New Crypto Derivatives Let You Bet on (or Against) Tether's Solvency

Credit default swaps (of “The Big Short” infamy) have come to the Ethereum blockchain. Opium Exchange says they can help crypto investors manage risk.

AccessTimeIconSep 3, 2020 at 1:00 p.m. UTC
Updated Sep 14, 2021 at 9:51 a.m. UTC

After years of debating whether tether (USDT) is fully backed 1-for-1 with U.S. dollars, the stablecoin’s critics and defenders alike can now put their money where their mouths are.

Opium, a derivatives exchange, has introduced credit default swaps (CDS) for USDT. The product, launched Thursday, insures the buyer in the event of default by Tether, the issuer of the world’s largest stablecoin and fifth-largest cryptocurrency overall.

In this case, a sharp drop in USDT's price from the usual $1 is used as a proxy for Tether turning out to be insolvent. So if the token fell to 70 cents, the writer of the contract would pay the buyer 30 cents at maturity.

It’s the second time in a month that Opium has launched a CDS tied to a digital asset. Such contracts have been around on Wall Street since the 1990s and gained notoriety for their role in the 2008 global financial crisis

However, they were invented to manage risk, and their prices arguably offer markets an early warning signal of credit troubles. Also, unlike the paper agreements litigated in “The Big Short,” these new CDS are smart contracts, executed by code on the Ethereum blockchain.

A CDS is a “transfer of the insurance from people who know and are confident to people who’d like to be insured. Derivatives are just about transferring the risk. Some people would like to have the risk and get paid, some people would like to pay to get rid of risk,” Opium founder Andrey Belyakov said in an interview.

Investors don’t need to hold USDT to purchase this coverage. They can use CDS to bet against the asset, while those who trust Tether to honor its obligations can earn a premium for standing ready to cover defaults.

"You can use it to protect yourself against (or speculate on) a systemic failure of the most widely used stablecoin in crypto. It also allows you to earn interest on your capital in case you are willing to bet on the quality and sustainability of USDT," Opium said in a blog post to be published Thursday.

Paolo Ardoino, chief technology officer at Tether, said through a spokesman: "Tether is solvent. Therefore, this solution is not really interesting to us or our community."

Hedge for crypto exchanges

In late August, Opium Exchange rolled out a contract that insures the buyer against defaults on “credit delegation” loans, a form of unsecured borrowing on decentralized money market Aave. 

For both CDS products, information about off-chain events that would trigger payouts (in this case, a change in USDT's price) is fed to the smart contracts by “oracle” service Chainlink, a 2020 standout project in terms of market adoption.

While fully collateralized smart contracts may remove the counterparty risk once embodied by AIG, they introduce a new kind of risk: bugs in the software. To mitigate this possibility, security firm SmartDec audited the new CDS' code and Opium itself.

The new CDS tethered to USDT can be customized to pay out under different scenarios, such as the stablecoin falling under a preset value, said Aave founder Stani Kulechov, who is advising Opium.

“You can insure Tether for the next one month [or] three months. And you can insure Tether at different price levels. You could set the credit default event to 95 cents or 90 cents. If it hits [that price point], that means it's a credit default event. The buyer of the CDS will get the amount covered,” Kulechov said.

As Opium’s blog points out, USDT is the lifeblood of the borderless cryptocurrency marketplace. It is designed to maintain its value in fiat currency, hence the term "stablecoin." The oldest stablecoin, USDT remains the largest such cryptocurrency by market cap and a top-five coin overall with $13.8 billion in issuance. Traders often use it to move money in and out of exchanges quickly to take advantage of arbitrage opportunities.

The firm behind the stablecoin is under investigation by the New York Attorney General’s office for alleged misappropriation of funds, along with its sister firm, crypto exchange Bitfinex.

Tether revealed in April 2019 that only 74% of USDT was backed by “cash and cash equivalents.” The firm later said USDT was once again fully backed in a November 2019 retort to an academic paper that blamed the stablecoin for the 2017 bitcoin bubble. 

Either way, Belyakov said Opium’s CDS can act as a hedge for crypto exchanges that have large exposures to Tether’s solvency.

The derivative also functions as insurance for “long-tail risks” of rare events that are common to decentralized finance (DeFi) applications and should soon be available for stablecoins USDC, BUSD and even algorithmic stablecoin dai (DAI), he said.

UPDATE (Sept. 3, 13:30 UTC): Added comment from Tether in ninth paragraph and background on stablecoins in fifteenth paragraph.


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