Stablecoin on the Run

July 29th, 2020

Stablecoin on the Run

Research Primer on Tether (USDT)

HIGHLIGHTS

  • Created in 2014, Tether (USDT) has remained the dominant and most widely used stablecoin and can be credited with kickstarting the stablecoin boom we analyzed in our 2018 and 2019 State of Stablecoins reports
  • Since early 2019 Tether has consistently ranked as a top-5 cryptocurrency in terms of market value and recently supplanted Ripple (XRP) in the top-3
  • Various estimates place USDT’s trading volume either second or ahead of the largest cryptocurrency by market value, bitcoin (BTC)
  • In addition to its market value and liquidity advantages, Tether is one of the most significant cryptocurrencies in terms of the total number of cryptoasset trading pairs and central role it occupies in leading cryptoasset trading markets, particularly Asian exchanges
  • Tether has operated in a more opaque manner than many other stablecoins, running from one banking partner and regulatory jurisdiction to another, raising numerous criticisms and legal concerns
  • Recently both Tether management and various regulatory actions have created greater transparency into Tether’s reserves and operations, but reasonable concerns over future regulatory status and banking access remain
  • While Tether has so far successfully fended off many new stablecoin competitors, without obtaining the backing of a top US bank (which seems unlikely) it will have difficulty dramatically multiplying its size beyond current levels

OVERVIEW

Formerly known as RealCoin, Tether was established in 2014, making it one of the oldest stablecoins. USDT is a cryptocurrency that leverages distributed ledger technology to allow individuals and organizations to store, sends, and receive digital tokens pegged primarily to US dollars (USDT), but also euros (EURT), the Chinese yuan (CNHT), and gold (XAUT). Tether tokens can be sent/received peer-to-peer across the globe, quickly and for a fraction of the transaction costs of many legacy payment networks.

Traditionally, to create tether currency units (USDT), one must first make a US dollar deposit to Tether Limited, the company that operates the stablecoin. Per Tether Limited’s FAQs, USDT digital tokens “are 100% backed by Tether’s reserves”, and Tether Limited is committed to maintaining a conversion rate of “1 tether USDT equals 1 USD”. To our knowledge, Tether Limited has reliably redeemed USDT tokens at par throughout its operating history.

The actual Tether digital crypto token is issued and redeemed using different blockchain networks. For most of its history Tether utilized the Omni Layer protocol (previously known as Mastercoin), an ‘overlay network’ that runs on top of the Bitcoin blockchain. More recently, Tether expanded to enable USDT token issuance/transactions/redemption via the Ethereum (ETH), Tron (TRN), EOS (EOS) networks, as well as the Liquid bitcoin ‘sidechain’.

Issuance and use of the Ethereum ERC-20 token version of Tether (USDT-ETH) have exploded, surpassing the Omni Layer in late-2019. In spring 2019 the value of all Tether transferred on the Ethereum network also surpassed transfers of Ethereum’s native currency unit (ETH). For the current value of USDT issued on different blockchains and other statistics, please refer to a live summary of Tether tokens issued on the Tether website.

Backed by off-chain collateral, Tether protects its stakeholders from cryptocurrency volatility through a soft peg. The value of USDT fluctuates around its one-to-one reserve ratio between the token (tether) and its associated traditional fiat assets (e.g. US dollar bank deposits). However, arbitrageurs have a financial incentive to moderate any significant fluctuations by redeeming/purchasing USDT whenever it is meaningfully profitable to do so.

Once issued, a tethered token can be transferred, stored, and spent like a bitcoin or any other cryptocurrency. The fiat currency deposited to create tethers is thereby effectively transformed, gaining the general properties of a cryptocurrency while also having its price “tethered” (stabilized) to the reserve assets.

The tether can be traded for other tokens at exchanges or withdrawn and held in any bitcoin wallet where the user controls their private keys. Tether Limited generates revenue from imposing a small fee on the issuance of new tokens.

