Gennaro is the founder of FourWeekMBA, a leading source on business model innovation.
Where do we start?
This story is so intricate that we need to take a step back.
It was 2009 when Satoshi Nakamoto… Sorry, not telling you this again.
So let’s start by 2021.
In a Tim Ferris Show interview to Ethereum’s co-founder, hosted by Naval Ravikant, as they discussed the future of crypto, Vitalik Buterin highlighted something that might have opened a Pandora’s box “I think the Bitcoin ecosystem does have its own […] ticking time bomb demons too, like Tether is one example.”
What’s Tether, why is it a ticking bomb? And what makes Vitalik Buterin think this is a “Bitcoin only” issue?
Instead, some have already labeled it as the Lehman Brothers of crypto, with the potential to send crypto to a glacial age, that might prevent its further adoption for a decade (in the best case scenario) or just make the whole crypto universe collapse on itself forever (what Nassim Nicholas Taleb has warned many times as the “absorbing barrier” or a point of no return!).
In Lehman Brothers’ case, the paradox of centralization is that it eventually prevented a systemic collapse. Indeed, central players like the Fed and the government bailed out the system (with the bailout of AIG first, and then with the Troubled Asset Relief Program which pumped back $700 billion in liquidity into the system).
In the crypto space, without a last-resort authority in charge of preventing systemic risks, as everything is going awry, can this just mark the end of it all?
I believe it’s critical to answer these questions, to make sure we continue to see the blockchain and crypto ecosystem grow and really become the Web 3.0 we all dream of. And yet, to make this happen we need to make clarity on the short-term existential threats existing right now.
And beyond all the scammy projects, buzz, and cultism going on in crypto, Tether is the most dangerous one, because it’s sold as the “real thing” potentially masqueraded as the greatest Ponzi Schemes of all times.
So let’s make some clarity here.
A Quick Glance At Tether’s History
As Bitcoin had gained traction over the 2010s, the idea of enabling other tokens to be built on top of Bitcoin’s protocol took off (indeed, this was also the original idea of Ethereum in 2014).
This gave rise to the Mastercoin project. The vision was to solve two of the most important barriers to Bitcoin mass adoption: Insecurity and instability (as highlighted in this Coindesk piece).
Mastercoin, therefore, has been credited by some as ‘inventing the ICO’ space. Mastercoin would be rebranded as Omni by 2015.
The rebranded Omni Protocol would serve as the foundation for Tether, which got built on top of this protocol (Tether was also an ERC20 token – built on top of Ethereum’s blockchain protocol). At the same time, Tether initially was called “Realcoin” and only later on (by 2014) renamed Tether.
As explained on its website, nowadays “Tether tokens exist as digital tokens built on bitcoin (Omni and Liquid Protocol), Ethereum, EOS, Tron, Algorand, SLP and OMG blockchains.”
And as further explained “Tether Platform currencies are 100% backed by Tether’s reserves. Tether tokens are redeemable and exchangeable pursuant to Tether Limited’s terms of service. The conversion rate is 1 Tether USD₮ token (USD₮) equals 1 USD.”
Tether had since the start a clear mission, that of facilitating the exchanges across digital currencies, by providing what’s called a stablecoin. A stablecoin itself is a digital currency pegged to an underlying asset. In Tether’s case that is the US dollar.
Thus, by pegging the Tether to the dollar, whoever is converting its cryptocurrencies back to a stablecoin has the advantage of being able to trade back across various digital assets. They would be able to do so without having to incur wild price swings, which are intrinsic to the crypto world.
In short, stablecoins have become the liquidity providers, especially for central exchanges.
As liquidity providers, those are as good as those exchanges accept them as liquidity reserves.
There are dozens of stablecoins and yet the top three (Tether, USD Coin and Binance USD) almost reach a hundred billion market cap as of the time of this writing.
And the most interesting part is that those stablecoins for better or for worse have become so popular that at this point there isn’t really a conversion between Bitcoin and USD, rather the convention between Bitcoin to USDT (short for Tether) has become widely adopted.
This implication is critical because it means that Bitcoin liquidity does not exist in fiat currency (to say you can’t really convert all the existing Bitcoins back to dollars – at least not those that are going through central exchanges). This again poses a serious systemic risk, as in the short-term, if a good chunk of USDT would be exchanged back for dollars, it might be easy to imagine a massive liquidity drought.
In fact, while some might say, “you know Tether is only over $60 billion in market cap when Bitcoin is over $600 billion” (at the time of this writing). But this reasoning doesn’t make any sense. Because if a crisis of liquidity happens this would drag down the price of Bitcoin (and all the other cryptocurrencies) to the point that we don’t know what would happen next.
