Tether: A 0% Interest Offshore Hedge Fund

The emergence of stablecoins has brought attention to the importance of reserve management practices. Managing these reserves poses various risks, including counterparty risk, credit risk, and liquidity risk, which could affect the stability and credibility of stablecoins. The following examines real world instances such as market downturns or other signicant events, and analyzes measures taken to prevent or mitigate reserve risk. The case study analysis will provide insights into the measures stablecoin issuers take to manage reserve risks and how these have been effective or inadequate in such situations.

Written by: Adam Lovasz & Bear Matthews

The emergence of stablecoins has brought attention to the importance of reserve management practices. Managing these reserves poses various risks, including counterparty risk, credit risk, and liquidity risk, which could affect the stability and credibility of stablecoins. The following examines real world instances such as market downturns or other signicant events, and analyzes measures taken to prevent or mitigate reserve risk. The case study analysis will provide insights into the measures stablecoin issuers take to manage reserve risks and how these have been effective or inadequate in such situations.

By closely examining the interplay between regulation, adoption, and issuer practices, this research aims to shed light on the implications of stablecoin insolvency for the crypto and digital asset exchange industry. This research seeks to address the observed inverse correlation between regulation and the adoption of stablecoins by market participants. As more regulations are imposed on stablecoin issuers, there is a discernible decrease in their adoption. This finding underscores the delicate balance between regulatory oversight and fostering widespread acceptance of stablecoins as a viable financial instrument.

The research identifies an alarming trend where stablecoins that are subject to limited regulation, becoming what is essentially, risk-free, zero-interest borrowing mechanisms for their issuing entities. This situation arises due to the absence of regulatory obligations during periods of financial instability, leaving these issuers less accountable for managing potential risks. The implications of this phenomenon require careful consideration to maintain the integrity of the financial system.

An analysis of major stablecoin issuers' performance reveals contrasting outcomes based on their regulatory compliance and transparency. While some issuers who have de-risked by complying with regulators have experienced limited financial gains, others, notably Tether $USDT, have thrived by operating in deregulated environments. Conversely, the most regulated and transparent stablecoin, Circle $USDC, recently faced financial turmoil during the SVB crisis. These ndings highlight the complex dynamics between regulatory compliance, financial performance, and stablecoin stability.

This research serves as a cautionary investigation into the potential risks posed by unregulated stablecoins, with a specic focus on Tether's dominance in the market. The study emphasizes the need for regulatory oversight and robust reserve management practices to mitigate the financial spillover risks associated with stablecoin insolvency.

Literature on stablecoins and their reserve management practices is still evolving. Several studies have been conducted to explore various aspects of stablecoins, including their types, mechanisms, and applications. One of the earliest studies on stablecoins was conducted by Carlo Cocuzzo and Antonello Scorcu2, who proposed a framework for analyzing the stability of stablecoins based on their underlying reference assets. They argued that stablecoins could be classied into three categories: at-based, commodity-based, and crypto-based stablecoins. A study by Dong He et. al3, analyzed the potential benets and risks of stablecoins for cross-border payments. They argued that stablecoins could enhance the eciency and inclusiveness of cross-border payments by reducing transaction costs and increasing accessibility. However, they also identied several risks, including regulatory uncertainty, operational ambiguity, and systemic contagion. A more recent study by Garrick Hileman et al.4 provided a comprehensive overview of stablecoins and their applications. Here, they classied stablecoins into four categories based on their underlying mechanisms and discussed the advantages and disadvantages of each type of stablecoin. The following research contributes to the ongoing exploration of stablecoins role in financial markets, and provides an intimate analysis of Tether Limited’s internal operating procedures, risk appetite, and interdependency with the crypto ecosystem.

Chapter One: A Cross-Market Comparative Analysis

Classifying Stablecoins: Money, Deposits, or Banks

To thoroughly examine the systemic and reserve management risks associated with reserve-backed stablecoins, we must rst understand the probable classication and role of stablecoins in the financial world. According to a 2021 research paper by Gary B. Gorton and Jeery Y. Zhang titled “Taming Wildcat Stablecoins”,5 we can classify three subsections of the banking economy: money, deposits, and deposits or banks.

Cryptocurrencies are digital tokens on a blockchain that can be transacted amongst private actors. This no-trust intermediation of value transfer between pseudonymous parties has been one of the primary appeals of blockchain technology since the emergence of the Bitcoin network in 2009. The fundamental role of stablecoins is to provide on-chain stability and consensus value. According to Gorton and Zhang, this principle can be called ‘NQA’, or the no-questions-asked principle. Under this core assumption, “NQA means both parties to a transaction must agree that the money be accepted at par—a ten-dollar bill should be accepted as worth ten dollars, not a penny less. Achieving the characteristics of NQA has, historically, been very hard.”6

For a transaction medium such as a tokens to maintain the NQA principle, it must uphold a par value to a consensus form of security such as a at currency (US dollar, Euro, GBP). The most prominent form of stablecoins, such as Tether $USDT, Circle $USDC and MakerDAO $DAI, is reserve-backed stablecoins maintaining par value to the US dollar or an equivalent at currency. To maintain the NQA principle and thereby value stability, the consensus reserve value denominated in at holdings must always equal the circulating supply representing that value to the stablecoin holders.

The function upholding a at peg and the transacting value of reserve-backed stablecoins is the promissory agreement that a token can be redeemed for cash by the issuer. The circulating supply of stablecoins representing at reserves must be adjusted accordingly. If the token price is to stay pegged, then, to equate supply and demand, the quantity of circulating supply must be adjusted. The concern of particular importance to our research is that the quantity can adjust quickly to zero during a bank run under this arrangement. In this situation, the backing of the token becomes suspect, and holders instead want cash. Privately produced money, such as at-pegged, reserve-backed stablecoins, are potentially vulnerable to such runs.

To further classify stablecoins, we analyse the financial instrument that stablecoin issuers wish to represent: money. Money is a unit of account, a medium of exchange, and a store of value. Stablecoins are meant to serve a stable unit of account and a medium exchange settled on-chain. The argument for whether reserve-backed stablecoins meet the ‘store of value’ necessity for full NQA adherence to monetary standards depends on reserve management practices and asset backing.

“Stablecoin issuers, therefore, face a trade-o with respect to opacity and transparency. On the one hand, it would be best if the backing for their stablecoins were so opaque that nobody would nd it protable to produce information about the backing assets. On the other hand, if the backing is not credible, the market will want to produce information about the backing. Stablecoin issuers may believe that transparency is best because they are not regulated and cannot rely on bank examiners (thus, cannot be opaque).” 7

Trust in stablecoins relies on the transparency of reserves upholding a at-peg of circulating token supply. Redeemability of at deposits irrespective of market events should determine trust of the token issuer. Therefore, to classify reserve-backed stablecoins as money, we must examine the nature of the deposit agreements with stablecoin issuers, such as Tether $USDT, Circle $USDC or MakerDAO $DAI. The primary dierentiator in deposit agreement classications is whether a deposit swap issued by a stablecoin provider is a debt agreement. Under this provision, one could consider a stablecoin issuer in a similar financial operating structure to a bank, in which a depositor holds an agreement and claims cash funds in the event of redemption. The bank holds its dollar deposits and can engage in financial activity using consumer deposits to generate interest and protable returns on the reserves.

“Based on the Department of Justice’s interpretive letter, some stablecoin issuers like Tether might be treated similarly to money market funds because their contractual relationship with stablecoin holders resembles the relationship between money market funds and their investors. To be sure, one could strongly counter-argue that Tether’s contract is a debt contract even if it has certain characteristics of money market funds under the Department of Justice’s interpretive letter. For example, no holder of Tether coins can obtain gains directly from holding those coins, and there is nothing on Tether’s website suggesting that a holder might benet from any gain on investments. To the extent there is such a gain, the issuer of the coin (Tether) appears to keep it.”8

Under this arrangement, the stablecoin issuer, Tether, has no contractual obligation to share prots through interest rate payments on deposits to stablecoin holders. This form of non-interest-paying deposit agreements rules out the notion of Tether acting as a form of a banking intermediary. To consider systemic risks of increasing stablecoin market capitalization, we must also analyze the concept of demand deposit agreements. According to a 1966 supreme court amendment, we can classify the current US position on stablecoins as:

“Application of this standard to the Board’s interpretation of the “demand deposit” element of § 2(c) does not require extended analysis. By the 1966 amendments to § 2(c), Congress expressly limited the Act to the regulation of institutions that accept deposits that “the depositor has a legal right to withdraw on demand.” 12 U.S.C. § 1841(c). The Board would now dene “legal right” as meaning the same as “a matter of practice.” But no amount of agency expertise—however, sound may be the result—can make the words “legal right” mean a right to do something “as a matter of practice.” A legal right to withdraw on demand means withdrawing deposits without prior notice or limitation. Institutions oering NOW accounts do not give the depositor a legal right to withdraw on demand; rather, the institution retains the ultimate legal right to require advance notice of withdrawal. Therefore, the Board’s denition of “demand deposit” is not an accurate or reasonable interpretation of § 2(c).47”9

Based on this excerpt from the supreme court conclusion on demand deposit agreements on bank deposits, we see there is plausible diculty upholding demand deposit agreements in the event of a stablecoin bank run in two ways:

  1. Stablecoin issuer asset holdings liquidation delays: An issuer holding a mixed bag of diversied liquid and semi-liquid reserve assets, may experience liquidation delays on high volume capital calls. In this event, deposit withdrawals may be delayed or suspended until capital availability catches up with demand, resulting in distrust of an issuer. Consequently, the emerging pressure on the liquidation of stablecoin holdings may likely result in a spiral event where holders are willing to sell at a discount to willing buyers oering to take on the added risk premium of purchasing de-pegged stablecoins.
  1. Systemic banking deposit delays: Even though we cannot fully classify the relationship between stablecoin holders and issuers as a banking intermediary, stablecoin reserves, to an extent, are cash deposits held in partner commercial banks. As we know, in the case of licensed banks in the United States, FDIC deposit insurance only extends to $250,000 in account deposits. In all legal disclosures issued by Tether, they state that “Digital Tokens are not legal tender and are not backed by any Government. Digital Tokens are not subject to Federal Deposit Insurance Corporation (“FDIC”) or Securities Investor Protection Corporation protections.”10 There is potential for a signicant moral hazard scenario emerging from the lack of government jurisdiction overseeing the reserve management practices of an issuer such as Tether. All risk falls directly on the stablecoin holder rather than the issuer in upholding the at peg via proper reserve management practices.

Stablecoin Internal Operations Case Study

Tether, Operational Resilience. $USDT was originally built on the Bitcoin blockchain using the Omni Layer protocol. Tether has since launched $USDT on other networks, including Ethereum, Tron, and Algorand. Utilizing multiple blockchain networks introduces additional complexities and risks, such as potential interoperability issues and liquidity fragmentation.

As noted by Forbes,11 Tether has never had a denitive audit of its reserves and has been accused of manipulating markets. Paolo Ardoino, Tether's CTO, has admitted that Tether invests in risky assets outside the US Treasury's and money market funds.12 In 2021, the New York Attorney General and CFTC ned Tether $41 million for falsely claiming that $USDT was backed by U.S. dollars one-for-one. Previous reporting13 has attempted to understand Tether’s ownership structure, which is allegedly controlled by four men who own 86%. All supporting evidence suggests these individuals lack experience managing a financial institution of this scale. The executive sta have experience in online gambling, child acting, plastic surgery and aircraft refueling. Tether is currently under investigation by the U.S. Justice Department for aliation to terrorist nancing.

Tether, Transparency and Disclosure. Valid concerns remain about the accuracy of information provided by Tether. In 2019, the company revealed that its reserves were held in cash and cash equivalents, short-term securities, and bitcoin. According to the Financial Times14, Tether holds the majority of its reserves at several small Bahamas banks. While Tether has declined to reveal where it holds its assets, it has disclosed a banking relationship with Deltec Bank & Trust. The Wall Street Journal15 raised questions about Tether's "other investments" that were listed at $2.6 billion as of September 30th, 2022. Tether didn't specify what those were or disclose their market value. Tether's outstanding litigation and liabilities are yet to be estimated by management and its counsel.