Stablecoin on the Run

STRENGTHS

Longevity and Familiarity

Tether is one of the oldest stablecoins and therefore benefits from the so-called ‘Lindy effect’, which posits that age enhances the life expectancy of a technology. Of today’s large stablecoins, Tether also has significantly longer stability and redemptions track record and thereby earned the trust of many traders.

Liquidity

While its market value share significantly declined in Q4 2018, Tether dominates the current stablecoin trading volume landscape with an estimated >80% exchange volume market share.

Tier-1 Exchange Support

Tether has proven particularly attractive to major exchanges that do not offer US dollar customer accounts. For example, in 2017, Tether experienced a rapid increase in volume on Poloniex, arguably playing a pivotal role in it becoming the then-market leading exchange by volume in mid-2017.

Tether’s market cap has dramatically grown from ~$7 million in 2017 to ~ $10 billion today. The upsurge in USDT’s total market value has mainly come from adoption by active cryptocurrency traders who use Tether as risk management and hedging tool. Crypto traders can move funds into USDT to de-risk from general crypto volatility while simultaneously avoiding leaving the cryptocurrency market by converting back to fiat currency. As shown in the below chart, Tether’s continued growth demonstrates the significant demand for fiat-backed cryptocurrencies in the market.

Stablecoin on the Run

ISSUES / TRADEOFFS

Negative Publicity

Since 2015, many cryptocurrency exchanges and trading platforms have integrated and partnered with Tether to support deposits and withdrawals. However, Tether has been accused of running a ‘fractional reserve’, which many felt was proven to be true following disclosure of a hidden ~$850 million loans to sister company, Bitfinex. Tether’s reputation and image have been impacted by challenges associated with public transparency regarding its backing, though it has maintained that USD reserve equivalents have always been sufficient. The recent FSS report was a first step in showcasing such proof, but more will be needed to improve public transparency going forward.

Counterparty Risk & Reliance on Traditional Banking System

Tether’s vulnerability to counterparty risk is significant and inherent to its current design. The company relies on legacy banking institutions, in offshore banks previously in Taiwan and now in the Caribbean, to custody its fiat reserves. Therefore, tethers are subject to the same credit and counterparty risk inherent with any standard bank deposit.

Lack of Legal Rights for Tether Holders

Concerns have arisen over what exactly Tether promises and its legal obligations regarding redemptions. Tether Limited issued a legal clarification, which in essence states that holding tethers provides no legally enforceable rights for the holder.

Opaqueness / Single Point of Failure

Tether more broadly represents two main problems with fiat-backed stablecoins: (1) lower transparency than on-chain collateralized systems, and (2) a centralized, single point of failure. Many believe Tether has not gone far enough to minimize the degree of trust and dependence on Tether Limited, which is relied upon to circulate funds by creating and destroying asset-backed tokens.

OPPORTUNITIES FOR IMPROVING TETHER

Disclose Reputable Asset Custodian

Any asset-backed cryptocurrency is only as secure as the ultimate custodian of the underlying assets. Depositing the underlying funds/assets in a banking institution that is secure, reputable, and trusted would potentially represent a significant improvement to Tether. In short, the safer the bank, the better. An ideal candidate would be a true ‘narrow bank’ in which assets are as liquid as its liabilities, meaning that deposits are invested one-to-one in safe government bonds or held in cash with no fractional reserve banking. While Tether’s Nov. announcement that it had secured a banking relationship with Deltec, based in The Bahamas was a step in the right direction, Deltec is not a Tier-1 financial institution. It lacks the balance sheet and reputation custodians used by some of Tether’s competitors.

Enhance Trust in the Issuing Entity

Significant improvements could also be made with regards to the issuing entity as this is where the majority of the operational risk lies regarding the creation and destruction of asset-backed tokens — the greater the trust and transparency, the better. In fact, this entity could be a deposit-accepting bank itself.

