Is Tether a bank? (I)

Origin: What is a stablecoin?

Before we start analyzing Tether, and all the implications that the most controversial and dominant stablecoin in the market generates, let’s start by the beginning.

Before we start analyzing Tether, and all the implications that the most controversial and dominant stablecoin in the market generates, let’s start by the beginning.

Stablecoins are defined by the ECB[1] as “digital units of value that do not belong to a specific currency, based on a set of stabilization tools that promote the minimization of fluctuations in the price of such currencies”. Without going into an in-depth analysis of the technology implemented for this purpose, stablecoins are constituted through a Smart Contract (protocols that automate the execution of contracts), which is embedded under the infrastructure of distributed ledgers (DLTs), and which allows to eliminate or reduce the dependence on a third party in the verification of the operation. They aim to protect the cryptoasset ecosystem from the high level of volatility that affects it.

The value of stablecoins, although assumed to be linked to a given currency at 1:1 parity, does not have to be maintained, since the collateral only serves to guarantee the redemption of an initial valuation agreement, but does not prevent the potential variation in the demand for such token from causing its value to fluctuate. The difference with “traditional” cryptoassets is that stablecoins have price stabilization mechanisms, which are basically of two types:

• Issuer: this involves managing fluctuations in the price of stablecoins by modifying the money supply through token purchase and sale operations. The protocols that make it possible to modify the money supply are centralized in nature, regardless of whether they are executed on an infrastructure of distributed ledgers (DLTs) such as blockchain.
• Participants: involves the creation of incentives on participants/investors to arbitrage supply and demand in such a way that the latter is stabilized around the price originally established in the protocol. Protocols that allow the incentive system applied to participants to be modified by aligning their interests with those of the protocol are decentralized in nature.

Through these two stabilization approaches, the entire stablecoin ecosystem can be understood, subsequently deriving second-level regulatory classifications, which are the ones currently applied in the legal frameworks that are being discussed.

The ECB understands the different stablecoin modalities from a triple dimension:

• The existence or absence of an issuer, responsible for satisfying the rights arising from the obligations it has contracted through the issuance of such tokens.
• The level of centralization or decentralization of responsibilities over the stablecoin.
• The system for fixing the value of the stablecoin, and its stability against the reference currency.

This gives rise to four types of stablecoins:

• Backed by funds.
• Backed by another asset class (traditional), which requires the participation of a custodian, and which are held by the issuer to the extent that the token holder does not demand their return (off-chain collateralized stablecoins).
• Backed by cryptoassets, which can be secured in a decentralized manner, and do not require the identification of the issuer (on-chain collateralized stablecoins).
• Backed by holders’ expectations about the purchasing power of their tokens, which require neither determination by either party, or the third-party custodian intermediary (algorithmic stablecoins).

On the other hand, the European regulation of the cryptoassets market, still at the proposal stage (MiCA, Market in Crypto Assets), makes a double distinction: Asset Referenced Tokens (ARTs), and E — Money Tokens (EMTs), to refer to tokens backed by a basket of currencies, an asset or a basket of assets (ARTs), or a single currency (EMTs). Despite of this is the basis on which the entire classification of stablecoins will pivot upon approval, we don’t want to ascribe to this new regulatory framework, but rather address the complexity of Tether without predetermined schemes.

As a premise, however, and to situate ourselves within the broad spectrum of categories, the authors conclude that Tether should be classified as a fund-backed stablecoin, which implies the commitment of the issuer, in this case Tether Holdings Limited, to guarantee the potential redemption of the tokens, and the need to use a third party — in this case, Deltec Bank — or a safeguard account to assume responsibility for the custody of those tokens. In this sense, we can say that USDT is a centralized stablecoin.

Tether issues tokens backed by different currencies (predominantly USD, although it also uses EUR). We point this out because although the analysis is performed considering USDT, which means collateralization via USD, it is important to highlight that the backing of funds is not limited to a specific pool of currencies, but the implemented data structure allows to adapt to any currency.

Is Tether a bank?

