Is Tether a bank? (II)

Tether’s business model:

Tether’s business model rests on two pillars: risk transformation, and the commission system applied. On the basis that Tether issuances are covered by its reserves — without specifying, as of February 2021, how the reserves are composed — Tether employs a manual system and an automatic profit generation system:

Manual system: the manual system refers to the strategy of reinvesting funds or collateral raised in the primary market by issuing USDTs. As they are issued at par, i.e. without charging a premium, Tether uses the funds obtained in the acquisition of assets that generate returns, subjecting itself to the risks derived from such activity.

So, if Tether commits a certain amount of USD in the granting of a loan, the flows obtained (principal and interest) are calendarized, so that in the event that an equal or greater volume of investors would want to withdraw their funds, it would not have sufficient funds to repay. This risk is mitigated by the cash ratio that the entity maintains, which is based on the confidence of the potential repayment of the tokens. Tether also assumes the risks inherent to the activities carried out, such as credit risk due to non-compliance with the credit obligations of the borrowers, market risk, due to fluctuations in the fair values of the assets acquired (for example, purchase of BTC), or operational risk, derived from technical failures in the execution of the entity’s internal processes, which are the same risks to which a banking institution is exposed (Basel Risk Based Approach).

Automatic system: Tether establishes a system of commissions, both per transaction and per withdrawal or redemption of tokens.

• Transaction: the use of USDT in transactions carried out on exchanges operating with Tether is charged through fees, which Tether calculates dynamically based on the aggregate value of transactions over the last 30 days.
• Deposit: Tether charges a fee of 0.1% of the deposited FIAT for conversion into USDT.
• Withdrawal: Tether charges a fee of the greater of 1,000 USD and 0.1% of the amount to be withdrawn.

For deposit or withdrawal, Tether establishes a minimum amount of 100,000 USD to be withdrawn, due to the fact that the structure costs for Tether derived from such operation are high, and they start to be offset from the minimum amount indicated on.

In addition, Tether benefits from arbitrage on its own token. Due to the application of commissions for its monetization, USDT generally trades below 1 USD. Tether can purchase its own tokens, as mentioned above, at a price lower than 1 USD, and provided that it has no commissions for USDT trading, generate a positive differential between the USD contributed by the purchase, and the USDT redeemed upon purchase.

In other words, Tether employs a dual system, and exploits a market inefficiency by leveraging its own structure to monetize and arbitrage the price differentials at which USDT trades in secondary markets.

What are USDT or USD Tether?

The accounting-financial nature of the USDT token can be understood in two ways: liabilities/equity or electronic money.

Under the first approach, controversy arises, since the notion of financial instrument does not fit into any of the types of instruments included in IFRS 9 (International Financial Instruments Standards), and raises serious doubts as to its assignment to the notions of liabilities and equity.

And we say this because USDTs are not debt, since they do not bear interest and do not mature; nor are they equity, insofar as they do not entail a participation in the ownership structure of Tether Holdings, and therefore do not allow the exercise of control by the holders in the sense established by the International Accounting Standards IFRS: the ability to direct the management and operating policies of the entity. In other words, they raise non-interest-bearing funds, as opposed to the cost borne by the banks on the deposits raised, which are remunerated at certain interest rates.

The only financial instrument that seems to fit the characteristics of the Tether is the non-interest bearing demand deposit, since it has no maturity and does not remunerate the holder, and can be redeemed by the holder at any time.

Deposit is defined in Directive 2014/49/EU[1] , as follows: any credit balance arising from funds that have been held on account or from transitory situations generated by normal banking operations and which a credit institution is obliged to repay under the applicable legal and contractual conditions, including fixed-term deposits and savings deposits, and excluding: instruments whose principal is not repayable at face value, or where the principal is only repayable at face value with a guarantee, or special agreement of the credit institution, or of a third party.

The exercise of the right of redemption is not regulated in any contract, , although it is assumed and intuited by the nature of the relationship between Tether and the token holder. There is onerousness, since there is exchange of asset (cash deposit) for asset (token), but the borrower does not generate return for the provision of the funds, nor is the ability to enforce the token against the FIAT USD. The token, if classifiable as a deposit, is not covered by the established protection schemes, such as deposit guarantee schemes (DGS), or Central Banks Margin Lending Facility (MLF), as the institution is not subject to prudential supervision by the competent authority.

On the other hand, Tether argues that the funds received are blocked as collateral for the tokens issued, but the opacity of Tether in relation to the management of such collateral does not allow to ensure whether indeed the funds received are in custody, so that Tether has no power to dispose of them, or, on the contrary, such dollars can be used for the exercise of asset operations.

