After a 22-month investigation into crypto exchange Bitfinex and its Tether stablecoin, which is purportedly backed 1:1 by the US dollar, the New York Attorney-General last month decided to stop the companies from any further trading in New York.
The companies agreed to an $18.5 million fine, without admitting any wrongdoing, for overstating reserves and hiding $850 million in losses. There has been speculation for years that Tether, while claiming it was backed 1:1 by the US dollar, was misleading customers about its true financial backing.
Stablecoins like Tether are virtual currencies backed 1:1 by regulated currencies like the US dollar, and have become hugely important to the crypto market. There are more than 34 billion Tether in issue, and the stablecoin now accounts for 50-60% of all bitcoin trades.
The reason many investors purchase bitcoin with stablecoins like Tether is that some exchanges will only transact in “virtual currencies”, sometimes for convenience, and sometimes to avoid regulatory oversight. Holding stablecoins is a way to park crypto profits in a “safe harbour” asset linked to US dollars without having to exit the crypto ecosphere.
“Tether’s claims that its virtual currency was fully backed by US dollars at all times was a lie. These companies obscured the true risk investors faced and were operated by unlicensed and unregulated individuals and entities dealing in the darkest corners of the financial system,” said New York Attorney-General Letitia James in a statement.
The Attorney-General says since mid-2017, Tether had no access to banking anywhere in the world, “and so for periods of time held no reserves to back tethers in circulation at the rate of one dollar for every tether, contrary to its representations”.
Bitfinex and Tether appear to have got off rather softly, but have agreed to provide quarterly disclosure on reserve backing for Tether, including cash and near-cash.
Tether’s massive role in the crypto space, and the uncertainties around its financial backing, has been a major hurdle for many institutions contemplating entry into this new asset class.
The resolution of this case in New York and Tether’s commitment to provide greater transparency around its reserves in future is seen as a positive for the broader crypto market.
There has been widespread speculation for years about the actual reserve backing of Tether and the potential impact this could have on bitcoin and cryptos in general.
Risk of confidence dip
A recent Bitcoin Report by JP Morgan says a sudden loss of confidence in Tether would likely generate a severe liquidity shock to Bitcoin markets, as they would lose access to by far the largest pools of demand and liquidity. Research by crypto and financial services group NYDIG suggests that since 2019 around 50-60% of bitcoin trades for USD Tether (USDT).
“USDT is engaged in a classic liquidity transformation along the lines of traditional commercial banks, but is not subject to the same strict supervisory and disclosure regime, and certainly does not have anything like deposit insurance,” says JP Morgan.
“Tether Ltd claims reserve assets of cash and equivalents equal to their outstanding liabilities, but has famously not produced an independent audit and has claimed in court filings that they need not maintain full backing. Thus, were any issues to arise that could affect the willingness or ability of both domestic and foreign investors to use USDT, the most likely result would be a severe liquidity shock to the broader cryptocurrency market which could be amplified by its disproportionate impact on [high frequency trading-style] market makers which dominate the flow.”
Bitcoin becoming more correlated with other asset classes
JP Morgan says the diversification benefits of bitcoin remain questionable “at prices so far above production costs, while the mainstreaming of crypto ownership is raising correlations with cyclical assets”.
Over shorter time horizons, crypto assets continue to rank as the poorest hedge for major drawdowns in global equities, particularly relative to the fiat currencies like the dollar which they seek to displace.
“To the extent that bitcoin remains an investment vehicle rather than a funding currency, it will always lack the short base that sponsors US dollar (and Japanese Yen or Swiss Franc) strength during periods of acute market stress,” says JP Morgan.
“A more unique macro shock related to much higher US inflation or a breakdown of the payments system could alter this pattern.”