The Wall Street Journal16 also revealed that Tether Holdings Ltd. and its sister company, Bitnex, used fake sales invoices and contracts to get access to global banking systems. The evidence, which included internal emails and documents, showed that the Tether/Bitnex aliate companies often hid their identities behind other businesses or individuals, and had connections to a designated terrorist organization.

USDC, Operational Resilience. $USDC operates on the Ethereum blockchain and other blockchains that support the ERC-20 standard. As reported by Bloomberg17, Circle Internet Financial Limited recently secured $400 million in funding from a group that includes BlackRock Inc. and Fidelity Management and Research LLC. The investment indicates traditional nance's growing acknowledgement of the stablecoins role in traditional financial markets. BlackRock has also partnered with Circle, exploring capital-market applications for $USDC and serving as a primary asset manager for the stablecoin's cash reserves. According to an employee memo, BlackRock believes digital assets and DLT will become increasingly relevant for the company and clients.

USDC, Transparency and Disclosure. Circle provides regular attestation reports and public statements from an independent accounting rm verifying the reserves backing $USDC. These reports provide transparency into the composition of the reserves and the valuation methodology used by Circle. Attestation reports do not provide information on the counterparties involved in the reserve management process, or the risk prole of select investments in commercial paper, corporate bonds, and other assets that could experience losses and are less liquid if customers ever tried to redeem the stablecoin en masse.

DAI, Transparency and Disclosure. MakerDAO publishes regular reports on the status of $DAI, which include information on the composition and valuation of the collateral backing $DAI. The reports are published on the MakerDAO blog, providing a comprehensive overview of the system's health. The reports also include information on any changes to the collateral requirements and the stability fee, the interest rate borrowers pay to mint $DAI. MakerDAO also maintains an open and transparent governance process, which allows community members to participate in decision-making about the system's future. MakerDAO token holders can propose and vote on changes to the collateral requirements, stability fee, and other system parameters. This governance process ensures that the community has a say in the management of the system and that decisions are made in the best interests of the users of $DAI.

DAI, Contagion and Spillover Effects. The $DAI Target Price is set at 1 USD, which means that the value of collateral assets $DAI holders receive in the case of an Emergency Shutdown is determined by this target price. This mechanism helps to maintain the peg between $DAI and the US dollar, which is important for the stability of the stablecoin. In the event of an Emergency Shutdown, the shutdown process can only be controlled by Maker Governance, and MKR voters can trigger an Emergency Shutdown by depositing MKR into the Emergency Shutdown Module (ESM), if enough MKR voters believe it is necessary. After an Emergency Shutdown is initiated, three phases follow. The Maker Protocol shuts down, Vault owners withdraw assets, and Collateral Auctions begin. The auction processing period guarantees that no auctions are outstanding at the end of the period, and $DAI holders use their $DAI to claim collateral directly at a xed rate that corresponds to the calculated value of their assets based on the $DAI Target Price.

CBDC, Operational Resilience. Ensuring the operational resilience of a CBDC system is crucial to maintaining condence in the currency and preventing disruptions that could lead to systemic risks. In the context of CBDCs, operational resilience refers to the ability of the system to function eectively and securely under a wide range of conditions, including normal operations, peak demand periods, and periods of stress or disruption. To achieve operational resilience, CBDC systems must be designed with robust cybersecurity measures, business continuity planning, and recovery arrangements.

In an article published by Swift18, Chief Innovation Ocer, Tom Zschach, discussed the successful testing of a solution developed by Swift to enable CBDCs to move seamlessly between DLT-based and at-based systems using existing financial infrastructure. The article highlighted the importance of operational resilience in ensuring the success of CBDCs, as technological infrastructure must be robust enough to prevent disruptions that could undermine condence in the currency. Zschach emphasised that the solution was tested across almost 5,000 transactions between two blockchain networks and a traditional at currency, with participation from 18 central and commercial banks. The solution enabled seamless exchange of CBDCs, even those built on dierent platforms. According to Zschach, the experiments showed the critical role that Swift can play in a financial ecosystem in which digital and traditional currencies co-exist. The article also stated that technological evolution in the global payments space can unlock a range of exciting new possibilities in financial services. Swift plans to continue to innovate and experiment with its community to develop real-world solutions that support its strategic focus to enable instant, frictionless, and interoperable cross-border transactions for value in all its forms. The successful testing of the solution is a positive development towards ensuring the operational resilience of CBDCs, as it allows for seamless exchange between dierent blockchain networks and at-based systems.

CBDC, Transparency and Disclosure. The central bank should provide accurate and up-to-date information on the assets that back the CBDC, including their types, amounts, and valuation methods. The central bank should provide information on how it manages the CBDC's liquidity and credit risk, including its approach to managing counterparty risk, sources of funding in times of stress, and any contingency plans for dealing with operational disruptions.

Transparency and disclosure can also play a role in ensuring that CBDCs are used for legitimate purposes and not used to facilitate illicit activities. Decrypt recently covered19 when Republican House Majority Whip Tom Emmer warned that a CBDC could jeopardize American civil liberties, erode Americans' financial privacy, and be used to "choke out politically unpopular activity." He expressed concerns that a CBDC in the U.S. would be a struggle for power between the government and its people. Meanwhile, Vice Chair for Supervision of the Fed Michael Barr spoke about CBDCs at an event hosted by the Peterson Institute for International Economics. He emphasized the need for the technology to have the same degree of insulation from government oversight as bank deposits currently do. Former Commodity Futures Trading Commission Chairman, Christopher J. Giancarlo stated20 that a CBDC that is designed to protect privacy and is free of surveillance tools could set a global standard and reach mass adoption. He believes that a digital dollar that is operationally and transparently private could counter China and Europe's digital currencies.

Reserve Management Practices: Stablecoins vs Traditional Financial Institutions

A depositor at a traditional commercial bank should not have to consider or have elevated concern if their US dollar holdings are worth a dollar; the same standard should be true for reserve-backed at-pegged stablecoins. This analysis aims to determine the systemic risks associated with the growing market capitalisation and circulating supply of stablecoins and explore similarities in the deposit agreement between stablecoin holders and issuers versus the deposit liquidity agreements and withdrawal provisions of commercial savings banks.

The primary focus is investigating the potential systemic risks associated with the burgeoning market capitalisation and circulation of reserve-backed stablecoins such as Tether USDT and Circle USDC. The underlying hypothesis is that stablecoins, when operating centrally, exhibit similar risk characteristics to traditional financial institutions, particularly central banks and commercial banks, regarding reserve management practices, deposit agreements, and withdrawal provisions. Moreover, the research will explore whether the relatively lower liquidity of the cryptocurrency market and the use of centralized exchanges for at swaps could exacerbate the risks associated with stablecoins.

To substantiate this hypothesis, we comprehensively examine the reserve management practices of stablecoin issuers and traditional financial institutions in Section 2 of the research paper. This analysis will involve scrutinizing the asset composition of the reserves, the transparency of reserve reporting, and the overall stability of the underlying assets. A key aspect of this investigation is to determine whether the reserve management practices of stablecoin issuers are suciently robust to withstand market uctuations and maintain the pegged value.

Reserve Management Practices of Traditional Financial Institutions

Traditional financial institutions, such as banks and other depository institutions, manage their reserves to maintain liquidity, meet regulatory requirements, and ensure the stability of their balance sheets. Some key aspects of reserve management in traditional financial institutions include

Capital Requirements. Regulatory authorities, such as the Basel Committee on Banking Supervision, impose capital adequacy requirements on banks to maintain a sucient capital buer to absorb potential losses. Banks must hold a certain percentage of their risk-weighted assets as high-quality capital.

The Bank of International Settlements (BIS) has released a report summarizing the Basel III reforms, which aim to improve the banking system's resilience and prevent the build-up of systemic vulnerabilities. The report outlines the main features of the Basel III framework, which include strengthening the quality and level of capital requirements, enhancing risk capture, adding macroprudential elements, and introducing a minimum leverage ratio requirement and international framework for mitigating liquidity risk. The revised Basel III reforms seek to restore credibility in the calculation of risk-weighted assets and improve the comparability of banks' capital ratios by enhancing the robustness and risk sensitivity of the standardized approaches for credit risk, credit valuation adjustment risk, and operational risk, constraining the use of internal model approaches, introducing a leverage ratio buer, and replacing the existing Basel II output oor with a more robust risk-sensitive oor. Specically, the revisions to the standardized approach for credit risk improve its granularity and risk sensitivity, reduce mechanistic reliance on credit ratings, and provide a foundation for a revised output oor to internally modeled capital requirements. The revisions include more granular approaches for unrated exposures to banks and corporates, a more granular look-up table for exposures to corporates, a more risk-sensitive approach for residential real estate exposures, and a more granular treatment for retail exposures, among others.

Liquidity Requirements. Banks must maintain certain liquid assets to meet their short-term obligations. The Liquidity Coverage Ratio (LCR) and the Net Stable Funding Ratio (NSFR) are two key liquidity measures used by regulators to assess the liquidity prole of banks.

  • Bank of International Settlements (BIS) report discusses the Net Stable Funding Ratio (NSFR), one of the two liquidity standards introduced in the Basel III post-crisis reforms. The NSFR aims to promote banks' resilience over a longer time horizon by incentivising banks to fund their activities with more stable sources of funding on an ongoing basis. The ratio relates the bank's available stable funding (ASF) to its required stable funding (RSF) and must equal or exceed 100%. The report explains how the ASF and RSF amounts are determined using supervisory assumptions and liquidity characteristics of funding sources and exposures and provides examples of ASF and RSF factors for various categories of liabilities and assets. The NSFR became a minimum standard applicable to all internationally active banks on a consolidated basis on 1 January 2018, although national supervisors may apply it to any subset of entities of large internationally active banks or all other banks.

Asset-Liability Management. Banks engage in asset-liability management (ALM)21 to manage the risks associated with mismatches between their assets and liabilities. This involves assessing their balance sheets' interest rate, foreign exchange risk, and credit risk exposure.

Asset-liability management (ALM) can be described as an integrated approach to managing a bank's total assets and liabilities concurrently. This comprehensive management of a bank's balance sheet involves strategic planning, implementation, and monitoring processes that inuence various aspects such as the volume, mix, maturity, interest rate sensitivity, quality, and liquidity of assets and liabilities. ALM's primary objective is to safeguard income and capital from interest rate risk, which arises due to disparities in the repricing of assets and liabilities. Interest rate risk management aims to keep interest rate risk exposures within permissible limits. Banks typically strive to optimize the repricing structure of their balance sheet to maximize benets from anticipated interest rate uctuations; however, this structure may be aected by liquidity concerns, especially if the bank lacks access to interest rate derivatives that can separate its liquidity and interest rate perspectives.22

Reserve Structures & Stability Management Practices of Leading Stablecoins

Due to the inconsistency of regulatory reserve management requirements of stablecoins, there has been an emergence of various methods for supply, stability, and asset collateralization.

Fiat-Collateralized Stablecoins. Fiat-collateralized stablecoins, such as Tether $USDT23 and Circle $USDC maintains reserves of traditional currencies (e.g., US dollars) or other liquid assets to back the value of their tokens. Issuers of these stablecoins must hold sucient reserves to enable redemption at a 1:1 ratio with the underlying asset. The transparency and adequacy of these reserves are crucial for maintaining the stablecoin's value and mitigating insolvency risk.

Crypto-Collateralized Stablecoins. Crypto-collateralized stablecoins, such as MakerDAO's DAI24, are backed by cryptocurrencies. Issuers of these stablecoins manage their reserves by requiring over-collateralization to account for the volatility of the underlying assets. They also implement mechanisms, such as liquidation and stabilization, to ensure the value of the stablecoin remains pegged to its reference asset.

Algorithmic Stablecoins. Algorithmic stablecoins, such as Ampleforth (AMPL)25, use algorithms and smart contracts to maintain their pegs by adjusting the supply of the stablecoin in response to market demand. Reserve management practices for these stablecoins involve monitoring and changing the algorithms to ensure the stability of the token's value.

Trust, Transparency, and Regulatory Moral Hazard

While traditional financial institutions and stablecoin issuers manage reserves to ensure trust, financial stability, and most importantly deposit liquidity, key dierences exist in the underlying assets, regulatory requirements, and risk management strategies.

Regulatory Requirements. Traditional financial institutions are subject to stringent regulatory requirements imposed by national and international regulators in their operating jurisdiction, such as capital and liquidity ratios. Stablecoin issuers, on the other hand, face a less established regulatory landscape, with varying levels of oversight depending on the jurisdiction and the specic type of stablecoin. This has led to calls for increased regulation and standardization of stablecoin reserve management practices.