Without going further into the aspects related to the effective management of collateral, USDT can also be classified as electronic money, since it digitizes a direct reference to a currency, guaranteeing its stability through its collateralization and subsequent redemption guarantee. The definition of electronic money contained in Spanish Law 21/2011 on Electronic Money, understands it as a monetary value stored by electronic or magnetic means that represents a credit on the issuer, which is issued upon receipt of funds for the purpose of carrying out payment transactions.

In this case, USDT seems to comply with the legal requirements established for its classification as such, since it is stored electronically through its registration in a data infrastructure (blockchain), generates a credit on the issuer, and Tether guarantees its redemption, albeit, conditioned to the payment of a commission. In addition, it can be exchanged as a means of payment, this being the utility delivered by Tether for the provision of funds by the token holder. Finally, the return of the credit is not at par, because it is subject to the payment of the commission, which de facto implies the redemption of the token at a lower price, and although potential legal consequences could arise in terms of consumer protection, the notion of electronic money is not undermined in any case.

Tether as a bank or Tether as an e-money institution:

This unique paradigm, coupled with the potential use of the dollars received in asset transactions, may lead to question whether Tether is a company that issues stablecoin or, is it a bank, a requirement that, on the other hand, MiCA seems to anticipate. Going back to the title of the article, is Tether a bank?

And now, the debate seems less clear, since there are arguments to defend that, although in view of the legal form of the entity, in no case we can speak of a bank, the underlying economic reality of the activity carried out makes it remarkably similar. And it resembles a bank, but only with the advantages of these, without going through the so demanding funnel of compliance for the financial sector.

A bank, in the sense of traditional commercial banking, is an entity licensed to raise repayable funds from the public, which are used in credit and loan operations. By transforming risks (raising funds, as opposed to the credit risk arising from the possible non-compliance with contractual obligations on the part of the borrower) and terms (deposits at a term other than the maturity of the loans granted), banks generate positive interest spreads, which feed their income statement and make it possible to offset the costs of structure and financing (generation of provisions for credit risk).

In the case of Tether, the company is an entity without a license to raise funds, which issues tokens against dollars held in custody, i.e., it is financed against the issuance of tokens representing 1 USD, so that the tokens constitute instruments of a singular nature. In this regard, let us recall that the license is required insofar as fundraising is an activity whose risks may result in a banking collapse. The reputational risk due to non-compliance of obligations on the part of the entity may result in a request for a massive withdrawal of deposits, which in no case could be honored, since they are placed in asset operations.

And, in addition, Tether places such financing obtained in asset transactions, so that any type of credit or asset transaction with interest rates above 0%, already generates a positive spread for Tether, without the products generated being subject to any control in terms of solvency by a supervisory authority. This means that the potential default of Tether’s borrowers could result in the inability to redeem the tokens issued in the event of the token owner’s exercise of its credit rights.

Ultimately, we can say that Tether acts as a deposit-taker without the banking license required for this purpose and carries out asset operations without being subject to solvency regulations due to the risks assumed with the funds of the theoretical depositors. From this point on, the debate is open.

On the other hand, following the reasoning of the previous point, if Tether is an issuer of electronic money, as the stablecoins of tokenized funds typology are assimilated to such category (or EMT according to MiCA), the ascription of Tether Holdings Limited as a subject obliged by the Electronic Money regulations[2] obliges to constitute Tether Holdings Limited as an Electronic Money entity. And from this, another important consequence arises:

The regulations require the creation of a safekeeping account in which client funds are held separately from the entity’s funds. Why? Because the law understands that the collateral received cannot be commingled with the entity’s funds, since the former is recorded in memorandum accounts as it is not classified as an asset, and the latter is part of the entity’s balance sheet. In such case, the obligation to safeguard the USDT collateral would oblige the company to always guarantee the 1:1 parity, without being able to develop fractional banking models to reinvest the collateral in other riskier assets.

However, the legal classification of a stablecoin as a Tether under USDT depends on the legal framework implemented in each jurisdiction. In the case of the European Union, as MiCA foreseeably requires a common license to operate in the European Union, the requirements of the Electronic Money Directive 2015/2366/EU should be examined in order to check whether they can be ascribed to the category of electronic money — and become an Electronic Money Institution or similar legal figure in their country of origin — or whether the characteristics they present allow them to be incorporated under another legal form.

[1] Specifically, in Article 2.1.3)

[2] In Spain, Law 21/2011