Readers likely know that your humble blogger is no fan of crypto, but we’ll shortly turn to a big news item of the last couple of days, how the “stablecoins” Tether and TerraUSD have proven to be anything but.
To be explicit about our dim view of crypto, it’s taken literally hundreds of years to make simple-minded banking not-too-dangerous for the financial health of its customers. There is no reason to think that crypto promoters are going to design a better and certainly not a safer mousetrap any time soon. Among other things, they are finding the hard way that they are having to replicate the features of traditional banking. And there’s no way they’ll match the transaction speed and cost of some of the current plumbing, such as the Visa/Mastercard network.
But it’s been disconcerting to see regulators who ought to have known better stand back and let crypto gain a following, as opposed to either outlawing it or making sure it remained a fringe activity. What Michael Lewis said about Salomon Brothers’ mortgage securities operation is true of having your own fiat currency: “Salomon Brothers let slip through its fingers the rarest and most valuable asset a Wall Street firm can possess: a monopoly.”
Now to TerraUSD and Tether. Both were supposed to be able to keep their trading value at $1. Instead both fell below that level, TerraUSD pretty dramatically. This is as damaging to crypto-land as the Reserve Mutual Fund (and later some others that held so-called asset backed commercial paper) “breaking the buck” was in the first acute phase of the financial crisis. The first chart is from the Wall Street Journal, the second from the Financial Times:
We’ll spend more time on Tether because it was theoretically the more stable and better designed one, and even then it was obviously a load of hooey.
But first let’s go back to the question of why anyone would bother holding a cryptocurrency that was meant to emulate the dollar, as opposed to dollars or a money market fund. The reason appears to be largely aesthetic. First, there seems to have been perceived value in presenting crypto as not always and every speculative and volatile, particularly in discussions with regulators. Second, crypto speculators strongly preferred to sell in and out of stablecoins, as in use them as de facto clearing and settlement accounts. Why that would be preferable to trading in and out of your real world currency is beyond me, save maybe for taxes if swapping in and out of stablecoin wasn’t a taxable event but trading in and out of dollars would be. Perhaps various wallets made it easier to move in and out of stablecoin than hard currencies. Otherwise, it looks like crypto boosterism: promote the ecosystem, regardless of the underlying risks.
As reader SimonJB at the Financial Times put it:
The reason people use it is that it is the only timely way to use to move money into or out of any Crypto coin on an exchange and it uses Blockchain like crypto. Without crypto there is no need for stablecoins. Stablecoins take the daylight risk between fiat money systems and instantaneous Blockchain systems. That’s why describing them as the plumbing for the Crypto ecosystem is apt. The problem is that the plumbing is lead pipes and the flow could be infinitely large, breaking the pipe and spilling the water. It could well be argued that we need Blockchain systems to settle our fiat money claims (chains) when we buy and sell shares, money funds, bank deposits etc..
The issue is that if stablecoins take a credibility hit and suffer large redemptions then Crypto will be much less easy to trade, reducing its liquidity and attractiveness and then its price. Causing further redemptions of stablecoin etc.
In many ways Terra Luna is like Creditanstaldt which failed due to settlement risk on foreign exchange. It went bust on May 11th……1931.
Now, of course, if you were going to run what amounts to a money market fund, you’d keep a bunch of very short term, low risk, liquid investments. But this swapping in and out of crypto appears to have addled the stablecoin operators’ brains and maybe added costs too.
A geeky new article at VoxEU explains the stablecoin design choices and why there could never be a winning formula. The piece explains why a stablecoin like TerraUSD was vulnerable to speculative attack, but I don’t find the alternatives it proposes to be anything more than less bad:
Stablecoins operate on the blockchain and are pegged at parity to the US dollar. They serve as vehicle currencies for trading cryptoassets generally due to a reduction in intermediation costs by operating on the blockchain. To understand stablecoin designs, we use the framework in Figure 1. Out of three objectives – peg stability, decentralisation, and capital efficiency – only two can be met by a given design.
