Stablecoins Part 2

I wrote Stablecoins about Tether and its "magic money pump" seven months ago. A lot has happened and a lot has been written about it since, and some of it explores aspects I didn't understand at the time, so below the fold at some length I try to catch up.

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In the postscript to Stablecoins I quoted David Gerard's account of the December 16^th pump that pushed BTC over $20K:

We saw about 300 million Tethers being lined up on Binance and Huobi in the week previously. These were then deployed en masse.

You can see the pump starting at 13:38 UTC on 16 December. BTC was $20,420.00 on Coinbase at 13:45 UTC. Notice the very long candles, as bots set to sell at $20,000 sell directly into the pump.

In 2020 BTC had dropped from around $7.9K on March 10^th to under $5K on March 11^th. It spiked back up on March 18^th, then gradually rose to just under $11K by October 10^th.

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During that time Tether issuance went from $4.7B to $15.7B, an increase of over 230% with large jumps on four occasions:

1. March 28-29^th: $1.6B = $4.6B to $6.2B (a weekend)
2. May 12-13^th $2.4B = $6.4B to $8.8B
3. July 20^th-21^st $0.8B = $9.2B to $10B (a weekend)
4. August 19-20^th $3.4B = $10B to $13.4B (a weekend)

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Then both BTC and USDT really took off, with BTC peaking April 13^th at $64.9K, and USDT issuing more than $30B. BTC then started falling. Tether continued to issue USDT, peaking 55 days later on May 30^th after nearly another $16B at $61.8B. Issuance slowed dramatically, peaking 19 days later on June 18^th at $62.7B when BTC had dropped to $$35.8K, 55% of the peak. Since then USDT has faced gradual redemptions; it is now down to $61,8B.

What on earth is going on? How could USDT go from around $6B to around $60B in just over a year?

Tether

Source

In Crypto and the infinite ladder: what if Tether is fake?, the first of a two-part series, Fais Kahn asks the same question:

Tether (USDT) is the most used cryptocurrency in the world, reaching volumes significantly higher than Bitcoin. Each coin is supposed to be backed by $1, making it “stable.” And yet no one knows if this is true.

Even more odd: in the last year, USDT has exploded in size even faster than Bitcoin - going from $6B in market cap to over $60B in less than a year. This includes $40B of new supply - a straight line up - after the New York Attorney General accused Tether of fraud.

I and many others have considered a scenario in which the admitted fact that USDT is not backed 1-for-1 by USD causes a "run on the bank". Among the latest is Taming Wildcat Stablecoins by Gary Gorton and Jeffery Zhang. Zhang is one of the Federal Reserve's attorney, but who is Gary Gorton? Izabella Kaminska explains:

Over the course of his career, Gary Gorton has gained a reputation for being something of an experts’ expert on financial systems. Despite being an academic, this is in large part due to what might be described as his practitioner’s take on many key issues.

The Yale School of Management professor is, for example, best known for a highly respected (albeit still relatively obscure) theory about the role played in bank runs by information-sensitive assets.
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the two authors make the implicit about stablecoins explicit: however you slice them, dice them or frame them in new technology, in the grand scheme of financial innovation stablecoins are actually nothing new. What they really amount to, they say, is another form of information sensitive private money, with stablecoin issuers operating more like unregulated banks.

Gorton and Zhang write:

The goal of private money is to be accepted at par with no questions asked. This did not occur during the Free Banking Era in the United States—a period that most resembles the current world of stablecoins. State-chartered banks in the Free Banking Era experienced panics, and their private monies made it very hard to transact because of fluctuating prices. That system was curtailed by the National Bank Act of 1863, which created a uniform national currency backed by U.S. Treasury bonds. Subsequent legislation taxed the state-chartered banks’ paper currencies out of existence in favor of a single sovereign currency.

Unlike me, Kahn is a "brown guy in fintech", so he is better placed to come up with answers than I am. For a start, he is skeptical of the USDT "bank run" scenario:

The unbacked scenario is what concerns investors. If there were a sudden drop in the market, and investors wanted to exchange their USDT for real dollars in Tether’s reserve, that could trigger a “bank run” where the value dropped significantly below one dollar, and suddenly everyone would want their money. That could trigger a full on collapse.