Risk Management Strategies. Traditional financial institutions employ various risk management strategies to mitigate insolvency risk, including diversication, asset-liability management, and stress testing. In contrast, stablecoin issuers can deploy various risk management strategies such as asset over-collateralization, smart contract balancing, and algorithmic adjustments to manage risks associated with the volatility of the underlying assets and maintain the pegged value of their tokens.

Stablecoin Reserve Management Case Study

Tether, Asset Composition, Liquidity and Credit Risk Management. $USDT is the largest stablecoin by market capitalization, with a total market value of over $70 billion. As of December 31, 2022, Tether Holdings Limited reported a minimum consolidated total asset of $67,044,148,175. This asset value comprises four main categories: cash and cash equivalents, corporate bonds, funds, precious metals, other investments, and secured loans. The largest asset category is cash and cash equivalents, which includes short-term deposits, commercial paper, and U.S. Treasury bills, with a total value of $39,230,259,046. This category is followed by corporate bonds, funds, and precious metals, which total $3,444,097,599. The other investments category has a total value of $2,685,786,230, while secured loans total $5,852,823,328. The New York Times26 has discussed that a signicant portion of Tether’s reserves were tied up in unsecured corporate debt (commercial paper). The Wall Street Journal has also reported27 Tether’s holdings of Treasury bills have surged and now make up almost a quarter of the investments backing the stablecoin.

Tether manages liquidity risk by maintaining a pool of assets that can be used to redeem $USDT tokens and by monitoring market conditions and adjusting the supply of $USDT tokens. In regards to credit risk, Tether mitigates this by diversifying its reserve asset pool and monitoring counterparties' creditworthiness. Tether has stated that it only invests in highly liquid assets with minimal credit risk, and that it only invests in assets with less than 90 days of maturity. The Financial Times28 has highlighted how stablecoin issuers increasingly invest in short-dated US government debt as part of their liquidity and credit risk management strategies. According to research from JPMorgan, stablecoin issuers such as Tether and Circle held $80 billion worth of US Treasury bills as of May 2022, which accounted for 2% of the market for Treasury bills. Tether has since pledged to reduce its commercial paper holdings to zero, and buy US Treasury bills, considered ultra-low risk assets. The article suggests that greater transparency and disclosure of reserve assets could be a way to mitigate such risks, as proposed by the Responsible Financial Innovation Act co-sponsored by senators Cynthia Lummis and Kirsten Gillibrand.

USDC, Asset Composition, Liquidity and Credit Risk Management.. The fair value of assets in the $USDC Reserve is the total balance of U.S. dollar-denominated assets at the report dates in the Circle Reserve Fund and Segregated Accounts held by the Company with U.S. financial institutions on behalf of $USDC holders. The Circle Reserve Fund is a government money market fund, and the Company owns one hundred per cent of the equity interests in the Fund represented by the Fund's Net Asset Value (NAV). Segregated Accounts are unencumbered accounts held on behalf of $USDC holders that are segregated from other accounts of the Company, including general corporate funds. As of January 31, 2023, the fair value of assets in the $USDC Reserve is $42,335,734,074, which is also greater than the $USDC in circulation of 42,288,053,870. The assets held in the Circle Reserve Fund include U.S. Treasury Securities with a total value of $33,723,644,221, cash held at U.S. regulated financial institutions of $54,742,853, and cash due to/(owed by) Circle Reserve Fund due to timing and settlement dierences, net of ($116,203,278).

Circle has stated that the reserve is designed to be "highly liquid and low-risk", that it "routinely reviews its liquidity positions" and "actively manages the liquidity of its reserves to ensure that they are sucient to meet its obligations."29 In the event of a default or credit event, Circle has stated that it would take "appropriate actions" to protect the value of $USDC. These actions may include liquidating the defaulted asset or using reserves to compensate for losses. Circle has also stated that it has "sucient capital and insurance"30 to cover any possible losses. As reported by Bloomberg31, $USDC disclosed that it held $3.3 billion of its reserves at Silicon Valley Bank. During SVB's failure, investors became concerned about $USDC's exposure, and the stablecoin drifted from its closely-watched dollar peg. Despite the exposure, Circle reassured investors that it was "operating normally" and has reserves across various banks, including BlackRock-managed money-market funds. The CEO of Circle, Jeremy Allaire, said in an interview that the company will depend more on the globally systemically important banks, which now have a structural backstop and a slightly dierent prole. Even after the rm recouped deposits that were caught up in the collapse of SVB, $USDC faced redemptions at a greater pace than its issuance.32 According to CryptoCompare, users redeemed $738.6 million $USDC on March 20, while Circle issued less than $9 million of the token on the Ethereum blockchain. The article by Bloomberg notes that $USDC dumping is visible on decentralized nance apps, indicating that traders favor Tether and other stablecoins over $USDC.

DAI, Asset Composition, Liquidity and Credit Risk Management. $DAI is a collateral-backed cryptocurrency generated by depositing collateral assets into Maker Vaults within the Maker Protocol. This collateralisation ensures that every $DAI in circulation is directly backed by excess collateral, which means that the value of the collateral is higher than the value of the $DAI debt. The collateral assets accepted by Maker Vaults are determined by MKR holders, who can accept or reject collateral based on their risk assessment. Currently, the Maker Protocol accepts any Ethereum-based asset approved by MKR holders, with specic Risk Parameters set for each accepted collateral. The Risk Parameters determine the level of risk associated with the collateral asset, with more stable assets receiving more lenient parameters and riskier assets receiving stricter parameters. The collateral assets in Maker Vaults are kept in excess, ensuring that they can cover the $DAI debt even if the value of the collateral asset drops. The excess collateral provides a buer against price volatility, enabling $DAI to maintain its value relative to the US Dollar. The collateral assets themselves are held in smart contracts, with their value constantly monitored by oracles, ensuring that the Maker Protocol can liquidate the collateral if the value of the collateral asset drops too low.

To ensure the stability of the $DAI peg and mitigate insolvency risk, MakerDAO utilizes a system of automated auctions and collateral management. MakerDAO ensures that there is always enough collateral in the Maker Protocol to cover the value of all outstanding debt by liquidating any Maker Vault deemed too risky. The Maker Protocol makes this determination by comparing the Liquidation Ratio to the current collateral-to-debt ratio of a Vault. Each Vault type has its Liquidation Ratio, which is determined by MKR voters based on the risk prole of the particular collateral asset type.

When a Vault is liquidated, the Maker Protocol uses automated auction mechanisms to sell the collateral and cover the Vault's outstanding obligations, including the Liquidation Penalty fee set by MKR voters for that specic Vault collateral type. The auction mechanisms enable the system to liquidate Vaults even when price information for the collateral is unavailable. If enough $DAI is bid in the Collateral Auction to cover the Vault obligations plus the Liquidation Penalty fully, the auction converts to a Reverse Collateral Auction to sell as little collateral as possible. Any leftover collateral is returned to the original Vault owner. However, the decit is converted into Protocol debt if the Collateral Auction does not raise enough $DAI to cover the Vault's outstanding obligation. The $ DAI covers protocol debt in the Maker Buer. If there is not enough $DAI in the Buer, the Protocol triggers a Debt Auction. During a Debt Auction, MKR is minted by the system (increasing the amount of MKR in circulation) and then sold to bidders for $DAI.

$DAI proceeds from auctions and Stability Fee payments go into the Maker Buer, which serves as a buer against an increase of MKR overall supply that could result from future uncovered Collateral Auctions and the accrual of the $DAI Savings Rate. If the $DAI proceeds from auctions and Stability Fee payments exceed the Maker Buer limit set by Maker Governance, they are sold through a Surplus Auction. During a Surplus Auction, bidders compete by bidding increasing amounts of MKR to receive a xed amount of $DAI. Once the Surplus Auction has ended, the Maker Protocol autonomously destroys the MKR collected, thereby reducing the total MKR supply. Automated auctions and collateral management allow MakerDAO to manage liquidity and credit risk eectively to maintain the stable value of $DAI.

Coindesk reported33 that MakerDAO is considering investing an additional $750 million in U.S. Treasuries. The DAO had previously invested $500 million in government notes and bonds to stabilize $DAI, which was already over collateralized at the time. According to the article, the proposed investment would take advantage of the favorable yield environment and stabilize the $DAI stablecoin. The article also explained that the DAO would invest in six-month U.S. Treasurys using a ladder strategy with a bi-weekly rollover, which means that the purchased notes will have maturities equally split over the full period. Allan Pederson, CEO of decentralized nance asset manager Monetails, wrote in a post that the ladder of U.S. Treasuries over six months with biweekly maturities present a strong, exible, and eective solution for MakerDAO. Bloomberg34 conrmed that MakerDAO is moving $500 million worth of the token to short-term US Treasuries and investment-grade corporate bonds. According to a statement issued by MakerDAO, the allocation of $DAI will promote the usability of digital assets in the traditional space, extending $DAI’s inuence beyond crypto. The community behind MakerDAO agreed to put 80% of the fund in short-term Treasuries and 20% in investment-grade corporate bonds.

CBDC, Asset Composition, Liquidity and Credit Risk Management. Central Bank Digital Currencies (CBDCs) represent a new frontier in digital currencies, as unlike private stablecoins, managed by private entities, CBDCs are sovereign digital currencies that carry the trust and stability of the issuing nation's central bank. CBDCs are designed to maintain a stable value by being pegged to a reserve of traditional, sovereign currency or other assets the central bank holds. As such, they are fully backed by the issuing central bank, which manages the reserves to ensure that CBDCs are redeemable at any time.

The reserve management practices for CBDCs are often more conservative than those for private stablecoins, as central banks have the mandate to maintain financial stability and promote public trust in their currency. CBDCs, as an extension of central bank policy, are subject to the same transparency requirements that govern traditional monetary policy. This level of transparency is often higher than that of private stablecoins, which can be more opaque due to the lack of regulatory oversight. The heightened transparency of CBDCs can help to reduce the potential for insolvency risks, as it ensures that market participants have a clear understanding of the underlying reserve holdings and management practices. CBDCs are fully collateralized by the reserves held by the central bank, which can include a combination of traditional currency, government bonds, and other assets.

The collateralisation of CBDCs diers from that of private stablecoins, which may use a variety of assets or cryptocurrencies as collateral. Central banks' use of sovereign assets provides a higher degree of stability and lower risk of insolvency compared to private stablecoins, which may be more vulnerable to uctuations in the value of their collateral. While CBDCs oer a more stable and transparent alternative to private stablecoins, there are concerns surrounding their potential impact on the broader financial system. Some critics argue that CBDCs could lead to the disintermediation of the traditional banking system, as consumers might prefer to hold digital currency issued by the central bank rather than deposits in commercial banks. This could, in turn, aect the ability of banks to lend and may require central banks to adjust their reserve management practices to accommodate for these shifts in the financial landscape.

CoinTelegraph reported35 that the Bank of England estimates that up to 20% of retail and consumer deposits could potentially move towards Central Bank Digital Currencies (CBDCs). The article highlights that the Bank of England is exploring options to implement a digital pound CBDC for retail payments, with a task force investigating the use of a digital pound for distributing payrolls and pensions. Sir Jon Cunlie, the deputy governor for financial stability, supports this initiative and cites the declining use of cash in the United Kingdom in recent years, which was greatly accelerated by the advent of the COVID-19 pandemic that discouraged physical contact in transactions. Sir Cunlie also states that they have modeled a prudent assumption that 20% of household and corporate transactional deposits based in the banking system could move out of the banking system and into central bank digital money. However, he admits that the current state of cryptocurrency aairs could potentially threaten financial stability within the country, given that 95% of digital assets are unbanked and only 5% are stablecoins. On the opposite side of the Atlantic, the United States has a less positive outlook, saying that regulated stablecoins designed by the private sector make CBDCs redundant.