Figure 1 The stablecoin trilemma
The most common stablecoin type is centralised stablecoins, led by Tether, the balance sheet of which includes commercial paper and less liquid assets (Lyons and Viswanath-Natraj 2020a). Decentralised (over-collateralised) stablecoins are led by MakerDAO’s DAI. In this design, individuals issue DAI tokens through over-collateralised positions in which they deposit cryptocurrency collateral (typically, ETH). While they are decentralised, they are less capital-efficient than their centralised counterparts (Kozhan and Viswanath-Natraj 2021). The third type is algorithmic stablecoins, led by TerraUSD, which are typically under-collateralised. While this is a more capital-efficient design, it has the drawback that they are prone to speculative attacks and can trade at a large discount (Eichengreen 2019).
The Wall Street Journal explains what happened to TerraUSD:
The cryptocurrency TerraUSD had one job: Maintain its value at $1 per coin…
The collapse saddled investors with billions of dollars in losses. It ricocheted back into other cryptocurrencies, helping drive down the price of bitcoin….
Stablecoins attempt to resolve a conundrum: How can you make something stable in a volatile financial system?
Some stablecoins attempt to do this by holding safe asset…
TerraUSD has a more complex approach. It’s an algorithmic stablecoin that relies on financial engineering to maintain its link to the dollar.
Previous attempts at algorithmic stablecoins ended in failure when the peg collapsed. [TerraUSD’s outspoken creator] Mr. [Do] Kwon and his colleagues believed they had created a better version, less prone to runs….
Jim Greco, a partner at crypto quantitative investment firm F9 Research, was celebrating his birthday at Manhattan’s Le Bernardin on Saturday night when he got a message notifying him that TerraUSD had dropped below 99.5 cents.
He told his team to sell the coin, which had been part of F9’s broader stablecoin holdings. Later his firm made a profitable bet that the coin would keep falling, said Mr. Greco.
“We all knew it was going to fail eventually,” Mr. Greco said. “We just didn’t know what the catalyst would be.”
Traders said the catalyst for the drop, which began over the weekend and snowballed Monday, was a series of large withdrawals from Anchor Protocol, a kind of crypto bank created by developers at Mr. Kwon’s firm, Terraform Labs. Such platforms allow digital-currency investors to earn interest on their coins by lending them out.
Over the past year, Anchor had fueled interest in TerraUSD by offering lofty returns of nearly 20% on deposits of TerraUSD. That was far higher than the rates available in traditional dollar bank accounts, and more than what crypto investors could get from lending out other, more conventional stablecoins.
Anchor, like other crypto lending protocols, would lend the TerraUSD to borrowers that used the coins for various trading strategies or for earning built-in rewards that blockchain networks provide for processing transactions.
Critics, including crypto investors who have attacked Mr. Kwon on social media, questioned whether such yields were sustainable. Still, by late last week investors had deposited more than $14 billion of TerraUSD in Anchor, according to the platform’s website. The bulk of the stablecoin’s supply was parked in the Anchor platform.
Big transactions over the weekend knocked TerraUSD from its $1 value. The instability prompted investors to pull their TerraUSD from Anchor and sell the coin.
That, in turn, led more investors to withdraw from Anchor, creating a cascading effect of more withdrawals and more selling. TerraUSD deposits at Anchor fell to about $2 billion by Thursday, down 86% from their peak, the protocol’s website shows.
Dunno about you, but a 20% yield on something that’s supposed to hold value is sure to be a fraud. And one has to assume that the developers behind Anchor knew that and may have been behind the big liquidations. The odds that lawsuits will eventually get to the bottom of this are high.
But the supposedly better stablecoin child, Tether, is a crock too, just not to the same degree. I recall reading about Tether over a year ago, with its vague claims that its stablecoin was backed by billions of “Treasuries.” SimonJB tersely restates what I’d noticed back then:
Tether is an unregulated unaudited bank registered in China that takes in dollars and earns nothing on those dollars unless it takes a risk, credit or duration. It thus is a Chinese controlled asset with virtually no expected return but considerable principal risk.