Tether: The Currency of CEXs
What prompted in the first place this massive adoption of stablecoins, and in primis of Tether?
I mean why do people use stablecoins when they can simply trade back in dollars? There are various reasons for this phenomenon. However, incentives from central exchange platforms have widely pushed the adoption of stablecoins.
One of the features that made stablecoins a good thing to have is the reduced intermediation fees to trade them.
A second, killing feature that made stablecoins the go-to digital currency for investors is the fact that some central exchanges only accept them in the first place. As highlighted in the paper “What Keeps Stablecoins Stable?” Crypto exchanges like Binance and Poloniex, already in 2019, only accepted stablecoins as a medium of exchange.
This means that “liquidity” across these exchanges is mediated by stablecoins (this implication is critical because it makes us redefine what liquidity means on those exchanges, and how this can be pumped up easily).
This brings us back to a central issue for Tether. As the core assumption is that in case of a mass liquidation Tether would still be able to redeem it and yet maintain the peg with the dollar. Here the problem instead is that not only this peg would not be maintained.
But worse of all, in case of a flight to liquidity it might create a massive negative domino effect on the whole crypto ecosystem.
So how does liquidity work on central exchanges?
How Central Exchanges Liquidity Works
Running a Central Exchange has been – paradoxically – one of the first viable business models on top of Bitcoin. That’s a paradox because as the say goes “Not Your Keys, Not Your Coins” would imply that you don’t need anyone holding the key for you.
And yet “we hold your key” has been the main business model for successful exchanges like Coinbase. And many hard-earned lessons have been learned by the crypto community in the last decade as various central exchanges went bust (the epitome of that has been Mt. Gox bankruptcy back in 2014).
So why did this central exchange business model work? Well, because it enabled a wider and wider number of people to join in. They could join without having to worry about wallets, storage, and more intricacies that make the crypto world still very hard to understand.
You jump on a platform like Coinbase, with a great UX, a gamified section (the Earn platform enables you to start earning cryptocurrencies by answering a few simple questions) and you have the feeling to be already an expert.
With the motto of “you don’t have to worry about your key” central exchanges exponentially grew the user base, and with the increasing price of most cryptocurrencies, running a central exchange has become highly profitable.
Perhaps, in Q1 2021, a platform like Coinbase recorded an almost 10x increase in revenues from over $179 million to $1.59 billion.
And the thing is, the whole central exchange business model is based on trading volume, as they make money mostly via fees.
Central exchanges, therefore, have worked wonders in the crypto markets by easily expanding the user base.
And they used a simple shortcut to solve the liquidity problem: stablecoins.
Back to Tether!
Why Stablecoins Solve For Liquidity But Pose Other Serious Systemic Risks?
A 2018 article, entitled “Why Stablecoins Make No Sense” called Tether a “naive stablecoin” as it was not introduced as an independent currency. Instead, that is a sort of banknote or an “I owe you” or a promise of payment, that tells you that in case you want to exchange your USDT (Tether) back to dollars this will be easily backed.
There is a problem here though, as what makes a banknote valuable is how much you can trust the bearer. And in the case of Tether, the bearer is a private company called Bitfinex.
That is also why 2021 has become a key year in which Decentralized Exchanges (DEX) were needed. And among the most successful ones, Uniswap solved for liquidity – as Decrypto highlighted – “by allowing the exchange to swap tokens without relying on buyers and sellers creating that liquidity.” At this time also DEXs have some core issues (like so-called “rug pulls” one of the hardest problems to solve for a decentralized platform that isn’t managed by any central player).
In short, Central Exchanges solved for short-term liquidity (which is one of the greatest plagues of crypto) through stablecoins but – especially in the case of Tether – they create a plethora of other issues. The most fundamental one is that they only “centralize the system” by requiring investors to having to trust the bearer, thus killing the whole premise of a blockchain-based system.
And things only get worse when the bearer is a private company, which lacks transparency.
So enter Bitfinex.
A Glance At Bitfinex
Bitfinex is another central exchange that has become extremely popular (thanks to Tether) making it among the top five central exchanges.
This is owned and operated by iFinex Inc., a company based in Hong Kong. While Tether is primarily issued by a company called Tether Limited, owned by the same owners of Bitfinex.
So where does the problem stand here?
Let’s see some of the red flags that made this bearer very hard to trust.
*Assuming that a “blockchain economy” can exist in the first place on these stablecoins backed by private companies with no regulation whatsoever. So the paradox here is that if we want a system driven by central exchanges and stablecoins regulation is a must!