According to the Financial Times36, CBDCs are facing public resistance due to concerns about privacy and transparency. While 85 central banks are engaged in CBDC projects, citizens view them as an encroachment on their private lives and are unsure of the benets of such projects. One of the potential implications of CBDCs is the impact on private lenders, who could face liquidity shortages if a ood of money is shifted into state coers. To prevent this, policymakers could impose holding limits or oer limited or no interest on deposits, but this would impede the adoption of CBDCs. The adoption of CBDCs has been piecemeal in countries where they have been launched. In Nigeria, less than 0.5% of citizens used the eNaira more than a year after its launch due to a lack of trust between citizens and the government. The same is true in China, where transactions using private digital payment systems for the third quarter of 2022 were valued at Rmb87.5tn ($12.5tn), while those using the digital renminbi were just a fraction of that at Rmb100bn ($14.5bn). Concerns about privacy and transparency are also hindering the adoption of CBDCs in the eurozone. While the European Central Bank has pushed for a digital euro to compete with US payment giants Visa and Mastercard, a 2021 consultation found that European citizens were deeply concerned about the implications for the privacy of a CBDC. In the US, digital dollars have been dubbed "Biden bucks" and "Biden coin" and have become the subject of online misinformation campaigns. Some nance ocials are far from keen on the idea of a US CBDC, with Fed governor Christopher Waller saying he is "not a big fan."

The asset composition of a CBDC may dier depending on the issuing central bank's policy objectives, legal framework, and macroeconomic conditions. In general, CBDCs are backed by a combination of at currency reserves and other assets, such as government securities or corporate bonds. The choice of underlying assets for a CBDC is crucial for its stability and credibility. If the CBDC is backed by highly volatile assets, such as cryptocurrencies, it may be subject to sudden price uctuations and pose a higher risk of insolvency. On the other hand, if the CBDC is backed solely by at currency reserves, it may be less exposed to market risks but may face other challenges related to the management of the reserve assets.

Moreover, the asset composition of a CBDC can have implications for its monetary policy and financial stability. For instance, if the CBDC is backed by government securities, it may create a demand for these securities, which could have an impact on the government's borrowing costs and the yield curve. In addition, if the CBDC is widely adopted and holds a signicant share of the domestic currency market, it may aect the transmission mechanism of monetary policy and pose risks to financial stability. As published by Bloomberg37, the Bank of England (BOE) and the UK Treasury are reported to be stepping up work on creating a digital currency to sit alongside physical banknotes. The moves are part of an eort by central banks around the world to adapt to new forms of payment that work more quickly and smoothly in online transactions. The BOE and the Treasury will call for opinions and evidence on whether they should build a central bank digital currency, which they have ocially dubbed “Britcoin,” in a consultation paper due to be published. The BOE said holders will not be able to earn interest on their digital coins, and there will be a limit on how many they can initially buy. That measure is aimed at preventing a mass rush of consumers pulling their money out of traditional banks and buying

Britcoin if it launches. Bank and Treasury ocials are focused on the long-term when looking at the case for a CBDC, imagining a world where cash is used less and “big tech” rms such as Inc. and Google owner Alphabet Inc. are issuing their own stablecoins to facilitate quick and smooth online payments. A CBDC would be designed as an alternative to these private sector stablecoins, which investors can hold in the condence that they are backed by the BOE. And by oering an “open” and “transparent” alternative to private stablecoins, it is understood that the Treasury hopes to discourage opacity in other digital currencies. The value of the CBDC would be directly linked to sterling, unlike bitcoin whose value moves around with demand.

According to Reuters38, the Governor of the Bank of Japan, Haruhiko Kuroda, recently emphasized the importance of issuing CBDCs that can coexist with other forms of money. He stated, "Ensuring the coexistence of CBDC with various other forms of money ... is something that we need to and will in fact achieve in the future." Kuroda also highlighted that the central bank has a duty to prepare itself to respond exibly to any change in circumstances. This includes being ready to issue a digital yen, which the bank will test through a pilot program starting in April. The article suggests that the Bank of Japan is taking a cautious approach to CBDC issuance, with a focus on ensuring that it can coexist with other forms of money.

Central bank digital currencies (CBDCs) pose unique challenges to liquidity and credit risk management compared to traditional at currencies. The design and implementation of CBDCs must consider the potential impact on monetary policy, financial stability, and the overall eciency of the payment system. Eective liquidity and credit risk management are essential to maintaining the stability and reliability of the CBDC system. To manage liquidity risk, central banks can use various tools, including open market operations, standing facilities, and reserve requirements while considering risks such as the potential for unintended consequences and moral hazards. One approach to managing credit risk is to require collateral or limit the amount of CBDCs that can be issued to a single counterparty. Additionally, central banks can use credit risk management tools such as credit assessments and stress tests to evaluate the creditworthiness of counterparties. Another important consideration for CBDCs is the need for eective monitoring and reporting. Central banks must be able to monitor the usage and ow of CBDCs to detect potential liquidity or credit risk issues.

Tony Yates, a former professor of economics and senior adviser at the Bank of England, recently argued against the implementation of CBDCs in the Financial Times39. Yates highlights a potential liquidity risk associated with CBDCs, as these digital currencies may drain money from banks, especially during periods of heightened financial risk. He explains that this could force banks to either nd new sources of funds or shrink their loans, which in turn could amplify tightening in financial conditions when the central bank is trying to loosen them. Moreover, Yates points out that the central bank could respond to the liquidity risk by reinvesting CBDC deposits back into the banks, but he questions whether this would leave the financial system in a better place. He suggests that this approach would move the system from one where the government stands behind the banks and takes a stake when things go badly to one where it is always on the hook to the tune of the deposits reinvested.

Liquidity Provisions: Stablecoins vs Commercial Banks

In a July 2020 working paper released by the Federal Bureau of Economic Research titled, US Banks and Global Liquidity, numerous liquidity provisions are highlighted and implemented in the banking system, hedging insolvency risk and the probability of a bank run on consumer deposits. These are critical considerations in dening proper reserve management criteria for reserve-backed stablecoins such as Tether $USDT, Circle $USDC and MakerDAO $DAI since most of their liquid reserves (i.e. Cash or Cash Equivalents) are held as deposits in commercial banks. These banks, operating in the US Federal Reserve and US treasury domain, are held to specic liquidity standards in their deposit reserve management.

There are numerous institutional risks associated with reserve management risk interfering with the ability of a reserve-backed stablecoin to uphold its 1:1 dollar peg, namely insolvency risk for commercial banks in the event of a signicant capital call in stablecoin redemptions and the potential for over-fraudulent issuance of new stablecoin supply by centralized exchanges using illiquid collateral such as Ethereum or Bitcoin trading pairs. To fully discover the risk proles associated with these stablecoin issuers, we must rst examine the reserve criteria on these deposits and the potential insolvency provisions imposed.

Unlike commercial banks, stablecoin issuers such as Tether $USDT, Circle $USDC and MakerDAO $DAI, representing an over $100bn US dollar market cap as of March 14th, 2023, are not in the business of lending money in the interest of making money for depositors and shareholders. Stablecoins are designed and serve the primary purpose of being a reserve-backed digital dollar asset on the blockchain, hedging risk from crypto market volatility, and being a comprehensible and transparent method of value transfer on the blockchain. Users only retain condence in transacting stablecoins due to the consensus value (i.e. US Dollar) and immediate redeemability to your local currency via a so-called crypto-at oramp. In this process, astablecoin holder can deposit their stablecoin holdings, the oramp solution veries the legitimacy and value of the tokens, and then instantly, for a small fee, initiates a bank payout in at to the holder's bank account in exchange for the face value of the stablecoins.

Deposit Agreements and Withdrawal Provisions

Stablecoins. Deposit agreements for stablecoins typically outline the terms and conditions under which users can deposit at currency with the issuer in exchange for the equivalent stablecoins. These agreements generally include provisions regarding the redemption of stablecoins for at currency, fees associated with deposits and withdrawals, and any transaction limitations. Stablecoin holders need to understand the terms of these agreements, as they may impact their ability to redeem their stablecoins for at currency or transfer them to other users. Adam Levitin, a professor specializing in financial regulation at Georgetown Law, has argued that stablecoins could not turn to the Fed for liquidity, and there is no deposit insurance, making it an investment gamble.40

According to a Financial Times article, Barcllays bank commented the following on the Tether deposit agreement and withdrawal provisions:

“Tether’s closed-shop redemption mechanism means it cannot be viewed like a money-market fund. Processing delays can happen without explanation, there’s a 0.1 per cent conversion fee, and the facility is only available to veried customers cashing out at least $100,000. Skepticism about collateral quality is a reason to sell below the $1 peg value, but it's just one reason among many, says Barclays:

The only way to get immediate access to at is to sell the token on an exchange, regardless of the size of holding . . . [W]hile redemption is ‘guaranteed’ at par, the secondary market price of tether can trade lower, depending on the willingness of holders to accept a haircut in return for access to immediate liquidity. As last week’s price action suggests, some investors were willing to accept a nearly 5 per cent discount to liquidate their USDT holdings immediately.

We think that willingness to absorb losses, even though USDT is fully collateralized and has an overnight liquidity buer that exceeds most prime funds, suggests the token might be prone to pre-emptive runs. Holders with immediate liquidity demands have an incentive (or rst-mover advantage) to rush to sell in the secondary market before the supply of tokens from other liquidity-seekers picks up. The fear that USDT might not be able to maintain the peg may drive runs regardless of its actual capacity to support redemptions based on the liquidity of its collateral.” 41

Commercial Savings Banks. In the case of commercial savings banks, deposit agreements serve a similar purpose, outlining the terms and conditions under which a customer can deposit funds into a savings account. These agreements typically include provisions related to interest rates, fees, and withdrawal limitations. The primary dierence between deposit agreements for stablecoins and commercial savings banks is that the latter are subject to extensive regulation and oversight, which helps ensure customer deposits' safety and stability.

Withdrawal provisions for commercial savings banks are typically more straightforward, as these institutions are subject to well-established regulations and oversight designed to protect customer deposits. Banks must maintain certain reserves to meet withdrawal requests and are subject to periodic inspections by regulatory authorities. Additionally, allowing for bank depositors to directly withdraw deposits from the bank itself, adds a layer of security and trust not otherwise seen in crypto and stablecoin markets overall. Minimum deposit limits eligible for direct withdrawals, as seen with Tether USDT, bars most Tether holders from directly withdrawing at USD directly from the issuer; therefore, having to rely on intermediaries such as centralized exchanges or o-ramps.

Risk of Over-Consolidation in Stablecoin Issuance

Although the cryptocurrency and blockchain industry is still very much in the early days of true large scale adoption, there has been substantial consolidation in market capitalization into a handful of key providers in the stablecoin market. The highest standard of trust and reliability has emerged from reserve-backed issuers such as Tether $USDT and Circle $USDC rather than other crypto backed or algorithmic stablecoin issuers. 42As of April 2023, Tether $USDT represented roughly 62.6% of total stablecoin market capitalization with an $81.5bn circulating supply. According to the European Central Bank’s research titled “Stablecoins’ role in crypto and beyond: functions, risks and policy,” Tether $USDT trading pairs also accounted for roughly 65% of all bitcoin trading volume during their analysis period in 2022.

In terms of contagion risk and consolidation of Tether holdings, the ECB issued the following graphic:43 The ECB reports that “holdings of Tether, USD Coin and DAI are concentrated among large investors, i.e. those holding more than 1 million coins (See chart above). They account for more than 80-90% of the supply of these stablecoins on the Ethereum blockchain,[32] while retail investors, dened as having a balance of less than 10,000 units of each of these stablecoins, represent 3% or less.” Based on this evidence, given the consolidation of market capitalization with specialized institutional investors, such as specialized crypto funds or hedge funds, the spillover effects into the financial system from financial distress would be limited from a distress in stablecoin assets alone.

Given the majority holdings of stablecoins remain in the control of large institutional investors, exchanges, and market makers, there must be a closer examination of where these large institutional holders are deploying and utilizing stablecoins financial instruments. The key signal regulators and investors need to pay particular attention to, is the ever growing utilization and dependence on stablecoin trading pairs in the for cryptocurrency asset liquidity and valuations. The paper will further examine this dependence and its implications to the entire cryptocurrency market in section 1.6.

Implications of Growing Stablecoin Capitalization in Crypto Markets

Examining the growing market capitalization and consolidation of market share into three primary issuers $USDT, $BUSD, $USDC, we must also observe closely the growing number of trading pairs denominated in these synthetic digital currencies rather than true at pairs. The perceived liquidity in the crypto ecosystem is increasingly reliant and dependent on the reserve management of these stablecoin issuers and the at peg they are entrusted to uphold. According to a recent market data report issued by Kaiko Research, we can observe that the market share of BTC trading volume pairs denominated in stablecoins have grown from just 1.5% in 2017 to over 87.5% in 2023. 44

The key issue arising from this increased dependence on stablecoin trading pairs in cryptocurrency markets, is the growing obscurity surrounding the legitimacy of perceived liquidity in the digital asset market.

