereum), when users send tethers to other addresses, they need to carefully check the destination address to confirm the format and select the correct protocol. As we discussed in Episode 13 on interoperability on the Cosmos bitcoin hub, Tether is another such bridge to enable digitized dollars to enter the crypto ecosystem.

So How a Tether Actually Work

Someone needs to get USD into the crypto ecosystem. They deposit dollars with Tether Holdings Limited, a BVI based company, and receive an equal amount of Tether. At any time, any holder of those Tethers should be able to redeem them for those dollars. In this sense, Tether is a bit like a depository receipt.

However, this reimbursement is dependent on meeting the terms and conditions of the Tether service agreement. However, Tethers have an active secondary market, so most people opt to trade tether for other assets. This is why Tether doesn’t always have a price of $1 — it fluctuates depending on the market’s sentiment about the redeemability of a Tether and the need for stable cash.

How is Tether used?

Why do people hold US dollars? See our notes for Episode 14 about liquidity, where we discuss this in depth. Because the US dollar is backed by the strength of the US economy and governance system and ability to protect its borders, which is what makes the US credible and credit-worthy. The US dollar is highly exchangeable, and it is deeply liquid.

Tether was originally created to solve a few problems in crypto exchange:

1. Provide a Reliable USD trade pair, especially in places where there is no USD liquidity, say, on a crypto to crypto exchange.
2. Enable Rapid Settlement. If two parties make a trade, can settle instantly on the same network where the trade happened. Tether enables this on BTC (via Omni) and ETH, more coming in the future.
3. Pooling of Liquidity. Enables aggregation and pooling of USD balances outside the correspondent banking system, and enable this liquidity to move across exchanges.
4. Manage Volatility. Many traders who cannot touch fiat may opt to store their crypto in Tether at times of high volatility. Likewise, regulatory events where bank access is cut off could also result in an increased demand for Tether.
5. Circumventing Restrictive Regulation. Once tethers are in the secondary market, they can be exchanged anywhere without limitations. Most of the newer, regulation-heavy stablecoins lack this feature and can only be traded in one venue or a small handful of approved venues.

A Brief Detour to Quantity Theory of Money

The daily volume of Tether changing hands ranges anywhere from $2B to $10B per day, which means the velocity of a tether is 1 or greater. The velocity of money is the frequency at which one unit of currency is used to purchase domestically- produced goods and services within a given time period. In other words, it is the number of times one dollar is spent per unit of time.

The velocity of money provides a perspective on money demand.

You may have heard the equation MV = PQ, which is called the quantity theory of money. It comes from Monetarism, also called the Chicago School of economics, which was popularized by Milton Friedman. This school of economic thought that holds that the money supply is the main determinant of economic activity.

In the equation MV = PQ, M is the money supply; V is velocity — the number of times per year the average dollar is spent; P is prices of goods and services; and Q is quantity of goods and services. The equation suggests that if V is constant and M is increasing, there must be an increase in either Q or P.

In other words, if the money supply is growing, the economy will grow, and if money-supply growth is accelerating, so will economic growth. We’re not debating economics here, but simply providing context for Tether’s astronomic growth, with a 100x increase in issued tether, M, and a corresponding increase in crypto P and Q. The insane velocity, V, and issued supply, M, of Tether has to be viewed in the context of changes in the crypto market.

Lastly, we would be remiss if we didn’t compare Tether to the overall market for digital on-chain dollars. Tether is still the favored on-chain digital dollar.

Data retrieved from coinmarketcap.com on 4/28/19, but suggest Messari to those serious about their data. Disclosure — as an investor in Messari, I’m biased.

So What’s the Deal with These Dollars

Ok. So now we get to the important part. The main reason Tether has been under so much scrutiny is because the question is — are the dollars that are supposedly backing Tether actually there?

All tethers are pegged at 1-to-1 with a matching fiat currency (e.g., 1 USD₮ = 1 USD) and are backed 100% by Tether’s reserves. As a fully transparent company, we publish a daily record of our bank balances and the value of our reserves. Tethers can be securely stored, sent and received across the blockchain and are redeemable for cash (the underlying pegged asset) pursuant to Tether Limited’s terms of service.

There’s a different between assets that are fully collateralized, or have a 1:1 backing with the underlying asset, and a partially collateralized asset. The difference is RISK. When you buy a note or an instrument that is not fully collateralized, the bearer (holder of that note) takes on the credit risk of the issuer. Reading Tether’s terms of service is important here. So if Tether is not 1:1 backed with dollars, but holders believe it is, these holders of Tethers are taking an unexpected risk. The issue here is transparency and trust.

So What is Going on with Tether, and What May Happen Next?

NY AG wants information. They want to know what risk is posed by Tether, BitFinex, and its banking partners. By the way — if it subpoenas Tether or Bitfinex, it will have a treasure trove of data its counterparties. Given the recent refusal of many exchanges to participate in the AG’s data collection requests, we may see more moves like this in the near future.

Currently, Tether volume and prevalence in the market far exceeds that of its counterparts. This will continue to be the case for a long time to come, in my view, because people are willing to take the RISK of Tether not being exchangeable in order to USE it as an on and off ramp for trading efficiency, liquidity, ease of use, and all the other features it has.

I believe that in the future every platform will have its own stable currency pegged to fiat or other existing financial benchmarks. The technical barrier to entry is basically zero, especially as protocols compete to have dollars and other assets issued on top of them with ICO foundation money. The popularity and use of these dollar assets or pegged assets will depend on the liquidity and connectivity of these assets to the markets where assets trade. The key question will be how these instruments are constructed, collateralized, represented, managed, and audited. As with all things in life, the devil will be in the details…

For the rest — listen to the episode!