The First Red Flag: False Claims On 1:1 Peg With USD
Already in 2018 Bitfinex was alleged of hiding $850 million in funds, masked as Tether reserves.
As the NY Attorney General stated
Bitfinex and Tether recklessly and unlawfully covered-up massive financial losses to keep their scheme going and protect their bottom lines,”
Attorney General James continued:
Tether’s claims that its virtual currency was fully backed by U.S. 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. This resolution makes clear that those trading virtual currencies in New York state who think they can avoid our laws cannot and will not. Last week, we sued to shut down Coinseed for its fraudulent conduct. This week, we’re taking action to end Bitfinex and Tether’s illegal activities in New York. These legal actions send a clear message that we will stand up to corporate greed whether it comes out of a traditional bank, a virtual currency trading platform, or any other type of financial institution.
And it concluded:
Today’s agreement requires Bitfinex and Tether to discontinue any trading activity with New Yorkers. In addition, these companies must submit regular reports to the OAG to ensure compliance with this prohibition.
This case posed already some serious concerns about Tether as a stablecoin, and we were in a time where this whole thing could have been prevented, as the scale was still limited to less than a billion-dollar volume.
An article from NY Times, back in 2018, also claimed that back in 2017 the Bitcoin price was manipulated by Tether.
Again, even only the suspect that this might be true is a serious concern for all the crypto space.
The Second Red Flag: The Commercial Paper Mammoth
For the first time, in March 2021, Tether, which now became a mammoth, released for the first time:
While Tether claimed a cash reserve of 3.87%, it also claimed a giant commercial paper reserve which propelled it as a global giant, as the Financial Times noticed.
Therefore, the most worrying part of this report was the commercial paper backing, representing by large the most important backing for Tether.
As Coindesk has noted, commercial paper is “a form of corporate debt that can be easily converted to cash – or not, depending on the issuer and market conditions.”
As Coindesk further noted, “Tether declined to identify the borrowers of the loans or the collateral backing them.”
Thus, as far as we know, there are even more doubts and questions to be answered to this breakdown.
The Third Red Flag: The Tether Printing Machine
In a thread between Nassim Nicholas Taleb and Paul Santos over Twitter, Paul Santos highlighted two very important points:
1. Price action of BTC is dictated by Tether trading pair: BTC/USDT, not BTC/USD. Look at the volume charts. Tether is BTC, even if you never trade for Tether.
2. Exchanges are fiat illiquid. They all shut down at the same time when their is a market crash to stop USD outflows.
And Taleb replied, “If correct it is effectively printing Tether.”
If this turns out to be true, it means that, just like central banks, Tether is printing currency to pump short-term liquidity in the system (and help speculation), but behind it has a private company, of which we know little to nothing, if not the breakdown they recently provided!
Imagine if the whole financial system was based on a person that told you “I promise I can pay you back” but showed you a wallet with plenty of toilet paper?
- Central exchanges have become the primary enabler of the crypto-economy by expanding the user base of investors, with the motto of “you don’t have to worry about your key.” As cryptocurrencies are still considered very risky by most banks, none or a few conventional banks want to do business with these exchanges. This led to a magic trick to solve the short-term liquidity issue these central exchanges face: stablecoins.
- In essence, stablecoins are the crypto version of banknotes where the trust is in the bearer to keep a stable peg between the digital currency and an underlying asset like let’s say the dollar. And the popularity of these stablecoins depends on the willingness of the central exchange to accept them.
- Stablecoins turned out to be extremely successful in 2021 because they enabled investors to prevent higher intermediary fees. It gave them the ability to easily convert them into other digital currencies at any time. It also created a massive systemic risk. In short, a good chunk of the Bitcoin liquidity perhaps is tied to the Bitcoin/Tether peg. In short, if you want to convert a Bitcoin back to USD, you have to go through USDT (Tether) first. And if Tether is not backed by real USD there is no liquidity at all.
- Worse of all, if a flight to liquidity might happen this might make the whole crypto space insolvent. And without central authority potentially saving the system what will happen?
What questions do we need to answer today, quickly?
- What’s really behind Tether?
- In case of a collapse of Tether what measures exist to prevent the whole system from collapsing?
- How can this be avoided in the future?
Answering these questions now makes the difference from having a crypto ecosystem destroyed or at least its long-term ability to drive change intact.
Disclaimer: The opinions in this article belong to the author alone. Nothing in this article constitutes investment advice. Please conduct your own thorough research before making any investment decisions.
by Gennaro @gcuofano. Gennaro is the founder of FourWeekMBA, a leading source on business model innovation. FourWeekMBA
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