At first glance, it seems like an absurd question. Although it is important to distinguish between the company (Tether Holdings Limited), and the cryptocurrency or token issued. Tether is a stable cryptocurrency or centralized stablecoin, backed by dollars, held in custody through its intermediary Deltec Bank. That is, Tether issues 1 token (USDT) for each dollar received, dollars that act as collateral for the token itself, which is matched to 1 USD. The stabilization of the token comes from the collateralization applied by Tether, which guarantees the existence of 1 USD for each token issued through the validation performed by the smart contract, providing stability in the exchange rate between tokens, within the current framework of extreme volatility suffered by cryptoassets.

Why has Tether come to light?

Since its foundation in 2014 as a successor to Realcoin, Tether has provided liquidity to the crypto system through the issuance of its tokens and helps to control the volatility of the ecosystem by providing stable funding.

Together with the exchange Bitfinex, it is part of a group of companies with parent company iFinex. It is important to highlight the corporate structure in which Tether Holdings Limited is imbricated, since its relationship with Bitfinex has given rise to several scandals: lawsuit by the New York Attorney General’s Office to Bitfinex due to an alleged money laundering scandal with Bitfinex’s payment processor, lack of collateralization of tokens issued from Tether, and market manipulation of cryptocurrency prices in Bitfinex.

The relationship with Crypto Capital:

Bitfinex, the exchange house registered in the British Virgin Islands and based in Hong Kong, until 2016 used Wells Fargo and four other Taiwanese banks as a platform or payment processor, so that Bitfinex customers’ deposits were stored in accounts that these commercial banks opened on behalf of the exchange house. As a result of weaknesses in money laundering prevention models, and the increasing requirements of the FATF (Financial Action Task Force), the international group created by the G7 to combat money laundering, these banks decided to end their collaboration with Bitfinex, forcing the exchange house to turn to other entities.

Specifically, Bitfinex relied on Crypto Capital, a Panama-based payment processor, to open accounts for its clients, store their funds, and ensure the flow of cash to the exchange house. However, Crypto Capital allegedly used at least USD 800M from Bitfinex clients to launder money, triggering an anti-money laundering operation that has de facto frozen or blocked the USD 800M.

Consequently, there are two possible scenarios:

• Bitfinex has reported an accounting loss in its income statement as a non-recurring expense against its cash outflow: accounting record would be as follows:

• Bitfinex maintains in its balance sheet, in its treasury account, the balance of USD 800M despite the fact that these funds remain frozen, and therefore does not meet the definition of an asset for its registration. We say this because the accounting regulations define an asset as a good or right controlled by the company that can generate future economic returns, and the blocking of the funds by the authorities prevents the control of these funds.

In any case, iFinex ordered, as a hedge against the losses of its subsidiary Bitfinex, to its company Tether to lend USD 900M to Bitfinex (when Tether’s total volume of funds was USD 2,000M, i.e. almost 50% of its reserves) through the revolving credit line, so that Bitfinex recorded a financial income against the cash received, offsetting the previously recorded loss, or recording a financial liability.

In this case, the accounting recognition would be as follows:

· If Tether registered the line of credit:

· If Tether did not register the line of credit:

The impact of this transaction is unknown, since the consolidated balance sheet of iFinex would require the elimination of reciprocal income and expenses between Bitfinex and Tether, or the elimination of reciprocal credits and debits if an asset and a liability were recorded per credit line, respectively. Thus, although in individual Bitfinex accounts the accounting loss would be corrected, in consolidated accounts, it would emerge when the effects of the loan transaction are netted out.

The effect has only been registered in terms of liquidity, guaranteeing the eventual redemption of the tokens for cash, or the withdrawal of the same by the clients, although this loan has just been repaid.

And all of this is without prejudice to Tether’s failure to meet its obligations to collateralize the tokens issued by holding cash, or to justify reinvesting its liquidity reserves in credit trades as part of a traditional fractional banking model, as we will discuss later.