But when that might actually happen? When Bitcoin falls in the frequent crypto bloodbaths, users actually buy Tether - fleeing to the safety of the dollar. This actually drives Tether’s price up! The only scenario that could hurt is when Bitcoin goes up, and Tether demand drops.

But hold on. It’s extremely unlikely Tether is simply creating tokens out of thin air - at worst, there may be some fractional reserve (they themselves admitted at one point it was only 74% backed) that is split between USD and Bitcoin.

The NY AG’s statement that Tether had “no bank anywhere in the world” strongly suggests some money being held in crypto (Tether has stated this is true, but less than 2%), and Tether’s own bank says they use Bitcoin to hold customer funds! That means in the event of a Tether drop/Bitcoin rise, they are hedged.

Tether’s own Terms of Service say users may not be redeemed immediately. Forced to wait, many users would flee to Bitcoin for lack of options, driving the price up again.

Kahn agrees with me that Tether may have a magic "money" pump:

It’s possible Tether didn’t have the money at some point in the past. And it’s just as possible that, with the massive run in Bitcoin the last year Tether now has more than the $62B they claim!

In that case Tether would seem to have constructed a perfect machine for printing money. (And America has a second central bank.)

Of course, the recent massive run down in Bitcoin will have caused the "machine for printing money" to start running in reverse.

Matt Levine listened to an interview with Tether's CTO Paolo Ardoino and General Counsel Stuart Hoegner, and is skeptical about Tether's backing:

Tether is a stablecoin that we have talked about around here because it was sued by the New York attorney general for lying about its reserves, and because it subsequently disclosed its reserves in a format that satisfied basically no one. Tether now says that its reserves consist mostly of commercial paper, which apparently makes it one of the largest commercial paper holders in the world. There is a fun game among financial journalists and other interested observers who try to find anyone who has actually traded commercial paper with Tether, or any of its actual holdings. The game is hard! As far as I know, no one has ever won it, or even scored a point; I have never seen anyone publicly identify a security that Tether holds or a counterparty that has traded commercial paper with it.

USDT reserve disclosure

Levine contrasts Tether's reserve disclosure with that of another instrument that is supposed to maintain a stable value, a money market fund:

Here is the website for the JPMorgan Prime Money Market Fund. If you click on the tab labeled “portfolio,” you can see what the fund owns. The first item alphabetically is $50 million face amount of asset-backed commercial paper issued by Alpine Securitization Corp. and maturing on Oct. 12. Its CUSIP — its official security identifier — is 02089XMG9. There are certificates of deposit at big banks, repurchase agreements, even a little bit of non-financial commercial paper. ... You can see exactly how much (both face amount and market value), and when it matures, and the CUSIP for each holding.

JPMorgan is not on the bleeding edge of transparency here or anything; this is just how money market funds work. You disclose your holdings.

Binance

But the big picture is that USDT pumped $60B into cryptocurrencies. Where did the demand for the $60B come from? In my view, some of it comes from whales accumulating dry powder to use in pump-and-dump schemes like the one illustrated above. But Kahn has two different suggestions. First:

One of the well-known uses for USDT is “shadow banking” - since real US dollars are highly regulated, opening an account with Binance and buying USDT is a straightforward way to get a dollar account.

The CEO of USDC himself admits in this Coindesk article: “In particular in Asia where, you know, these are dollar-denominated markets, they have to use a shadow banking system to do it...You can’t connect a bank account in China to Binance or Huobi. So you have to do it through shadow banking and they do it through tether. And so it just represents the aggregate demand. Investors and users in Asia – it’s a huge, huge piece of it.”

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Second:

Binance also hosts a massive perpetual futures market, which are “cash-settled” using USDT. This allows traders to make leveraged bets of 100x margin or more...which, in laymen’s terms, is basically a speculative casino. That market alone provides around ~$27B of daily volume, where users deposit USDT to trade on margin. As a result, Binance is by far the biggest holder of USDT, with $17B sitting in its wallet.