To further understand how investors can view and understand the perceived liquidity in the digital asset cryptocurrency market, one must examine the three main signals: bid-ask spreads, market size, and the overall trading volume for a particular asset. 45

The main objective of measuring liquidity in the digital asset market is to determine how much of an asset can be traded or sold without directly aecting the price. The issue arising from the over reliance on stablecoin trading pairs in the leading markets for the leading digital assets in the cryptocurrency market by overall market capitalization and trading volume, is the potential control and manipulation of price movements by leading market makers.

As seen in the ECB report from section 1.5, over 80% of all stablecoin holding accounts are deemed to be institutional traders, market makers, or exchanges.

According to a report by CNBC, regulators are actively eyeing the risks associated with so-called wash trading on major cryptocurrency exchanges creating the illusion of elevated trading volumes and over-ecient market making from minimal bid-ask spreads in trading pairs. These potentially synthetically ecient markets are major barriers to widespread adoption and overall market trust. As mentioned in the CNBC article, “Exchanges may have an incentive to report fake volume. Bad actors may look to attract listings for new initial coin oerings, or ICOs, who want their cryptocurrency on an exchange where more trading goes on, Bitwise said. Those fees can run from $1 million to $3 million per listing, according to data from Autonomous Next.

U.S. regulators have taken a cautious approach to making bitcoin mainstream for traders. The SEC highlighted the risk of manipulation as reason for rejecting applications for other cryptocurrency ETFs. The oce of New York Attorney General also agged the issue in a recent report warning that exchanges are vulnerable. Because most cryptocurrency trading platforms don’t use the same monitoring tools as stock exchanges, SEC Chairman Jay Clayton has warned that investors may not get a fair assessment of bitcoin’s price.”46

Stablecoin Contagion, Spillover and Procyclicality Case Study

Tether, Contagion and Spillover Effects. As $USDT is used as a base currency for trading other cryptocurrencies, a loss of condence in $USDT can quickly spread to other cryptocurrencies and exchanges, potentially leading to a wider sell-o and market volatility. In April 2019, the New York Attorney General's oce alleged that Tether had used their reserves to cover up an $850 million loss by its aliated exchange, Bitnex. The Financial Times47, has also reported on the sentiment that Tether suered losses on its commercial paper holdings, which according Bloomberg48 last year, included Chinese commercial paper.

Tether, Procyclicality. When stablecoin issuers need to liquidate assets to maintain the stablecoin's peg, this can contribute to downward pressure on the prices of the underlying assets and trigger further market declines. $USDT has historically deviated from its peg on numerous occasions, which analysts attribute to concerns about Tether’s instantaneous liquidity and the possibility for delays to exacerbate market declines. Put simply, if Tether was forced to liquidate a signicant portion of its reserves to maintain the peg during a market downturn, it could contribute to downward pressure on the underlying asset prices, further exacerbating market declines.

USDC, Contagion and Spillover Effects. If Circle were to experience a sudden liquidity shock and could not meet redemption requests for $USDC, this could lead to a loss of condence in $USDC and a rush by users to redeem their tokens. This could result in a sudden sell-o of $USDC, putting downward pressure on its value and potentially impacting other digital assets. If other market participants, such as exchanges or DeFi platforms, hold signicant amounts of $USDC, this could lead to further contagion and spillover effects in the financial system. CNBC49 has discussed how Binance temporarily paused $USDC withdrawals due to increasing investor concerns about its stability following the collapse of rival exchange FTX. Decrypt reported50 that Circle previously revealed that the collapse of FTX and automatic conversions of $USDC on Binance to its own Binance USD (BUSD) stablecoin have caused Circle’s performance to be “materially lower” than previous forecasts.

USDC, Procyclicality. If the demand for $USDC increases during a market downturn, Circle may need to sell some of its assets to maintain the stablecoin's peg. This can put downward pressure on the prices of the sold assets, potentially leading to further market volatility. Moreover, as the popularity of stablecoins like $USDC grows, their potential to amplify market uctuations increases. In a scenario where a signicant portion of market participants hold $USDC, the sale of $USDC by Circle during market stress could have implications for market stability, potentially exacerbating market volatility and reinforcing procyclical tendencies.

DAI, Procyclicality. In the case of MakerDAO's $DAI, the stability of the stablecoin is maintained through a system of over-collateralization, where users lock up a certain amount of Ether (ETH) in a smart contract to generate $DAI. This collateralization ratio is currently set at 150%. If the value of the collateral falls below a certain threshold, a user's collateral is liquidated to repay the debt, thus stabilizing the $DAI.

While the over-collateralization mechanism provides a buer against market volatility, it can also be pro-cyclical. In times of market stress, users may be required to liquidate their ETH collateral to repay their debt, which can exacerbate market downturns and lead to further liquidations, creating a downward spiral. This can also lead to pro-cyclical market behavior where investors may over-collateralize more than needed to avoid being liquidated, leading to a liquidity shortage in the ETH market and higher market volatility. MakerDAO also recently introduced a debt ceiling for $DAI, which limits the total amount of $DAI that can be generated, thereby reducing the potential for excess supply and market volatility. However, it is important to note that procyclicality risk can never be eliminated, as it is an inherent feature of market dynamics. In addition, MakerDAO's over-collateralization mechanism may create a liquidity shortage in the ETH market, which can have knock-on effects on other markets and potentially lead to systemic risks.

CBDC, Contagion and Spillover Effects. Research has shown that CBDCs can potentially reduce the risks of contagion and spillover effects by providing a more secure and resilient payment system. CBDC issuers should implement eective risk management practices to mitigate these risks. Furthermore, the interconnectivity of the financial system means that CBDCs and other stablecoins can potentially trigger systemic risks. Systemic risks occur when the failure of one institution or market participant threatens the stability of the entire financial system. The potentially larger user base of CBDCs, coupled with their potential for widespread adoption, means that their failure could pose significant systemic risks.

CBDC, Procyclicality. In times of nancial stress, individuals and investors may withdraw their deposits from banks, leading to a sudden liquidity shortage and potentially triggering a crisis. In a world with CBDCs, individuals and investors may also be able to withdraw funds from commercial bank accounts into CBDCs quickly. Moreover, if the central bank is seen as the ultimate backstop for the financial system, it may face pressure to provide liquidity to the system during times of stress. This could lead to a situation in which the central bank is forced to provide liquidity to the banking system in order to prevent a collapse, potentially creating a moral hazard problem. Additionally, the introduction of CBDCs could aect the behavior of financial intermediaries and potentially amplify business cycles. In particular, the ability of individuals and investors to hold CBDCs outside of the traditional banking system could shift funding sources away from traditional banks towards the central bank. In order to mitigate the risk of procyclicality, central banks may need to adopt a variety of measures. For instance, they may also need to consider implementing measures to prevent or mitigate bank runs, such as imposing limits on withdrawals or implementing dierential interest rates on CBDCs held outside the banking system. This could include restrictions on the use of CBDCs by financial intermediaries or implement macroprudential measures to prevent the buildup of systemic risks.

Challenges of Stablecoin Regulation and Risks Based on Reserve Backing

The primary objective of reserve management practices in traditional financial institutions is to maintain liquidity and solvency. Central banks manage their reserves by holding assets that can be quickly and easily liquidated during a crisis or economic downturn. These assets typically include government securities, foreign exchange, and gold reserves. Central banks also use a range of financial instruments, such as repurchase agreements, to manage their liquidity. Regulating stablecoins, on the other hand, is a complex endeavor, as they encompass a wide range of assets and stabilizing mechanisms, are typically issued by nonbanks, and often operate across borders. This section will highlight the challenges of stablecoin regulation and the dierent types of risks based on reserve backing, drawing on insights from the International Monetary Fund (IMF).51

Challenges of Stablecoin Regulation

The rapid growth of stablecoins has accelerated links between traditional nance and the crypto ecosystem, resulting in new risks and raising concerns about financial stability, consumer protection, and market integrity (IMF). To address these challenges the IMF suggests that comprehensive, consistent, and coordinated global standards are required to address these challenges, especially for stablecoins and their broader ecosystem. The Financial Stability Board (FSB) is well-placed to lead the development of these international standards, considering sector-specic standards developed by other standard setters (IMF).

Risk-Based Regulation

The IMF recommends that stablecoin regulation be risk-based, focusing on the structural features of stablecoins and, in some cases, their usage (IMF). Key risks to users stem from the inability of issuers to deliver on the purported structural features of their stablecoins, such as the denomination of the stablecoin's face value, the investment mandate of the composition of reserves, and the pledge to redeem into cash (IMF 8). Appropriate regulation would vary depending on the stablecoin's structural features and usage, ultimately addressing the risks.

Risks associated with stablecoins depend on the nature of their reserve backing. For example, stablecoins denominated in a monetary unit of account and oering redemption into cash on demand should be fully backed by perfectly safe and liquid assets (IMF). Regulation for these stablecoins might draw from e-money frameworks or, if they become widely used, from bank regulation (IMF). Stablecoins oering redeemability within an elapsed time may be backed with safe but less liquid assets, while those providing redemption at the going market value of the underlying assets (or in-kind) may hold riskier assets, such as tokenized bonds. Regulation may draw from money market funds (MMFs), including constant net asset value funds (IMF).

Given the variety of legal frameworks and the evolving nature of stablecoins, regulatory authorities must coordinate to address the risks arising from stablecoins both domestically and globally. In markets where risks are multiplying, authorities should take immediate action using existing regulatory powers, guided by relevant international standards, and focus on areas of vulnerability, such as wallets, exchanges, and financial institutions' exposures. As stablecoin regulation continues to evolve, a risk-based approach that addresses the unique challenges posed by these assets is essential for promoting financial stability and consumer protection.

Stablecoin Regulatory Arbitrage Case Study

Tether, Regulatory Arbitrage. $USDT is subject to the regulatory frameworks of Hong Kong, the Bahamas and the United States. Separately, Tether is also subject to regulation in every jurisdiction that it is traded on a CED/DEX. Tether takes full advantage of dierences in regulatory frameworks to conduct business in less regulated environments. The Washington Post52 has noted that while the proportion of Tether's reserves that it lends out to other companies had been rising, there was no information on who is borrowing the money or what due diligence Tether conducted to make sure it can pay it back. The Financial Stability Board, a panel of global regulators, issued a report in October 2022 calling for an approach summarized as "same activity, same risk, same regulation," under which stablecoins would come under the same rules as rms that conduct similar activities in the real world.

USDC, Regulatory Arbitrage. In the United States, stablecoins are subject to regulatory oversight by various agencies, including the Securities and Exchange Commission (SEC) and the Commodity Futures Trading Commission (CFTC). The SEC has stated that some stablecoins may be considered securities and thus subject to securities laws and regulations. The CFTC has also indicated that some stablecoins may be considered commodities and thus subject to commodity futures trading regulations. In an interview with Bloomberg53 Jeremy Allaire, CEO of Circle Internet Financial Ltd, expressed his belief that the US Securities and Exchange Commission (SEC) is not the proper regulator for stablecoins. Allaire argued that payment stablecoins are a payment system and banking regulator activity, and that everywhere in the world, including the US, recognises this fact. He added that the uniform view worldwide is that stablecoins are in the prudential regulator space, not the securities regulator space. Allaire noted that he supports the SEC's recent proposal to subject virtual currencies to "qualied custodian" requirements, as this would help prevent the commingling of funds and provide appropriate control structures and bankruptcy protections.

DAI, Regulatory Arbitrage. MakerDAO's $DAI stablecoin is a signicant player in the DeFi market, which has grown rapidly in recent years, reecting increasing institutional investor interest in crypto-assets. However, this growth has also highlighted the potential for regulatory arbitrage in the DeFi market, which poses a signicant challenge for policymakers seeking to manage risks while maximizing DeFi's potential eciencies for financial markets. The decentralized nature of DeFi and its global reach and operation make it dicult for supervisory authorities to establish jurisdiction and enforce regulations. This jurisdictional uncertainty challenges enforcement, particularly given the speed and ease with which financial service providers are able to change locations in response to the actions of authorities.