Tether collateralization:

As we pointed out before, Tether protocol commits the issuance of the token to the maintenance of the collateral delivered, thus guaranteeing the parity 1 USDT = 1 USD. The reality is that this has not been fulfilled, and recently, it has come to light that only 74% of the tokens are secured by cash, equivalents and other less liquid types of assets. Additionally, it must be determined whether, in the absence of a formal promise, the institutional assertion by the entity that the tokens are fully backed creates a legitimate expectation that the holders can exercise an action for restitution of the deposit or have a claim on it. [2]

The rationale for stabilizing the value of the token is not fulfilled if the right of redemption of the token is not secured, and financial instability may arise. The reason for this is that if, due to distrust towards Tether (as issuer or as infrastructure), token holders decide to get rid of Tether to go long in another cryptocurrency, the massive sale of Tether itself devalues the price of the token. Such devaluation, in addition to the potential associated illiquidity risk, is taken advantage of by Tether to acquire its own tokens at a price below 1 USD, (which corrects the potential devaluation of the token) and redeem them, obtaining a positive spread recorded as income in the Income Statement. In addition, Tether’s own reduction in money supply generates an additional increase in the price of Tether and restores the price of Tether to 1:1 parity.

The accounting record would be as follows:

Considering the way Tether structures its balance sheet, it seems that it will not be able to guarantee the perfect collateralization of the tokens, as part of the funds are invested in other assets, such as loans, or even BTCs. In its defense, it should be noted that Tether’s reserve ratio is absolutely high compared to the required at a banking level (around 50% could be in cash or equivalents, compared to the 1% required of commercial banks by the European Central Bank), and it is unlikely that there is a concentration of half of USDT’s money supply for the redemption of its tokens.

Market manipulation:

The relationship that Bitfinex and Tether maintain as a result of the control exercised by the parent company allows that potential USDT issuances can be used to purchase certain cryptocurrencies, boosting their price. Tether issued unsupported USDT, which it introduced to Bitfinex to buy BTC, counteracting the downtrend in value through an alleged accounting fraud.

In accounting terms, although it will be studied in depth later, the issuance of tokens may involve the recording of a liability by Tether Holdings Limited, insofar as it generates a current obligation (of collateralization through USD) for the extinction of which the company must dispose of resources or assets, in this case, dollars. However, it also appears to meet the requirements for its consideration as Electronic Money. In any case, the tokens are issued according to market demand, but Tether does not make it clear whether it guarantees the exercise of the action to return the token.

However, in certain cases, Tether has allegedly issued USDT without a correlative funds raising by third parties, a circumstance that cannot be verified due to the opacity of its accounts (there is no access to the journal or ledger), and the fact that the funds tracking system has not been audited, nor is there any control over the process of providing a counterpart against the token that is registered on-chain.

In these cases, the issuance of USDT is supported against an accounting record that does not meet the cash criterion, i.e., in which there is no cash inflow in Tether accounts despite the fact that the accounting entry so states, and there is no contractually stipulated accrual. Subsequently, the new USDTs were transferred to Bitfinex, which placed orders to buy BTC on other exchanges (Bittrex, Poloniex) using the unsecured USDTs, which artificially increased prices.

Conclusions:

• Tether business model, as a centralized stablecoin, does not fit smoothly under the current regulatory schemes. Given its size (60B market cap at June 2021), reputational damage may affect to the financial stability, so it is mandatory to find a regulatory framework which drives its adoption as a safe mean of payment, alongside with the rest of the cryptoassets ecosystem (1,8T market cap at June 2021).
• Lack of regulation and supervision has allowed Tether to drive opaque actions, not honoring the original commitment of protecting the funds raised to collateralize USDT issuances.
• Forecoming regulation will ensure the fullfilment of requirements (internal organization, own funds, reporting obligations, etc.) which may reduce significantly the impact over financial stability.

[1] Paper: “In search for stability in crypto-assets: are stablecoins the solution? “ (Dirk Bullmann, Jonas Klemm, Andrea Pinna)

[2] Paper “A regulatory and financial stability perspective on global stablecoins” (Prepared by Mitsutoshi Adachi, Matteo Cominetta, Christoph Kaufmann and Anton van der Kraaij)

[3] Specifically, in Article 2.1.3)

[4] In Spain, Law 21/2011