A Contrarian Look At Tether

Digital tokens conjured by a child actor from the The Mighty Ducks, run by an ex-plastic surgeon from Italy, banked in the Bahamas by a bank owned by a co-creator of Inspector Gadget.

Tether (USDT-USD), one of the most gratifying subjects of financial journalism, has been blessed by many good lines like this, written by FT, Bloomberg and many other reporters on a quest to untangle its bizarre past.

The central question of all these articles: Why has there not been a bank run yet? How do people send hundreds of millions of dollars every day to the Inspector Gadget banker to mint Tethers to trade without knowing where their dollars go? Why have they not, on so many occasions of doubt (from court cases to fines by CFTC, all regarding Tether’s reserves) rushed to redeem their dollars all at once?

Bizarre as it is, Tether continues to stand. Not even the dramatic demise of Terra-Luna (LUNC-USD) (LUNA-USD) at the moment of peak distrust in any token-representing-real-money, could bring Tether down.

Tether as you will know is a depositary stablecoin, meaning it guarantees that for every $1 of Tether, it holds a $1 somewhere in safe and liquid form. The problem is, where? No one really knows.

Tether’s secretiveness, its unwillingness to disclose its reserves on a granular level has brought the company trouble, entertaining publicity and million dollar fines.

So, like, why is it so resilient? OK, there are some explanations.

1.

Some argue that Tether is a bad bank. Because, if you think about it, that is what Tether is, a bank. It takes in deposits that it should keep safe and mints tokens.

Unlike a bank, it does not pay any interest to its depositors, and also unlike a bank, its capital requirements are virtually none (0.2%). It could well be, so goes the argument, that Tether does not want to show what it is doing with the reserves, really, because it uses them to earn interest on risky stuff, which is pure profit for Tether, i.e. the ex-plastic surgeon and his crew.

2.

The other reason for Tether’s secretiveness is the not-so-obvious fact (unless you’ve gone the route of a founder in crypto) that when you set up a crypto startup, you get turned away several times by several banks in several countries, simply trying to open a bank account.

You could imagine that it is not easy for Tether to put those billions somewhere safe and normal. It could be that most normal counterparties won’t do business with it, bank accounts get closed, prime brokers, who Tether might like to use to buy securities, won’t do business with them.

For one, Bloomberg’s much entertaining piece on Tether seems to suggest that Tether does not use the traditional financial rails:

To fact-check this claim, a few colleagues and I canvassed Wall Street traders to see if any had seen Tether buying anything. No one had. “It’s a small market with a lot of people who know each other,” said Deborah Cunningham, chief investment officer of global money markets at Federated Hermes, an asset management company in Pittsburgh. “If there were a new entrant, it would be usually very obvious.”

Tether operates on the very fringes of the financial industry, constantly having to reshuffle its portfolio to meet redemptions when required, while not revealing its counterparties. This could be because those counterparties are somewhat obscure (definitely not the brand finance houses of the traditional financial world), but it could also be to Tether’s advantage to keep things close to its chest…

3.

…which brings me to the third point. It is somewhat esoteric, but please bear with me. There is a bit of magic about finance in the old world. Finance can convert a risky investment into a safe investment and very risky investment. The “safe” in the safe investment comes from the fact that if anything goes wrong, that tranche gets paid first, leaving the very risky tranche with whatever remains.

You could say that the fractional reserve system itself – the system of creating money from air – sort of works because it is opaque and because people are partly or completely agnostic as to how it works.

Or to put it in better words of Matt Levine:

notice that this is magic: At one end of the process you have risky businesses, at the other end of the process you have perfectly safe dollars. Again, this is due in part to deposit insurance and regulation and lenders of last resort, but it is due mainly to the magic of composing senior claims on senior claims.

Does a little bit of mystery help Tether? Hedge funds have been shorting Tether or setting up put options on Tether for months now. Western hedge funds are reportedly borrowing Tether from Chinese counterparties in exchange for Bitcoin put up as collateral. They then sell the borrowed Tether in expectation of its debacle in another Terra-Luna stablecoin catastrophe moment. Or the hedge funds buy a put option on Tether, which just means that someone (like Genesis Global Trading Inc.) sells it (writes a put option) the right to sell Tether back to them at a certain price.

But not seeing inside Tether, not knowing how, when and what must Tether sell, move or transfer to accommodate redemptions, gives them only a too wide area to attack, i.e. shorting the $65B token itself.

Just a wild speculation, but let’s say that they can see inside Tether. They could attack where it hurts the most at a critical moment, for example by mirroring Tether’s trade and shorting asset that Tether needs to sell to meet redemptions, thus disrupting Tether’s ability to make redemptions and triggering a bank run.

The Rails for Cryptoland

When Sam Bankman-Fried explained DeFi as a Ponzi black box on Bloomberg, many thought that this was the top. But the point that he was making, and that many may have overlooked, was that the black box can be valuable, if it attains a critical mass and stability over time.

Over time, some magic boxes become mature, their returns will become less magic but they will still offer a better passive rate than a traditional financial system ever could because, you know, they are fully automated and humanless (no middlemen – no payroll). You can see how eventually many more people will start using them to earn day to day passive earning, and more. There is no reason why DeFi could not outgrow its speculative use case and become a financing tool for real world needs. A world where people will be banking via DeFi boxes.

Tether is no DeFi. It is a depositary stablecoin. But the broader point is that there is a view (and yes that view is challenged during every crypto winter) that over time crypto will replace the traditional financial system completely. The technology is just better. Free cryptography vs. centuries-old system reliant on expensive counterparty guarantees.

In this transforming world, Tether plays an indispensable role. Never mind its strange set up, Tether seems to work. In its obscure, second-hand way, it always redeems funds and provides a product that is essential to the cryptoland – instantaneous unregulated funds transfers without exchange rate risk.

So What?

What is the trade? In June, Paolo Ardoino, the CTO of Tether got very angry with hedge funds on Twitter for shorting Tether:

Anyway, eventually these hedge funds, that borrowed and shorted billions of USDT will need to buy them back. What will happen then? Tether is the only stablecoin that is proven with fire under extreme pressure.

Nothing. It is a stable coin, so if the hedge funds are wrong they will pay some expensive interest for a short that does not pan out as expected and buy the USDT back at $1.

One thing to do is to monitor USDT borrowing rates and consider it as a source of passive income. Higher rates may implicitly mean more interest for betting against USDT. Even during normal times when they are not elevated (i.e. at times of no entertaining Bloomberg articles flying around), they are certainly interesting. If you are not persuaded about my contrarian thesis, watch bad headlines closely before considering this trade.

If you are going to take anything from this article, please do the lending directly from your cold wallet if possible and only through one of the decentralized lending platforms, like Aave (AAVE-USD), or reputable exchanges, like Coinbase (COIN).