Wikipedia describes "perpetual futures" thus:

In finance, a perpetual futures contract, also known as a perpetual swap, is an agreement to non-optionally buy or sell an asset at an unspecified point in the future. Perpetual futures are cash-settled, and differ from regular futures in that they lack a pre-specified delivery date, and can thus be held indefinitely without the need to roll over contracts as they approach expiration. Payments are periodically exchanged between holders of the two sides of the contracts, long and short, with the direction and magnitude of the settlement based on the difference between the contract price and that of the underlying asset, as well as, if applicable, the difference in leverage between the two sides

In Is Tether a Black Swan? Bernhard Mueller goes into more detail about Binance's market:

According to Tether’s rich list, 17 billion Tron USDT are held by Binance alone. The list also shows 2.68B USDT in Huobi’s exchange wallets. That’s almost 20B USDT held by two exchanges. Considering those numbers, the value given by CryptoQuant appears understated. A more realistic estimate is that ~70% of the Tether supply (43.7B USDT) is located on centralized exchanges.

Interestingly, only a small fraction of those USDT shows up in spot order books. One likely reason is that a large share is sitting on wallets to collateralize derivative positions, in particular perpetual futures. The CEX futures market is essentially a casino where traders bet on crypto prices with insane amounts of leverage. And it’s a massive market: Futures trading on Binance alone generated $60 billion in volume over the last 24 hours. It’s important to understand that USDT perpetual futures implementations are 100% USDT-based, including collateralization, funding and settlement. Prices are tied to crypto asset prices via clever incentives, but in reality, USDT is the only asset that ever changes hands between traders. This use-case generates significant demand for USDT.

Why is this "massive perpetual futures market" so popular? Kahn provides answers:

That crazed demand for margin trading is how we can explain one of the enduring mysteries of crypto - how users can get 12.5% interest on their holdings when banks offer less than 1%.

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The high interest is possible because:

The massive supply of USDT, and the host of other dollar stablecoins like USDC, PAX, and DAI, creates an arbitrage opportunity. This brings in capital from outside the ecosystem seeking the “free money” making trades like this using a combination of 10x leverage and and 8.5% variance between stablecoins to generate an 89% profit in just a few seconds. If you’re only holding the bag for a minute, who cares if USDT is imaginary dollars?

Rollicking good times like these attract the attention of regulators, as Amy Castor reported on July 2^nd in Binance: A crypto exchange running out of places to hide:

Binance, the world’s largest dark crypto slush fund, is struggling to find corners of the world that will tolerate its lax anti-money laundering policies and flagrant disregard for securities laws.

As a result, Laurence Fletcher, Eva Szalay and Adam Samson report that Hedge funds back away from Binance after regulatory assault :

The global regulatory pushback “should raise red flags for anyone keeping serious capital at the exchange”, said Ulrik Lykke, executive director at ARK36, adding that the fund has “scaled down” exposure.
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Lykke described it as “especially concerning” that the recent moves against Binance “involve multiple entities from across the financial sphere”, such as banks and payments groups.

This leaves some serious money looking for an off-ramp from USDT to fiat. These are somewhat scarce:

if USDT holders on centralized exchanges chose to run for the exits, USD/USDC/BUSD liquidity immediately available to them would be relatively small. ~44 billion USDT held on exchanges would be matched with perhaps ~10 billion in fiat currency and USDC/BUSD

This, and the addictive nature of "a casino ... with insane amounts of leverage", probably account for the relatively small drop in USDT market cap since June 18^th. Amy Castor reported July 13^th on another reason in Binance: Fiat off-ramps keep closing, reports of frozen funds, what happened to Catherine Coley?:

Binance customers are becoming trapped inside of Binance — or at least their funds are — as the fiat exits to the world’s largest crypto exchange close around them. You can almost hear the echoes of doors slamming, one by one, down a long empty corridor leading to nowhere.

In the latest bit of unfolding drama, Binance told its customers today that it had disabled withdrawals in British Pounds after its key payment partner, Clear Junction, ended its business relationship with the exchange.
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There’s a lot of unhappy people on r/BinanceUS right now complaining their withdrawals are frozen or suspended — and they can’t seem to get a response from customer support either.
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Binance is known for having “maintenance issues” during periods of heavy market volatility. As a result, margin traders, unable to exit their positions, are left to watch in horror while the exchange seizes their margin collateral and liquidates their holdings.

