What does Tether try to achieve?
According to Tether’s website, Tether aims at introducing a stable coin to the cryptocurrency space. It achieves this by pegging Tether (the name of the coin) to the value of a dollar, such that ideally, 1 Tether will always equal to 1 U.S. dollar.
Tether is listed on various exchanges (Binance and Bittrex for example) and traded against other cryptocurrencies. Traders can use Tether pairs as a safe haven during extreme market volatility periods.
Here is an example to using Tether as a safe haven. Suppose I have a portfolio consisted of 500 Ripple, and the market has been down for three consecutive days and I want to limit my risk exposure by converting my portfolio back to U.S. dollar. One way to do it is to sell Ripple for Bitcoin (or other major cryptocurrencies such as Ethereum or Litecoin) on the crypto-to-crypto exchanges (i.e. Bittrex), send the major cryptocurrencies to crypto-fiat exchanges (i.e. Coinbase), and sell the major cryptocurrency for U.S. dollar.
This method is costly in money (in terms of selling fees and transaction fees for moving cryptocurrencies through exchanges), and the latency between each transfer also introduces volatility and risks to my operation.
The alternative method is to use Tether. If my crypto-to-crypto exchange has XRP/USDT pair, I could sell my Ripple instantly for USDT, knowing that the value of USDT won’t change (theoretically) and can later use this USDT to re-construct my portfolio.
How does Tether achieve a 1:1 exchange rate?
Theoretically, when there is a greater demand for Tether and the value of Tether rises above 1 U.S. dollar, Tether Limited (the company that develops Tether) will issue new Tether to the market, thus increasing the supply of Tether and suppressing the price. When there is a lesser demand for Tether and the value of Tether falls below 1 U.S. dollar, Tether Limited will buy back the Tether and prop up the price.
It’s worth to note that Tether by itself is not a minable coin but a token issued through the Omni protocol (using the colored coin system), which stores data on the Bitcoin blockchain (recently Tether started using Ethereum as well). Although Tether Limited has no means to restrict users from sending Tether to one another, the company has the ability to issue and destroy any amount of Tether. This ability allows the company to make adjustments and maintain the 1:1 ratio between Tether and U.S. dollar.
Why is Tether under the public and government scrutiny?
Back in November 2017, Tether was hacked and lost $31 million worth of Tether (which actually did not hurt Tether Limited because a software upgrade was implemented, which means the network is hard forked and the lost tokens are locked up forever). The hacking did raise public attention towards this token. However, what’s most concerning is the fact that Tether Limited has been issuing millions of Tether since last December. Till this date, there is 2 billion Tether issued and circulating. Based on Tether’s value proposition, Tether Limited should be holding $2 billion in its bank account.
The fact of issuing a lot of Tether alone is not concerning. Tether Limited has to issue more Tether in order to keep the exchange rate at $1 dollar in the case of excessive demand for Tether. However, what’s concerning is that since April 2017, Tether has stopped accepting international wire-transfer deposits. So if millions of Tether were issued since December 2017, where does the U.S. deposit come from? Who is buying Tether?
So who is buying Tether/ to whom is Tether sold?
Exchanges. Exchanges might be the only reasonable explanation to the phenom of increasing issuance of Tether despite the international wire-transfer freeze. Large exchanges that offer Tether trading pairs might still contact Tether Limited and buy Tether from the company. This scenario also aligns with the hypothesis that most users use Tether as a safe haven asset during market turbulence (which trades Tether/Other Crypto pairs), instead of using Tether as a gateway to investing in Altcoins (which trades Tether/Fiat and Tether/Other Crypto pairs).
While we can formulate a reasonable hypothesis that explains Tether Limited’s recent activity of printing millions and millions of Tether, there is still no hard evidence(i.e. an audit report) that gives the whereabouts for the $2 billion reserve. Tether might not want to disclose where they stored the funds because most banks are reluctant towards working with clients in the cryptocurrency space (i.e. Wells Fargo ended its relationship with Tether in April 2017). As explained in this BitMex article, the biggest risk does not come from the lack of reserve but rather a shut-down from government orders.
It’s ironic that Tether’s original mission is to provide a stable cryptocurrency and offer a safe haven in times of market uncertainty. However, the Tether itself is becoming a major uncertainty in the market by drawing scrutiny from both the regulators and retail investors.