It’s back at par and on the defensive, but the questions about Tether’s recent detachment from its $1 peg value are not going away.
The world’s most popular stablecoin on Thursday posted a letter from MHA Cayman, an offshore outpost of UK mid-tier accountants MHA MacIntyre Hudson, that attests for consolidated total assets of just over $82.4bn. These quarterly updates are a mandatory requirement of Tether’s 2021 settlement with the New York Attorney General and (unlike its peg explainer-of-sorts published on Monday) are mostly new information.
MHA’s snapshot is from March 31, so it doesn’t capture the USDT coin’s subsequent $8bn drop in market value. It shows less than 5 per cent of reserves in cash, a sum eclipsed even by the mysterious and undefined “other investments” category.
Nevertheless, higher weightings of money-market funds and US Treasury bills meant more than half Tether’s total reported assets were in categories considered highly liquid:
If the above is taken at face value (which is not everyone’s preference), last week’s unnerving drift away from $1 still needs explanation.
The whole point of a liquidity buffer is to match redemptions immediately and absorb any risk of a fire sale. The capacity to do so was apparently plentiful. Tether’s reported buffer was fatter than that of the average institutional prime money-market fund, which typically keeps around 38 per cent of assets in instantly monetisable forms.
The last big test for money-market fund drawdowns came early in the pandemic amid a corporate “dash for cash”. In the two weeks to March 24, 2020, according to Barclays research, institutions pulled 30 per cent from prime money-market fund balances. Tether’s troubles are as nothing in comparison: redemptions peaked on May 12 at less than 4 per cent of reported reserves.
But Tether’s closed-shop redemption mechanism means it cannot be viewed like a money-market fund. Processing delays can happen without explanation, there’s a 0.1 per cent conversion fee, and the facility is only available to verified customers cashing out at least $100,000. Scepticism about collateral quality is a reason to sell below the $1 peg value, but it’s just one reason among many, says Barclays:
The only way to get immediate access to fiat is to sell the token on an exchange, regardless of the size of holding . . . [W]hile redemption is ‘guaranteed’ at par, the secondary market price of tether can trade lower, depending on the willingness of holders to accept a haircut in return for access to immediate liquidity. As last week’s price action suggests, some investors were willing to accept a nearly 5 per cent discount to liquidate their USDT holdings immediately.
We think that willingness to absorb losses, even though USDT is fully collateralized and has an overnight liquidity buffer that exceeds most prime funds, suggests the token might be prone pre-emptive runs. Holders with immediate liquidity demands have an incentive (or first-mover advantage) to rush to sell in the secondary market before the supply of tokens from other liquidity-seekers picks up. The fear that USDT might not be able to maintain the peg may drive runs regardless of its actual capacity to support redemptions based on the liquidity of its collateral.
Nor does it help that (as per yesterday’s release) tether reports skeleton figures once a quarter with a substantial lag. The lack of a realtime view in combination with the short-dated nature of the whole portfolio can raise suspicions about end-of-quarter window dressing.
All of which makes stablecoins more like ETFs than money-market funds, says Barclays. The issuer is selling a token, after which secondary markets take control. With ETFs, there is full transparency on the underlying portfolio, which enables market-makers to keep ETF shares trading in line with their benchmark. In the case of stablecoins, market liquidity and sentiment determine how close to realisable net asset value the token will trade:
When crypto asset prices rise, it is easy to sell stablecoins, as there are plenty of eager buyers ready to acquire the token at par. But this liquidity dries up quickly when other crypto asset prices fall . . . Even modest selling causes prices to gap lower and transaction sizes to shrink as buyers disappear. In Tether’s case, the pressure to sell is intensified by the inability of most investors to redeem directly, as well as the inherent first-mover advantage: to sell the token quickly before its price falls even further.
Open-ended investment funds can apply “swing pricing” mechanisms, where ad hoc exit penalties discourage any investor who thinks they smell smoke from bolting towards the exit. But with stablecoins, as with ETFs, the only haircuts available in times of escalating panic are via the secondary market. And while below-par sales ought to be free money for arbitrageurs with access to the redemption window, their firepower is limited by position size, potential delays, and uncertainty about whether the issuer itself can liquidate collateral without wearing a discount.
That’s why stablecoins — even those that, unlike tether and of its competitors, are one-for-one backed by a fully audited asset base — will still carry an unavoidable degree of market risk. Back to Barclays:
There is, in theory, an arbitrage to be made via the token’s creation and redemption processes. This is analogous to ETFs, which trade around their NAVs, while market makers use the create/redeem processes to maintain prices at levels close to the underlying collateral. Overall, there are several reasons why even this layer of arbitrage may fail, for example, if there are no willing arbitrageurs, if they do not have enough balance sheet to absorb all the selling flows, or if they fear that their requests to redeem will not be honoured in time or in full. Ultimately, full collateralisation helps to reduce stablecoin risk, but does not eliminate it.