And it isn't just getting money out of Binance that is getting hard, as David Gerard reports:

Binance is totally not insolvent! They just won’t give anyone their cryptos back because they’re being super-compliant. KYC/AML laws are very important to Binance, especially if you want to get your money back after suspicious activity on your account — such as pressing the “withdraw” button. Please send more KYC. [Binance]

Issues like these tend to attract the attention of the mainstream press. On July 23^rd the New York Times' Eric Lipton and Ephrat Livni profiled Sam Bankman-Fried of the FTX exchange in Crypto Nomads: Surfing the World for Risk and Profit:

The highly leveraged form of trading these platforms offer has become so popular that the overall value of daily purchases and sales of these derivatives far surpasses the daily volume of actual cryptocurrency transactions, industry data analyzed by researchers at Carnegie Mellon University shows.
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FTX alone has one million users across the world and handles as much as $20 billion a day in transactions, most of them derivatives trades.

Like their customers, the platforms compete. Mr. Bankman-Fried from FTX, looking to out promote BitMEX, moved to offer up to 101 times leverage on derivatives trades. Mr. Zhao from Binance then bested them both by taking it to 125.

Then on the 25^th, as the regulators' seriousness sank in, the same authors reported Leaders in Cryptocurrency Industry Move to Curb the Highest-Risk Trades:

Two of the world’s most popular cryptocurrency exchanges announced on Sunday that they would curb a type of high-risk trading that has been blamed in part for sharp fluctuations in the value of Bitcoin and the casino-like atmosphere on such platforms globally.

The first move came from the exchange, FTX, which said it would reduce the size of the bets investors can make by lowering the amount of leverage it offers to 20 times from 101 times. Leverage multiplies the traders’ chance for not only profit, but also loss.
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About 14 hours later, Changpeng Zhao [CZ], the founder of Binance, the world’s largest cryptocurrency exchange, echoed the move by FTX, announcing that his company had already started to limit leverage to 20 times for new users and it would soon expand this limit to other existing clients.

Early the next day, Tom Schoenberg, Matt Robinson, and Zeke Faux reported for Bloomberg that Tether Executives Said to Face Criminal Probe Into Bank Fraud:

U.S. probe into Tether is homing in on whether executives behind the digital token committed bank fraud, a potential criminal case that would have broad implications for the cryptocurrency market.

Tether’s pivotal role in the crypto ecosystem is now well known because the token is widely used to trade Bitcoin. But the Justice Department investigation is focused on conduct that occurred years ago, when Tether was in its more nascent stages. Specifically, federal prosecutors are scrutinizing whether Tether concealed from banks that transactions were linked to crypto, said three people with direct knowledge of the matter who asked not to be named because the probe is confidential.

Federal prosecutors have been circling Tether since at least 2018. In recent months, they sent letters to individuals alerting them that they’re targets of the investigation, one of the people said.

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Once again, David Gerard pointed out the obvious market manipulation:

This week’s “number go up” happened several hours before the report broke — likely when the Bloomberg reporter contacted Tether for comment. BTC/USD futures on Binance spiked to $48,000, and the BTC/USD price on Coinbase spiked at $40,000 shortly after.

Here’s the one-minute candles on Coinbase BTC/USD around 01:00 UTC (2am BST on this chart) on 26 July — the price went up $4,000 in three minutes. You’ve never seen something this majestically organic

And so did Amy Castor in The DOJ’s criminal probe into Tether — What we know:

Last night, before the news broke, bitcoin was pumping like crazy. The price climbed nearly 17%, topping $40,000. On Coinbase, the price of BTC/USD went up $4,000 in three minutes, a bit after 01:00 UTC.

After a user placed a large number of buy orders for bitcoin perpetual futures denominated in tethers (USDT) on Binance — an unregulated exchange struggling with its own banking issues — The BTC/USDT perpetual contract hit a high of $48,168 at around 01:00 UTC on the exchange.

