In the world of digital assets, volatility—in a catalytic way—is a key driver of growth. However, this volatility is not appealing to everyone, particularly to those who provide services to crypto firms and are compensated in digital tokens. Crypto initiatives, who hold their resources in highly volatile assets, also find the volatility appalling.
To those troubles, stablecoins offer a solution. In theory, stablecoins are digital currencies designed to have a moderately stable price. They achieve this by pegging their value to fiat currencies like the US dollar.
If these alleged “stablecoins” are backed entirely by cash reserves, they become concretely stable. On the contrary, if stablecoins are backed by less liquid assets, they could become unstable at times of congestion, triggering a crash in a worst-case scenario.
The Problems with Tether Today
Tether (USDT) is the largest stablecoin and the third-biggest digital asset by market capitalization. As per data by CoinMarketCap, Tether currently has a circulating supply of over $68 billion, outpacing the second largest stablecoin (USDC)—which has a market cap of $29.5 billion—by a wide margin.
Initially, Tether claimed that all USDT tokens are backed one-to-one by US dollars retained in cash reserves. However, as the transparency around Tether increased, it became obvious that the level of reliable cash equivalents is far off from the 100% avowed.
Stuart Hoegner, general counsel at Tether, released a filing in 2019 that declared approximately 74% of Tethers were backed by “cash and cash equivalents”, with the remaining in a “less liquid form.” The used terms were vague enough, provoking speculations about whether Tether reserves are reliable.
Nevertheless, Paolo Ardoino, chief technical officer at Tether, shared a filing in late March this year, demonstrating a breakdown of Tether’s reserves for the first time ever. As per the document, only 2.9% of USDT tokens are backed by cash reserves, while commercial papers and fiduciary deposits account for over half of Tether’s collateral.
Frances Coppola, a financial analyst at Financial Times, commented on the breakdown of Tether’s reserves, saying:
“I would have expected to see far higher levels of genuine cash equivalents such as T-bills and insured deposit accounts in a reserve report for a financial institution that claims to guarantee redemption at par.”
What Happens if Tether Crashes?
The quality of commercial papers and other assets that back USDT tokens is unidentified. Therefore, it can be argued that the reserves are exposed to unknown levels of liquidity risk. Commenting on this, Coppola said:
“There is a very real possibility that in the event of a run on USDT, Tether would be unable to realise sufficient real USD to meet redemption requests. The 1:1 peg to the USD is therefore not remotely credible.”
It is worth noting that as long as too many investors don’t withdraw their USDT tokens all at once, there is no risk to Tether. However, if a large portion of investors decides to cash out their USDT holdings simultaneously, Tether might face liquidity issues.
However, thanks to the increasing awareness around the Tether dilemma, more investors are now trying to reduce their exposure to USDT. Effectively, this can considerably diminish the overall damage done by USDT to the crypto market at the time of a crash.
Finally, in a worst-case scenario, when a run on Tether occurs, the value of USDT tokens would gradually plummet to zero (again, this would only happen if Tether failed to provide enough cash). Consequently, USDT would become a worthless digital currency, as it happened with Iron Finance’s Titan token.
Such a crash would also trigger a violent market reaction since the crypto market is very sensitive to bad news. Crypto exchanges would suffer major losses, as their USDT holdings would become worthless. Cryptocurrencies would also lose significant value, mainly because investors would take exit liquidities as a result of the fear dominant in the market.
While it is hard to predict the exact extent of the damage incurred when Tether crashes, it is not big enough to drag the entire market down. From a broad point of view, Tether is responsible for $68 billion of the global crypto market, which is capped at around $2 trillion. This implies that Tether constitutes less than 4% of the crypto market — too low to prompt a crucial market crash.