CBDC, Regulatory Arbitrage. In the case of CBDCs, regulatory arbitrage is less of a concern as they are typically issued by central banks and subject to a single regulatory framework. However, the potential for regulatory arbitrage arises when CBDCs are issued across dierent jurisdictions with varying regulatory standards. Moreover, international coordination and cooperation among central banks and regulators can establish common standards for CBDCs and reduce the potential for regulatory arbitrage. This can be achieved through the development of international regulatory frameworks, such as the Financial Stability Board's Principles for Stablecoin Arrangements, which provide guidance on the regulation and oversight of stablecoins, including CBDCs. In addition, central banks can consider implementing cross-border cooperation and information-sharing agreements to address the potential for regulatory arbitrage.

Chapter Two: Risk Analysis of Tether $USDT

2.1 Internal Operations

Tether was released in 2014 by Brock Pierce, Reeve Collins, and Craig Sellars. A subsidiary of the Hong Kong based iFinex Inc, Tether has previously been accused of manipulating the cryptocurrency market, and using funds from other cryptocurrencies to prop up its own value. As Tether is not regulated by any governmental agency, there is no guarantee that it will hold its value or be able to withstand market shocks. Unfortunately, Tether’s legacy got o to a rocky start in 2017 when the Paradise Papers revealed that Tether Limited’s CEO, Jan Ludovicus van de Velde, was also responsible for operating the international exchange, Bitnex. It was also revealed that both entities were owned by iFinex Inc. Tether’s representatives had previously lied, stating that Bitnex was a separate entity, with no common leadership.

Tether is not pegged to the U.S Dollar, but rather the market value of its reserve portfolio. In 2019, the New York Attorney General's oce launched an investigation into Tether's nances, alleging that the company had been using unbacked tokens to inate the price of Bitcoin during the 2017 crypto asset bubble. As mandated by the Oce of the Attorney General of the State of New York (“OAG”), signed February 18th, 2021, Tether Holdings Ltd. must publish on a quarterly basis for three years internal financial reports veried by a third party, independent auditor. These Consolidated Reserve Reports (“CRR”) include the reserves of all the subsidiaries of Tether Holdings Ltd. and the report is prepared according to the accounting standards of the country in which Tether wishes to domicile itself. The purpose of the report is to provide an overview of the financial position of Tether Holdings Ltd., specically the status, size and makeup of the reserve portfolio.

Notably, there is no mandated structure, or published reporting requirements for these reports. There is also no information regarding internal access limitations impeding a third party auditors’ assessment of reserve management practices and asset composition. As understood by recent CRR disclosure statements, Tether Limited provides the auditor with a framework that they have used to internally assess assets and liabilities. The auditor then reviews this framework to be an accurate and fair process for evaluating risk and assessing value, potentially without conrming the assets ever exist.

2.1.1 Key Personnel

We have written the following section with careful consideration for inflammatory language, bias or derogatory representation. It is important to consider the professional qualifications of executive staff known to be the only legal custodians and representative employees responsible for more than $80bn USD, in absence of deposit agreements. Although there is no standard framework for assessing the legitimacy or accuracy of these qualifications, we state in good faith that all of the following details are true, fair, impartial, and pertinent to a risk assessment of internal operations, reserve management, and market security.

Brock Pierce, Co-Founder at Tether. After starring as a child actor in several Disney lms, Brock Pierce established Digital Entertainment Network with Marc Collins-Rector and Chad Schackley. DEN raised $88m to deliver episodic video content and eventually led for bankruptcy in June 2000. The Network’s leadership, including Pierce, was arrested by Interpol after eeing a New Jersey federal grand jury indictment on charges associated with luring minors across state lines for sexual purposes.

The next year, Brock Pierce founded Internet Gaming Entertainment (IGE), which raised $60m with the help of Steve Bannon in 2001. He also founded ZAM, a network of websites oriented around massively multiplayer online role-playing games (MMORPG), in 2003. In 2013, Pierce joined brothers Bart and Bradford Stephens to found the venture capital rm Blockchain Capital (BCC), which currently holds more than $2b AUM.

Although Pierce co-founded Tether in 2014, he has stated that this relationship ended in 2015. “Tether is, I think, one of the most important innovations in currency, but it also seemed like one of the higher risk businesses”.54 By 2016, he raised over $4bn USD for via an ICO.55 Pierce also ran as an independent candidate in the 2020 U.S Presidential election,56 led a 2021 international delegation advising El Salvador’s adoption of Bitcoin,57 dropped out of the 2022 Vermont’s US Senate race,58 and is expected to run once again as an independent candidate in the 2024 U.S Presidential Election.

Reeve Collins, Co-Founder at Tether. Reeve Collins co-founded Tether in 2014, and served as its CEO until 2015. He is also the co-founder of BLOCKv, a platform for creating and distributing NFTs, and Smart Media Technologies, a Web3 platform that fuses AdTech with blockchain technology. Before his foray into the blockchain industry, Collins co-founded Trac Marketplace, an online ad network that was later acquired by Vivendi Universal. He also founded RedLever, a branded entertainment studio that was acquired by Adconion Media Group, and Pala Interactive, a legal, real-money gambling site. Collins is a graduate of Washington State University, where he earned a degree in Marketing and Finance.

Craig Sellars, Co-Founder at Tether. Craig Sellars is known for his role as the Chief Technologist of Bitcoin's Omni Layer, a protocol for digital asset creation, movement, and exchange. He previously co-founded Netconx D&C Wireless, served as the President and CEO at O2 Secure Wireless, and the Chief Technology Ocer at Wavelength Corporation. In 2014, Craig Sellars co-founded and served as the Chief Technology Ocer of Tether. During this same time, he served as the Chief Technology Ocer at Bitnex, co-founded vAtomic Systems, and Blockv alongside Reeve Collins. He is currently the CEO and Interim Chief Technology Ocer of Self-ID. Craig Sellars holds a BSc. in computer science from the Georgia Institute of Technology. He also completed an MBA in International Entrepreneurship from the Georgia State University College of Business.

Phillip Potter, Co-Founder & Fmr. Chief Strategy Officer at Tether. Philip Potter is a financial expert with a strong background in trading technology. He graduated from Yale University in 1994 with a B.A. in Physics, and began his career at Morgan Stanley as a derivatives analyst. Potter moved on to developing automated portfolio management technologies and assumed responsibility for the technological infrastructure and software development of Bear Stearns' Private Client Services division. He co-founded PacMid Technologies, and Dimension Capital, where he developed a number of widely used trading technologies, including the Mercury Trading Language (MTL) and the Dimension SDK.

In 2012, Potter merged his businesses with the principals of WTS to form World Trade Financial Group (WTFG), where he served as the Group CFO as well as the CEO of the new branded technology unit, Fusion Trading Solutions. He left WTFG in 2013 to pursue a number of Bitcoin-related projects, and joined Bitnex as Chief Strategy Ocer later that year.

Giancarlo Devasini, Chief Financial Officer at Tether & Bitfinex. Originally trained as a doctor at the University of Milan, Giancarlo Devasini is Bitnex’s Chief Financial Ocer. His businesses have been cited in more than a dozen fraud and counterfeit suits since 1996. By 2012 it is thought to be known that he invested in Bitcoin and joined Bitnex a year later “running its trading and risk management operations.”59 As described by the Financial Times, “To outside observers, Devasini is an elusive character, declining to speak to the mainstream press and today maintaining a minimal online presence, a break from the archetype of the bombastic and deant cryptocurrency entrepreneur.” Sam Bankman-Fried, the former CEO of FTX, described him as “responsive 24/7, and he’s not just responsive to crises or unbelievable opportunities, he’s responsive to day-to-day operations”.60 Devasini's status in the cryptocurrency world is a transformation from his previous careers, including plastic surgery, trading computer hardware, and building a healthy-eating food delivery service.

Jan Ludovicus van der Velde, Chief Executive Officer at Tether & Bitfinex. Jean-Louis Van Der Velde is the Co-Founder of Bitnex and CEO of Tether. He has held senior management positions at several large private and public corporations in IT, distribution, and manufacturing. JL joined Bitnex in early 2013 and structured the holding, DigFinEx. Having formerly faced lawsuits in China over unpaid bills and late tax payments, his career path to leading the world’s largest stablecoin is less than predictable.

The Dutch-native previously worked software sales in Hong Kong, Germany and China. Legal documents from 2006 show a history of corporate incompetence at Huashun Electronics under Velde’s leadership, with creditors telling the Financial Times that “The company was poorly managed and it could not repay the money”,61 “van der Velde, who has spent much of his life in Hong Kong since leaving the Netherlands in his 20s to attend university in Taiwan, continues to technically own Huashun through an oshore entity called Perpetual Action Group (Asia) Inc, or PAG Asia, Chinese government records show. The entity has also owned a slice of Tether.”62 Relative to Tether, Sam Bankman-Fried has commented on van der Velde saying, “My sense is that he’s less involved in the external operations aspect of the business and more involved in internal management and leadership,”63. van der Velde attended National Taiwan Normal University from 1985 to 1988.

Paolo Ardoino, Chief Technology Officer at Tether. Paolo Ardoino is a computer scientist who serves as the Chief Technology Ocer (CTO) of Bitnex and Tether. Ardoino is originally from Italy and graduated from the University of Genoa in 2008 with a Bachelor of Computer Science in Computer Science. After graduation, Ardoino started working as a researcher for a military project focused on high-availability, self-recovering networks, and cryptography. In 2010, Ardoino began developing financial-related applications and founded Fincluster as CTO in late 2013. Backed by two nancing investment rounds, Fincluster delivered an advanced web platform serving clients with customization capabilities. Paolo joined Bitnex as Senior Software Developer in 2014, tasked with trading engine development, and platform scalability. Later in 2016, Paolo transitioned to the role of CTO.

Claudia Lagorio, Chief Operating Officer at Tether. Claudia Lagorio is the Chief Operating Ocer (COO) at Bitnex and Tether. She has been with Bitnex for over seven years and has served as COO since January 2019. Prior to this, she worked as the Operations Executive at Bitnex and as the Creative and Digital Marketing Director at Tether. Claudia has over six years of experience as a freelance web designer. She has worked as a marketing consultant and web designer, providing services like PSD/AI (vector) design, design analysis, creative animations and marketing strategies. Claudia also worked as a footwear fashion designer.

Leonardo Real, Chief Compliance Officer at Tether. Leonardo Real is a compliance expert in traditional nance and funds compliance. Prior to his appointment as Chief Compliance Ocer at Tether, he served as the Anti-Money Laundering (AML) Manager at the Bank of Montreal. In 2016, he organized an AML-focused cryptocurrency event in Toronto.

Silvano Di Stefano, Chief Investment Officer at Tether (allegedly). Silvano Di Stefano is a fund manager and partner at Seven Pillars Capital Management in London. He has managed several funds in the past, investing in high yield and leveraged loan credit space and direct corporate lending to SMEs in Europe. Before joining Seven Pillars Capital Management, Di Stefano was a partner and CIO at Edmond Capital Partners, where he managed the Edmond Credit Opportunities fund. He has also worked as a fund manager at Duet Asset Management and Cheyne Capital, managing synthetic CLOs, credit long-short books, and credit/equity books in macro funds. Di Stefano holds a degree in economics and financial markets from Universita Bocconi Milan.

Although neither Tether or Bitnex publicly acknowledge Di Stefano as their Chief Investment Ocer, document analysis of assets referenced below provide reasonable credibility that he has been engaged in this position.64

Stuart Hoegner, General Counsel at Tether. Stuart Hoegner has served as general counsel of Bitnex and Tether since 2014. With over a decade of experience in the eld of online gambling and cryptocurrency, Hoegner has built a reputation for his legal expertise and industry knowledge. Prior to his tenure at Bitnex and Tether, Hoegner served as the deputy general counsel and director of compliance at Excapsa Software, a poker software company. During his time at Excapsa, the company faced legal challenges related to software-enabled cheating.