Add Legal Enforceability

Another perhaps difficult area is determining the legal status of the token itself. Tethers have no associated legal enforceability. Any coin that gave the owners real legal rights (but also still facilitated peer-to-peer exchange) would represent a vast improvement over the current offering. Whether such a coin would be legally deemed ‘money’,’ security, or something else is unclear.

LOOKING AHEAD

Despite its weaknesses, Tether remains entrenched in the top-5 cryptocurrencies in terms of total value and has moved ahead of bitcoin in terms of the daily trading volume. Contrary to its reputation, Tether has also embraced some regulatory oversight (e.g., registering as a Money Service Business with the Financial Crimes Enforcement Network (FinCEN)). However, Tether has been shrouded in suspicion around its collateral reserves, and third-party verification of Tether’s off-chain fiat reserves has not erased all doubts. Concerns over Tether’s role in crypto asset trading market manipulation have also been leveled, although recent research has countered such manipulation concerns.

Traders have not shied away from using Tether on crypto exchanges, and Tether has built up trust with leading cryptocurrency exchanges, which is a key factor in its continued dominance. However, Tether’s shortcomings have created an opportunity for an alternative stablecoin to enter the market, already indicated by the drop in its market value share to under 90%.

Stablecoins that minimize trust and counterparty risk by storing collateral on-chain offer a particularly sharp contrast with Tether’s relatively centralized and opaque structure. Tether users must remember that the principle of caveat emptor (“let the buyer beware”) still applies when holding Tether.

Looking further ahead, while Tether has so far successfully fended off many new stablecoin competitors, Tether acknowledges that without obtaining the backing of a top US bank (which seems unlikely at present) it will have difficulty dramatically multiplying its size beyond current levels. Another existential threat potentially facing the entire USD-backed stablecoin space is the introduction of a US digital dollar.

TETHER

Overview

TICKER(S): USDT

LAUNCH DATE: 2014

KEY DIFFERENTIATORS : Liquidity, longevity

Format

TOP-LEVEL CATEGORY (ASSET-BACKED vs ALGORITHMIC): Asset-backed

SUB-CATEGORY (EG OFF-CHAIN COLLATERAL-BACKED): Off-Chain Collateral Backed

COLLATERAL / RESERVES TYPE: USD, EUR (Yen pre-announced)

UPSIDE PARTICIPATION — GOVERNANCE TOKEN, DIVIDEND, INCENTIVE SCHEME (EG SEIGNIORAGE SHARES): No

STABILITY BENCHMARK / REFERENCE PEG: USD

TRANSPARENCY (FUNCTIONAL): Low-Medium

Adoption

MARKET VALUE: $9,992,386,657

RANK — OVERALL MARKET VALUE: 3

LIQUIDITY ( DAILY VOLUME): $40,942,092,731

RANK MARKET LIQUIDITY: 1

Legal / Compliance

Ownership: iFinex (BitFinex parent)

Legal Entity: Hong Kong-Based Ltd (Tether Limited)

Legal Jurisdiction (Country): British Virgin Islands

Regulatory Status: Money Service Business with the Financial Crimes Enforcement Network of the US Dept. Of Treasury

Country Location — HQ / Primary Team: London / Distributed

Technology

Platform: Omni Protocol, Ethereum, Tron, EOS

Decentralization: Low

Automation: Low

Complexity — Stability Mechanism: Low

Open Source (Yes = Full / Partial): Hybrid (operates on top of open-source blockchains like Omni, etc.)

Investors, Team & Partners

INVESTORS (TIER 1 & OTHERS): Unknown

FUNDING RAISED TO DATE: Unknown

BANKING RELATIONSHIPS: Deltec Bank (The Bahamas)

PARTNERS (BIZ DEV / ECOSYSTEM): BitFinex

GENERAL INTENDED USE: Synthetic US dollar

WEBSITE: https://tether.to/

Read more of our research primers at blockchain.com/research.

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