This is why the comment about “Treasuries” is a huge red flag. Even if that were true, that every dollar of token value was backed by a dollar of Treasuries, “Treasuries” usually implies Treasury bonds, not Treasury bills. And if you wanted to reassure investors about the not breaking the buck, you’d think they would have specified Treasury bills.
But when pressed about what exactly Tether had backing its tokens, it did a lot of not-remotely-reassuring handwaving. From the Financial Times:
Tether aims to maintain a peg to the dollar by keeping up a store of reserves of traditional assets. There are 80bn Tether tokens in circulation, meaning it should hold $80bn in assets — a sum that compares with the biggest hedge funds in the world. But details around how those reserves are managed are scant, and not subject to audits under internationally recognised accounting standards.
Paolo Ardoino, Tether’s chief technology officer, on Thursday vowed to defend the token’s dollar peg and said the company had bought “a ton” of US government debt, which it is willing to offload in that effort. But in an interview with the Financial Times, he declined to give details about its $40bn hoard of US government bonds because he did not “want to give our secret sauce”.
“Our counterparties are not public. We are not a public company,” he said. “So we keep that information [to] ourselves, but we are working with many big institutions in the traditional financial space.”
The use of the word “counterparties” is another red flag. If Tether simply had Treasuries in bank or brokerage accounts, those institutions are not “counterparties”. That nomenclature suggests at a minimum that Tether is repoing some of these positions, or alternatively, has constructed some synthetic positions rather than holding cash bonds.
Back to the first red flag, that the use of “Treasuries” suggested that Tether was held longer-term positions and had gotten hammered when interest rates rose. Financial Times reader Mass Appeal shared that suspicion:
There is no secret sauce. They likely bought long bonds with short duration funding. And on a mark to market basis they are likely down 15 points on 40 billion like any bond fund. So 6 billion mark on 80 billion of assets.
I hope the rest of the 40 bln isn’t invested in AAA mezz CDO.
There used to be an insurance company called AIG that put on the same trade. Just goes to show you the ways to make money with other peoples money remain the same. The names change but the concepts are the same
But we’re all charitably assuming there are, or were, $80 billion invested somewhere. Tether was already in legal trouble for inadequate disclosures about its reserves, begging the question as to why anyone with an operating brain cell would trust them. From New Money Review in March 2021:
Last month cryptodollar issuer Tether agreed with New York prosecutors to come clean on its reserves, long a topic of controversy. But the general public may still end up none the wiser about Tether’s backing.
In its 23 February settlement agreement with the New York State Attorney General (NYAG), Letitia James, Tether committed within ninety days to provide documents substantiating its reserve accounts. The token issuer said it would also verify it is keeping clients’ money separate from its own operational accounts and those of Tether’s affiliate company, cryptocurrency exchange Bitfinex.
But the NYAG failed to respond to a question from New Money Review about whether it will be publishing details of Tether’s reserve backing once it receives them.
The settlement agreement states that Tether will itself publish the categories of assets backing tether, and whether any category constitutes a loan to an affiliated entity, for a period of two years…
According to James, Tether had also repeatedly lied about its asset backing and had operated for long periods without adequate cash reserves.
Given the fact that none of the financial press seems to know what Tether now holds or recently held to back its stablecoin, it sure looks like it failed to comply with the settlement.
And this tidbit from the same New Money Review story is plenty alarming. Tether had asserted its funds were in its bank in the Bahamas. But the amount that should have been there was way bigger than the total foreign deposits of the Bahama banking system!
Tether’s bank, Deltec Bank and Trust, is based in the Bahamas. But the total foreign currency deposits across all the country’s banks at the end of 2020 were far short of the amount needed to back all the tethers in issue with hard cash.
According to the Bahamian central bank, the total foreign currency deposits held by domestic banks were $5.67bn at the end of 2020. At the same date, the total value of tether tokens in issue was $20.92bn.
You were warned. We told you crypto was prosecution futures. The odds that both these big stablecoin players were flat out frauds is high. The amounts at issue are so large that there’s likely to be real investigations and hopefully criminal charges. Stay tuned.