Marco Dal Lago, Head of Expansion at Tether and Bitfinex. Marco Dal Lago is the Head of Expansion at Tether and Bitnex, and has held this position since April 2022. In 2015, he was a researcher and teaching entrepreneur at the SUPSI Department of Innovative Technologies in Switzerland. He also worked as a visiting research scholar at Bremer Institut für Produktion und Logistik in Brema, Germany. He is currently an associate professor at Franklin University Switzerland, where he has been teaching since December 2019. He teaches digital transformation strategies for the MSc. in International Management (MSIM) program. Dal Lago has a Master of Business Administration (MBA) degree from IE Business School. He also has a Master of Science in Engineering (MSE) degree with a specialization in Business Engineering and Production and a Bachelor of Science (B.Sc.) degree in Management Engineering from the University of Applied Sciences and Arts of Southern Switzerland.

Davide Rovelli, Head of Special Projects at Tether. Davide Rovelli is the Head of Special Projects at Bitnex and Tether. In 2014, Rovelli founded GetMyCar, an Italian start-up for peer-to-peer car sharing. He served as the Chief Operating Ocer at GetMyCar for two years before becoming the CEO of ParkinGO International SA, a mobility model company. As the CEO of ParkinGO International SA, Rovelli expanded the company's parking facilities and launched an Initial Coin Oering (ICO) for ParkinGO, which raised $5m from international investors. Rovelli is a guest lecturer at Franklin University Switzerland and the University of Applied Sciences and Arts of Southern Switzerland.

Tamuna Magularia, Head of Strategic Financial Projects at Tether. Tamuna Magularia is the Head of Strategic Financial Projects at Tether, a position she has held since December 2022. Magularia holds an MBA from IE Business School. Before joining Tether, she was the Head of Financial Planning and Analysis at TBC Bank. Before that, she was the Director of Finance and Business Support at Pullman Tbilisi Axis Towers, a hotel owned by Accor. Magularia has a bachelor's degree in Business Administration, majoring in nance, from Caucasus University.

Jean Chalopin, Chairman at Deltec Bank and Trust. Jean Chalopin is a French bank executive who made a name for himself in the 1980s and early 1990s as the founder and president of the production company DIC. He is known for co-creating the animated television series Inspector Gadget. Chalopin is the largest shareholder and chairman of Deltec Bank and Trust, a Bahamas-based financial institution. After moving to the Bahamas in 1987, Chalopin began investing in Deltec Bank and Trust. As chairman, he sought out smaller technology-related businesses, including Tether and its controlling company Bitnex in 2018. Deltec was the only bank willing to work with cryptocurrency at that time. Chalopin's role at Deltec Bank and Trust is crucial to Tether's operations, as the bank is Tether's primary financial institution.

Christopher Harborne, Shareholder at DigFinex. Christopher Charles Sherri Harborne is a British businessman and technology investor who earned a MA, MEng, and MBA from Cambridge, and later earned an MBA from the Institut européen d'administration des aaires (INSEAD) in 1988. Harborne worked for ve years as at McKinsey and Co. before starting a research company in Asia. Currently, Harborne is the CEO of Sherri Global Group, a company that trades in private planes. Harborne is an "investor in new tech, including open software blockchain platforms", and enabled the founding of INSEAD San Francisco and created a Blockchain Research Fund. He has donated to Britain's Conservative Party in the past, but in 2019, he became a major donor to Britain's Brexit Party, donating over £6 million. In November 2022, Harborne donated £1 million to The Oce of Boris Johnson Ltd, one of the biggest donations ever made to an individual British politician. Harborne has been tied to Tether's alleged fraud under the pseudonym Chakrit Sakunkrit. He was and could still be a major shareholder of Dignex, the parent company of Tether and Bitnex.

Stephen Moore, Shareholder at Tether Holdings Ltd. Bitnex

2.2 Whitepaper

Tether Whitepaper. Introduced in 2014, Tether’s whitepaper provides an elementary outline of the processes and risk associated with deploying and sustaining a stablecoin. The material denes “tethers” as at-pegged instruments which rely on “asset-pegged” or portfolio-pegged liquidity. The document attests that Tether’s “proof of reserves” signicantly reduces counterparty risks, and Tether Limited “will not face any market risks such as Black Swan events, liquidity crunches, etc as reserves are maintained in a one-to-one ratio rather than relying on market forces”.65 Referenced under “Technology Stack and Processes”, Tether Limited is responsible for “accepting at deposits and issuing the corresponding tethers” and “custody of the at reserves that back all tethers in circulation” in an o-chain, private environment. Without consideration for financial attestations, the process for issuing and revoking tokens remains detached from financial transactions.

In respect to public audit and the veriability of on-chain “tethers” relative to o-chain reserve assets, Tether Limited’s “Proof of Reserves'' outlines the following. “In our conguration, each tetherUSD in circulation represents one US dollar held in our reserves (i.e. a one-to one ratio) which means the system is fully reserved when the sum of all tethers in existence (at any point in time) is exactly equal to the balance of USD held in our reserve. Since tethers live on the Bitcoin blockchain, the provability and accounting of tethers at any given point in time is trivial. Conversely, the corresponding total amount of USD held in our reserves is proved by publishing the bank balance and undergoing periodic audits by professionals”. Additionally, in order to prove USD bank reserves, the whitepaper states that Tether Limited will “publish the bank account balance on our website’s Transparency page.” They do not.

Tether Whitepaper, Flow of Funds Process. The Flow of Funds process is described in ve steps, starting with a user depositing at currency into Tether Limited's bank account and ending with Tether Limited destroying the tethers and sending at currency back to the user's bank account. The amount of at currency deposited by the user equals the amount of tethers issued to the user. Once tethers enter circulation, they can be freely traded between businesses and individuals, and users can obtain tethers from exchanges or other individuals. Tether Limited is the only party that can issue tethers into circulation or take them out of circulation, which is the main process by which the system solvency is maintained.

Tether Whitepaper, Proof of Reserves. The Tether whitepaper discusses the risks of insolvency in the cryptocurrency industry and suggests that current exchange and wallet audits are unreliable. To address this, Tether would implement a Proof of Reserves process that simplies the process of proving that each tetherUSD in circulation is fully backed by an equal amount of at currency held in reserve. The Solvency Equation is simply TUSD = DUSD, meaning that every tether issued or redeemed corresponds to a deposit or withdrawal of funds from the bank account. The bank account balance would be published on Tether's website's Transparency page, and professional auditors regularly verify and publish the underlying bank balance and financial transfer statement. It is not, and they do not.

Tether Whitepaper, Implementation Weaknesses. Tether acknowledges that their implementation of a stablecoin system is not immediately fully trustless as users must trust Tether Limited and their corresponding banking institution to be custodians of the reserve assets. They identify several weaknesses in their approach, including the possibility of bankruptcy, insolvency or freeze/conscation of funds by their bank, and absconding with reserve assets. Tether addresses each of these concerns by reassuring users that client funds would be safe even if the company goes bankrupt, that they use banking partners who are aware of and condent in Tether's business model, that their banks are accepting of Bitcoin businesses, and that they follow KYC/AML processes used by other digital currency exchanges. They also state that ownership of the account is legally bound to the corporate charter and that any transfers in or out of the bank account have associated traces and are bound by rigid internal policies.

Tether Whitepaper, Main Applications. Tether briey discusses the main applications of tethers in the Bitcoin/blockchain ecosystem for three user groups: Exchanges, Individuals, and Merchants. For exchanges, using tethers can relieve them of complications associated with accepting at deposits and withdrawals, such as identifying the right payment providers, integrating the platform with banks, and coordinating compliance and security. Tethers can also help exchanges to reduce counterparty risk, as holding at currencies on an exchange can be quite dangerous. For individuals, tethers can be used to transact in USD/at value, cold store USD/at value by securing one’s own private keys, and avoid the risk of storing at on exchanges. For merchants, tethers can help price goods in USD/at value, avoid conversion from Bitcoin to USD/at, prevent chargebacks, reduce fees, and gain greater privacy.

Tether Whitepaper, Limitations of Existing Fiat-pegging Systems. Tether's whitepaper highlights some limitations of existing at-pegging systems. Existing systems are based on closed-source software: "The systems are based on closed-source software, running on private, centralized databases, fundamentally no dierent than Paypal or any other existing mass-market retail/institutional asset trading/transfer/storage system." Decentralized systems that rely on alt blockchains are untested: "Decentralized systems that rely on alt-coin blockchains which haven’t been stress-tested, developed, or reviewed as closely as other blockchains, like Bitcoin."66 Pegging processes can have issues: "Pegging processes that rely on hedging derivative meta-assets, ecient market theory, or collateralization of the underlying asset, wherein liquidity, transferability, security, and other issues can exist." Lack of transparency and audits for custodians: "Lack of transparency and audits for the custodian, either crypto, at, or relating to their own internal ledgers (same as closed source and centralized databases)." Reliance on legacy banking systems and trusted third parties: "Reliance on legacy banking systems and trusted third parties (bank account owners) as a transfer and settlement mechanism for reserve assets."67

Tether Whitepaper, Market Risks. Tether’s whitepaper states that market risk exists when the price of the asset used as collateral moves in an adverse direction to the price of the asset it's backing, which can make the system insolvent. The risk is mitigated by the custodian closing the position before this happens. However, the whitepaper notes that a liquidity crunch can occur, making it impossible to liquidate the collateral fast enough to meet trading obligations, creating losses. The whitepaper goes on to explain that the cryptocurrency market is small and volatile, making this type of event more likely. Additionally, there must be a sucient supply of users posting collateral for the creation of the pegged-assets to exist in the rst place. The derivatives approach to asset backing/pegging has similar market risk characteristics to the collateralization method.

Tether Whitepaper, Legal and Compliance. According to Tether's whitepaper, the company is a Hong Kong limited company wholly owned by Tether Holdings Limited, a BVI business company. Tether is registered as a Money Services Business with the Financial Crimes Enforcement Network of the U.S. Department of the Treasury. Tether currently has accounts with Cathay Bank and Hwatai Bank in Taiwan, both of whom are satised with Tether's processes and compliance with Taiwan oshore banking regulations.

2.3 Financial Security

Audits & Consolidated Reserves Report. Every three months since June 30th, 2021, Tether Limited has published a “Tether Assurance” attestation that includes an internal “Consolidate Reserves Report” reviewed by an independent auditor such as BDO, MHA Cayman or Moore Cayman. Prior to these documents, between September 15th, 2017 and March 31st 2021, Tether Limited published ve additional attestations: Two “Tether Assurance” reports from Moore Cayman, a 27 word letter from Deltec Bank and Trust Limited, an “Account Snapshot Statement” by Freeh, Sporkin & Sullivan LLP and a “Consulting Report” by Friedman LLP. All of the aforementioned reports, although adhering to their 3 month attestation schedule, are purely a snapshot of supposed holdings with no timely liquidity and solvency updates to account for uctuating market conditions. The reporting standards, once suggested via their original whitepaper, should allow for real time live account balance updates, upholding the obligation for a constant 1:1 liquid and available USD peg and backing from their partner banks.

CRR Historical Analysis. From 31 Mar 2021 to 31 Dec 2022, Tether's total assets grew from $41,017,565,708 to $67,044,148,175. The highest asset value was on 31 Mar 2022 at $82,424,821,101. The total liabilities also increased from $40,868,295,798 to $66,083,530,757 during the same period, with the highest liability value on 31 Mar 2022 at $82,262,430,079. The net assets and equity experienced growth from $149,269,910 to $960,617,418. In the asset breakdown, there is a signicant decrease in CP and Cert Deposits from 31 Mar 2022 ($20,096,579,998) to 30 Sep 2022 ($49,981,855). In contrast, there is a noticeable increase in Treasury Bills from 31 Mar 2021 ($914,687,614) to 31 Dec 2022 ($39,230,259,046).

Commercial Paper Analysis. Based on the commercial paper breakdown and days outstanding data provided by Tether's Consolidated Reserve Reports, it appears that USDT has a high level of exposure to commercial paper, particularly A-1 and A-2 rated paper. This indicates that USDT is investing a signicant amount of its reserves in short-term debt securities issued by corporations with a high credit rating. Looking at the trends over time, there seems to be a decline in the total amount of commercial paper held by Tether from 30,807,654,349 USD in March 2021 to 8,402,426,505 USD in June 2022, followed by a slight increase to 49,981,855 USD in September 2022. This could suggest that Tether has reduced its investment in commercial paper as a proportion of its reserves. Furthermore, the data indicates that the average days outstanding of the commercial paper held by Tether has been declining. For instance, the amount of commercial paper with days outstanding of 0-90 days increased from 10,570,890,544 USD in June 2021 to 18,873,342,614 USD in March 2022, while the amount of commercial paper with a days outstanding of 181-365 days has been declining over the same period. This could suggest that Tether has been investing in shorter-term paper to reduce the risk of insolvency.