Bitcoin pumps are a good way to get everyone to ignore the impact of bad news and focus on number go up. “Hey, this isn’t so bad. Bitcoin is going up in price. I’m rich!”

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As shown in the graph, the perpetual futures market is at least an order of magnitude larger than the spot market upon which it is based. and as we saw for example on December 16^th and July 26^th, the spot market is heavily manipulated. Pump-and-dump schemes in the physical market are very profitable, and connecting them to the casino in the futures market with its insane leverage can juice profitability enormously.

Tether and Binance

Fais Kahn's second part, Bitcoin's end: Tether, Binance and the white swans that could bring it all down, explores the mutual dependency between Tether and Binance:

There are $62B tokens for USDT in circulation, much of which exists to fuel the massive casino that is the perpetual futures market on Binance. These complex derivatives markets, which are illegal to trade in the US, run in the tens of billions and help drive up the price of Bitcoin by generating the basis trade.

The "basis trade":

involves buying a commodity at spot (taking a long position) and simultaneously establishing a short position through derivatives like options or futures contracts

Kahn continues:

For Binance to allow traders to make such crazy bets, it needs collateral to make sure if traders get wiped out, Binance doesn’t go bankrupt. That collateral is now an eye-popping $17B, having grown from $3B in February and $10B in May:

But for that market to work, Binance needs USDT. And getting fresh USDT is a problem now that the exchange, which has always been known for its relaxed approach to following the laws, is under heavy scrutiny from the US Department of Justice and IRS: so much so that their only US dollar provider, Silvergate Bank, recently terminated their relationship, suggesting major concerns about the legality of some of Binance’s activities. This means users can no longer transfer US dollars from their bank to Binance, which were likely often used to fund purchases of USDT.

Since that shutdown, the linkages between Binance, USDT, and the basis trade are now clearer than ever. In the last month, the issuance of USDT has completely stopped:

Likewise, futures trading has fallen significantly. This confirms that most of the USDT demand likely came from leveraged traders who needed more and more chips for the casino. Meanwhile, the basis trade has completely disappeared at the same time.

Which is the chicken and which is the egg? Did the massive losses in Bitcoin kill all the craziest players and end the free money bonanza, or did Binance’s banking troubles choke off the supply of dollars, ending the game for everyone? Either way, the link between futures, USDT, and the funds flooding the crypto world chasing free money appears to be broken for now.

This is a problem for Binance:

Right now Tether is Binance’s $17B problem. At this point, Binance is holding so much Tether the exchange is far more dependent on USDT’s peg staying stable than it is on any of its banking relationships. If that peg were to break, Binance would likely see capital flight on a level that would wreak untold havoc in the crypto markets
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Regulators have been increasing the pace of their enforcements. In other words, they are getting pissed, and the BitMex founders going to jail is a good example of what might await.

Binance has been doing all it can to avoid scrutiny, and you have to award points for creativity. The exchange was based in Malta, until Malta decided Binance had “no license” to operate there, and that Malta did not have jurisdiction to regulate them. As a result, CZ began to claim that Binance “doesn’t have” a headquarters.

Wonder why? Perhaps to avoid falling under anyone’s direct jurisdiction, or to avoid a paper trail?

CZ went on to only reply that he is based in “Asia.” Given what China did to Jack Ma recently, we can empathize with a desire to stay hidden, particularly when unregulated exchanges are a key rail for evading China’s strict capital controls. Any surprise that the CFO quit last month?

But it is also a problem for Tether:

Here’s what could trigger a cascade that could bring the exchange down and much of crypto with it: the DOJ and IRS crack down on Binance, either by filing charges against CZ or pushing Biden and Congress to give them the death penalty: full on sanctions. This would lock them out of the global financial system, cause withdrawals to skyrocket, and eventually drive them to redeem that $17B of USDT they are sitting on.

And what will happen to Tether if they need to suddenly sell or redeem those billions?

We have no way of knowing. Even if fully collateralized, Tether would need to sell billions in commercial paper on short notice. And in the worst case, the peg would break, wreaking absolute havoc and crushing crypto prices.