Finances, Banking Partners. See appendix for materials to pull from. Should t into one or two paragraphs.

Finances, Managing Profits. Tether Holdings Limited reported a prot of $700 million and excess reserves of $960 million in Q4 of 2022. However, the accuracy of these gures could not be independently veried.

Finances, Asset Management. According to an article by Protos Sta, Tether's latest assurance from BDO Italia reveals an increase in Tether's "Shareholder Capital Cushion" to over $960 million. However, this number contradicts what Tether previously disclosed on its transparency page, which showed a shareholder capital cushion of approximately $250 million. This brings into question why Tether's shareholder capital cushion on the transparency page is so stable, why it doesn't match the consolidated reserves report, and why the page is not updated daily as described.68 In October 2022 Tether announced69 a major shift in its reserve management strategy, abandoning commercial paper in favor of US Treasuries. The move was part of an eort to improve the apparent quality of Tether's reserves amid growing discussions around stablecoin regulation in the United States. Commercial paper had been a signicant part of Tether's reserves, making up almost half of its holdings when it rst provided a reserve composition breakdown in May of the previous year.

Finances, Token Lending.

Finances, Consolidated Reserve Reports. Tether's solvency is a challenge to accurately assess due to the lack of transparency regarding its reserves. Tether calculates “cash and cash equivalents” and their U.S treasury bills at notional value, while secured loans are calculated at amortised cost. Some attestations have also included “"reverse repurchase agreements," which even Bloomberg hasn’t been able to explain. Tether's "other investments" oers little insight, and it is unclear if this includes Tether's venture capital portfolio. The company's statements seem to be untethered from reality, with the amount of quarantined tethers listed for Omni chain being wrong for years. Tether maintains a small cushion of assets over liabilities, which is stable except on days when new assurances are released.

Tether values credit-based assets at an amount "less than any expected credit losses," but it uses a "going concern basis of accounting," which requires signicant management judgment regarding Tether’s liquidity market and credit risks. The company has no provision for expected credit losses, even though it is currently a defendant in legal cases. Tether's $250 million shareholder capital cushion is a tiny percentage of its total $66 billion in assets. Until Tether provides greater detail on the composition of its reserves, it is dicult to assess the rm's solvency.

Finances, Token Swaps. In September 2022, Binance, one of the world's largest cryptocurrency exchanges, announced that it would forcibly convert several stablecoins, including USDC, USDP, and TUSD, into its own stablecoin, BUSD. Binance justied the move by claiming that it would improve liquidity and capital eciency for its users. While Binance has been slowly liquidating USDC on its platform, it continues to maintain a close relationship with Tether (USDT), the world's largest stablecoin. Binance and Tether have a storied history, with some accusing Binance of beneting from its customers' failed leveraged futures trades, many of which were denominated in USDT. Despite the decision to de-list USDC, Binance's exemption of USDT from its delisting announcement suggests that the company continues to value its relationship with Tether. However, the article points out that stablecoins, including Tether, do not guarantee stability. Many stablecoins have collapsed to near-$0 in the past, including TerraUSD, IRON, BasisCash, Acala USD, exUSD, DEUS, BitUSD, CK USD, DigitalDollar, and NuBits. Even Tether has intermittently uctuated from its peg, raising concerns about its insolvency risk associated with reserve management.

2.3.1 Transparency

The stablecoin Tether $USDT has long been controversial due to questions over its reserves and transparency. After settling with the New York Attorney General in 2021, Tether was forced to begin issuing quarterly attestations to prove its reserves were fully backed and that it wasn't using funds from Bitnex. Tether began this process with Moore Cayman and the rst results were concerning, showing that Tether was laden with commercial paper of unknown national origin, quality, and liquidity. Tether then switched to BDO Italia to provide assurances, but this did not improve transparency either. During an interview on CNBC, Tether's CTO Paolo Ardoino and Bitnex's General Counsel Stuart Hoegner made non-denial denials and promised a full audit of Tether's reserves in a matter of "months, not years." These documents have not been produced.

In May 2022, Tether's CTO Paolo Ardoino was involved in a heated Twitter Spaces chat with former hedge fund manager, George Noble, regarding the stablecoin's refusal to disclose a schedule of investments. Noble pressed Ardoino on why Tether has never released an audit or provided the names of its assets, citing routine disclosures as standard in other industries. Ardoino claimed that existing regulations did not require Tether to release full disclosure of its assets and that the company did not need to silence its critics. However, Noble compared Tether's growth to Enron's run-up before its 2001 collapse, where the senior sta consistently refused to respond to requests from the public for balance sheets or cash ow statements.70

Tether releases periodic "snapshots" of its assets, but these are not a full audit, and the New York Attorney General's investigation into Tether and Bitnex conrmed that Bitnex had transferred $382 million to the bank account just hours prior to Friedman LLP attestation. Tether has repeatedly promised to conduct an audit but has failed to produce one. Noble accused Tether of moving money into an account before getting that attestation and moving it back out after the attestation. Tether and Bitnex previously lied about matters like their close relationship, and Bitnex's transfer of money to Tether bank account before Friedman LLP attestation demonstrated a willingness of both companies to cover for each other.

In May 2022, The Financial Times reported that Tether was using an obscure Bahamas-based bank called Capital Union to hold some of its reserves, which totaled over $72 billion. Tether had previously disclosed that it had placed around $15 billion in cash and bonds with another Bahamas-based bank, Deltec Bank & Trust, and had "strong banking relationships" with "more than seven, eight banks across the world." It's currently unknown how much of Tether's funds are held by Capital Union or when the partnership began. 71

According to CoinDesk,72 Tether's general counsel Stuart Hoegner admitted in an adavit led with the New York Supreme Court that as of April 30th, 2019, the USDT stablecoin was only about 74% backed by at equivalents. Hoegner stated that Tether held approximately $2.1 billion in cash and short-term securities, which represented approximately 74% of the current outstanding tethers at the time.

Transparency, Falsifying Documents. According to the Wall Street Journal, Tether has been accused of falsifying documents provided to its banking partners and is currently under investigation by the Department of Justice for bank fraud. The report reveals that Tether and Bitnex relied on opening accounts controlled by other people, including one allegedly used to launder money for a Hamas group. Additionally, a shareholder of Tether Holdings Limited, Stephen Moore, reportedly signed fake invoices and contracts to hide deposits and withdrawals related to Tether. These allegations raise concerns about the stablecoin's insolvency risk associated with its reserve management. As one Tether trader in China reportedly recommended abandoning the plan because he "would not want to argue any of the above in a potential fraud/money laundering case."73

2.4 Wash Trading, Financial Spillover Risk, Regulatory Pressure

In addition to examining the organizational liabilities of Tether in terms of executive team qualications and trustworthiness, it is important to note the operational hazard and risk from the misuse of circulating UDST supply. As section 1.3.4 highlights, the growing dependence on stablecoin trading pairs in major crypto exchanges brings about a new array of regulatory challenges and constraints. The risk of stablecoins being used as a decentralized tool for market manipulation is more relevant than ever.

In order to comprehend the eect of an increasing market capitalization of stablecoin providers such as Tether, we must closely consider the spillover risk and potential for crypto asset price manipulation. With the liquidity of a crypto asset relying heavily on the perceived demand and trading volumes on the buy/sell order books, there is a strong possibility for market makers and unregulated exchanges to take advantage. These claims and risk proles are not unbacked, as the CFTC (Commodity Futures Trade Commision) has previously led lawsuits against Tether and their associated Bitnex exchange for “wash-trading” and market manipulation of Bitcoin asset prices using their own issued Tether USD stablecoin.74

According to an NPR interview regarding crypto price manipulation in 2022, wash trading was dened by Kim Grauer from Chainanalysis as, “a trading strategy in which the buyer and the seller is eectively on both sides of the trade, and a person will sell themselves an asset to create the illusion that a particular asset is trading far more than it actually is.”

At the same time, the court ndings also discovered that Tether did not uphold their full 100% reserve backed guarantee in the trading period examined. The CFTC lawsuit against Tether and Bitnex states that, “Tether held sucient at reserves in its accounts to back USDT tether tokens in circulation for only 27.6% of the days in a 26-month sample time period from 2016 through 2018.” Given these court ndings, all assets trading during this period denominated in USDT Tether trading pairs only held 27.6% of the liquidity believed to be present in the pricing and trade execution of crypto assets. Provided that the examination under court order only focused on Bitnex’s order book, the extent of the liquidity disconnect in crypto asset pricing in this period is not entirely known. Furthermore, we must note the majority ownership of all Tether circulating supply in 2021 was held by market makers responsible for trade execution of the former Bahamas based FTX crypto exchange and currently the largest exchange by trading volume, Binance.

In November 2021, Protos published an article detailing who acquired the majority of $USDT75 After accounting for disclosed chain swaps, Tether was found to have distributed $108.5 billion in $USDT and received $32.7 billion in $USDT. The majority of $USDT was sent directly to market makers and liquidity providers, identied as entities that received multiple individual transactions from Tether treasuries of $100 million $USDT or more. Alameda Research and Cumberland Global were found to be Tether's biggest customers, having received at least $60.3 billion in $USDT. These gures imply that Tether is highly dependent on these market makers for liquidity, raising insolvency risk if these entities were to withdraw or sell their $USDT holdings.

iFinex was one of Tether’s rst true “market makers,” and the Hong Kong-headquartered rm issued iFinex $4.5 billion in $USDT between October 2016 and the start of 2020 — equal to 96% of iFinex’s trackable receipts. The report by Protos disclosed that Tether sent at least $4.5 billion in $USDT to iFinex. iFinex received at least 4% of all outbound volume. Nexo, a Zug-registered company, received over 2% of all outbound volume and had been sent $2.6 billion in $USDT. The New York Attorney General has issued Nexo a cease and desist notice to stop it from oering services to crypto users in the state.


Despite the extensive and rapid growth of the stablecoin market capitalization in recent years, it is valuable to note that the overall risk of financial spillover into the financial system of regulated banking environments is minimal. However, the overall reliance on the existence of stablecoins in crypto markets is increasingly critical and in need of regulatory oversight.

Through our quantitative market overview regarding stablecoin issuer market share growth and trading pair market share, coupled with the research paper’s extensive operational and regulatory risk analysis of major issuers, there remains on primary concluding theory surrounding the continued success of stablecoins.

While our research indicates an inverse correlation between regulation and the adoption of stablecoin issuers by market participants, it is essential to recognize that increased regulation can contribute to a more stable and secure financial ecosystem. The findings suggest that stablecoins, in their current state, have become a risk-free borrowing mechanism for issuers, particularly in the absence of stringent regulations. This absence of regulatory obligations poses signicant concerns, especially in times of financial stress and uncertainty.

It is noteworthy that stablecoin issuers who have taken steps to de-risk and comply with regulatory requirements have not achieved the same financial gains as their less regulated counterparts. For instance, during the last quarter, Tether (USDT), the largest stablecoin by market capitalization and with less regulatory oversight, made signicant prots. Conversely, the most regulated and transparent stablecoin, USDC, faced financial turmoil during the SVB partner bank crisis, highlighting the complex dynamics at play.

In light of these ndings, it is crucial to maintain a cautious approach towards stablecoins, particularly Tether, due to its signicant inuence and dominant position as the primary source of liquidity in crypto markets. The reliance on an unregulated stablecoin issuer authority poses inherent risks to the crypto and digital asset exchange industry. This research emphasizes the necessity of regulatory oversight and the development of robust reserve management practices to mitigate potential financial spillover risks associated with stablecoin insolvency.

In conclusion, while the overall risk of financial spillover into regulated banking environments from stablecoin insolvency appears minimal, the increasing reliance on stablecoins in crypto markets warrants heightened regulatory attention. The ndings highlight the importance of striking a balance between fostering innovation and ensuring financial stability. As the stablecoin ecosystem continues to evolve, proactive regulatory measures should be implemented to safeguard market participants and maintain the integrity of the financial system. Further research and collaboration between regulators, issuers, and market participants are vital to address the challenges posed by stablecoin insolvency and enhance the resilience of the broader financial ecosystem.