Alternatively

It’s possible that regulators will move as slow as they have been all along - with one country at a time unplugging Binance from its banking system until the exchange eventually shrinks down to be less of a systemic risk than it is.

That's my guess — it will become increasingly difficult either to get USD or cryptocurrency out of Binance's clutches, or to send them fiat, as banks around the world realize that doing business with Binance is going to get them in trouble with their regulators. Once customers realize that Binance has become a "roach motel" for funds, and that about 25% of USDT is locked up there, things could get quite dynamic.

Kahn concludes:

Everything around Binance and Tether is murky, even as these entities two dominate the crypto world. Tether redemptions are accelerating, and Binance is in trouble, but why some of these things are happening is guesswork. And what happens if something happens to one of those two? We’re entering some uncharted territory. But if things get weird, don’t say no one saw it coming.

Policy Responses

Gorton and Zhang argue that the modern equivalent of the "free banking" era is fraught with too many risks to tolerate. David Gerard provides an overview of the era in Stablecoins through history — Michigan Bank Commissioners report, 1839:

The wildcat banking era, more politely called the “free banking era,” ran from 1837 to 1863. Banks at this time were free of federal regulation — they could launch just under state regulation.

Under the gold standard in operation at the time, these state banks could issue notes, backed by specie — gold or silver — held in reserve. The quality of these reserves could be a matter of some dispute.

The wildcat banks didn’t work out so well. The National Bank Act was passed in 1863, establishing the United States National Banking System and the Office of the Comptroller of the Currency — and taking away the power of state banks to issue paper notes.

Gerard's account draws from a report of Michigan's state banking commissioners, Documents Accompanying the Journal of the House of Representatives of the State of Michigan, pp. 226–258, which makes clear that Tether's lack of transparency as to its reserves isn't original. Banks were supposed to hold "specie" (money in the form of coin) as backing but:

The banking system at the time featured barrels of gold that were carried to other banks, just ahead of the inspectors

For example, the commissioners reported that:

The Farmers’ and Mechanics’ bank of Pontiac, presented a more favorable exhibit in point of solvency, but the undersigned having satisfactorily informed himself that a large proportion of the specie exhibited to the commissioners, at a previous examination, as the bona fide property of the bank, under the oath of the cashier, had been borrowed for the purpose of exhibition and deception; that the sum of ten thousand dollars which had been issued for “exchange purposes,” had not been entered on the books of the bank, reckoned among its circulation, or explained to the commissioners.

Gorton and Zhang summarize the policy choices thus:

Based on historical lessons, the government has a couple of options: (1) transform stablecoins into the equivalent of public money by (a) requiring stablecoins to be issued through FDIC- insured banks or (b) requiring stablecoins to be backed one-for-one with Treasuries or reserves at the central bank; or (2) introduce a central bank digital currency and tax private stablecoins out of existence.

Their suggestions for how to implement the first option include:

• the interpretation of Section 21 of the Glass-Steagall Act, under which "it is unlawful for a non-bank entity to engage in deposit-taking"
• the interpretation of Title VIII of the Dodd-Frank Act, under which the Financial Stability Oversight Council could "designate stablecoin issuance as a systemic payment activity". This "would give the Federal Reserve the authority to regulate the activity of stablecoin issuance by any financial institution."
• Congress could pass legislation that requires stablecoin issuers to become FDIC-insured banks or to run their business out of FDIC-insured banks. As a result, stablecoin issuers would be subject to regulations and supervisory activities that come along with being an FDIC-insured bank.

Alternatively, the second option would involve:

Congress could require the Federal Reserve to issue a central bank digital currency as a substitute to privately produced digital money like stablecoins
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The question then becomes whether policymakers would want to have central bank digital currencies coexist with stablecoins or to have central bank digital currencies be the only form of money in circulation. As discussed previously, Congress has the legal authority to create a fiat currency and to tax competitors of that uniform national currency out of existence.

They regard the key attribute of an instrument that acts as money to be that it is accepted at face value "No Questions Asked" (NQA). Thus, based on history they ask:

In other words, should the sovereign have a monopoly on money issuance? As shown by revealed preference in the table below, the answer is yes. The provision of NQA money is a public good, which only the government can supply.