Regulation Could Actually Help Tether

DeFi has cut into Tether's dominance of the stablecoin market. Will greater regulation help win back customers?

CoinDesk Insights
Mar 3, 2021 at 8:48 p.m. UTC
Updated Sep 14, 2021 at 12:20 p.m. UTC

If you follow the cryptocurrency scene, by now you'll have heard about Tether's settlement with the New York Attorney General's office.

The settlement marks a big win for stablecoin users. For the next two years, Tether will be required to live up to some of the same regulatory standards as its licensed stablecoin competitors. That means tether (USDT) stablecoins will be safer for the public to use.

J.P. Koning, a CoinDesk columnist, worked as an equity researcher at a Canadian brokerage firm and a financial writer at a large Canadian bank. He runs the popular Moneyness blog.

It might even be good for Tether, too. Of late, the company's blistering growth has been slowing – the market just doesn't seem to trust it. Some oversight might alter its trajectory.

For those who aren’t aware of either Tether or its settlement with the New York Attorney General, here’s a quick introduction. Tether's self-named stablecoin is the largest in the cryptocurrency universe, with some $35 billion tethers in circulation.  

The New York Attorney General's office launched an investigation into Tether in 2019 for fraud. After months of picking through Tether documents, it finally settled with Tether last month.

In the settlement agreement, the Attorney General accuses Tether of being dishonest with  customers by describing tether stablecoins as fully backed by dollars. Rather than keeping customer funds safely invested in dollars “safely deposited in our bank accounts,” Tether routinely diverted customer funds towards an assortment of risky assets. These included a potentially non-recoverable claim on Crypto Capital Corp, a fraudulent third-party payments processor, and a risky loan to an affiliate company, Bitfinex. Tether even deposited millions of dollars of customer money into a Bank of Montreal account held in its lawyer's name.

These misrepresentations would be less concerning if Tether was just a tiny run-of-the-mill payments company. It isn't. Consider this. Fintech behemoth PayPal had around $35 billion in customer balances at the end of 2020. Tether says it hit the $35 billion mark this month. That means it has accomplished in just seven years what took PayPal 23 years.

So Tether, a company that seems to be held together with spit and duct tape, has suddenly become one of the largest U.S. dollar payments platforms in the world ranked by customer balances.

No one ever worries about PayPal dollars falling below $1. But speculation that Tether could break its peg is routine in the crypto community. People have good reason to trust the stability of PayPal dollars. PayPal is regulated on a state-by-state level as a money transmitter. Tether is unregulated. That is, it is not beholden to any financial regulatory framework.  

Tether says that it hit the $35 billion mark this month. That means it has accomplished in just seven years what took PayPal 23 years.

For instance, PayPal could never have lent its customers' funds to a dodgy third-party payments processor. If it did, it would have been breaking the law. As part of its licensing requirements, PayPal is prohibited from investing customer funds in risky assets. If it did make an illegal investment, PayPal couldn’t hide it. It is required to regularly submit audited financial statements to state financial supervisors.

For its part, Tether is incorporated in the British Virgins Islands, which does not have a financial regulatory framework for protecting customers of money transmitters. And so Tether can do things that PayPal can't.

But the settlement changes this. It requires Tether to provide customers with plenty of useful information about how it invests their money. Specifically, each quarter Tether will have to inform the public about the percentage of reserves that are held as cash, loans, securities and amounts due from affiliates. And so for the first time, Tether customers may finally have enough information to verify whether their choice to hold tether is commensurate with underlying risk.

There are a few other measures Tether will have to take. Notably, it will have to provide the Attorney General’s office with proof that it is segregating customer funds from company and affiliate accounts. The commingling of funds is just one of many practices that made tethers unsafe. And Tether will also have to regularly provide the Attorney General with a list of its payment processors, along with location and contact information.

The settlement will expire after two years. But until then, unregulated Tether will be regulated-ish. And so, courtesy of the New York Attorney General, Tether users are all a bit safer.

Regulation for good

I'd argue that a bit of regulation, and the extra trust that it could engender, is exactly what Tether needs.

Regulated stablecoins like USD coin (USDC) and paxos standard (PAX) were first launched in 2018. Like PayPal, the issuers of these stablecoins are licensed and must abide by the rules set out in state financial regulatory frameworks. 

But despite new competition, unregulated tether remained the most popular stablecoin. Its four-year head start had allowed it to become the standard dollar brand for Asian cryptocurrency exchanges and for inter-exchange arbitrageurs. Tether's new stablecoin competitors might be safer, but they couldn't replicate tether's liquidity. Tether usage was locked-in, much like how QWERTY remains the world's standard keyboard configuration.

But network effects don't last forever.

Over the last six months, Tether's dominance has been declining. Whereas there used to be 10 tethers in circulation against its largest competitor, USDC, now there are only four tethers for each USDC.

Much of tether's erosion can be attributed to the huge growth of decentralized finance, or DeFi, the set of financial tools created on the Ethereum network that allow for borrowing, lending and trading. DeFi tools require safe and stable collateral as grist. When DeFi began to take off in 2020, these tools began to ingest significant quantities of stablecoins. 

DeFi has consciously tried to shut Tether out.

For instance, the largest DeFi protocol – MakerDAO – allows people to take out loans with stablecoins as collateral. People who submit stablecoins that are supervised under a financial regulatory framework (i.e., USDC, True USD, Gemini and PAX) currently pay a yearly borrowing rate of just 0%. But users that submit USDT as collateral are charged an usurious 8%.

There is another way that the deck is stacked against tether. Maker subjects all tether loans to a hefty 150% collateralization ratio. That is, a $100 loan from MakerDAO requires $150 worth of tether collateral. But regulated stablecoins like USDC enjoy slim collateral ratios of just 101%.

MakerDAO administrators say they treat tether this way because of its "history of opaqueness and fractional reserve." The result is there is almost $700 million in USDC collateral locked up in MakerDAO, almost 10% of all USDC in existence. But there are just a measly 709 tethers in MakerDAO.

Nor is MakerDAO the only DeFi protocol to discriminate against Tether. Compound and Aave, the two largest pure lending protocols, do not allow USDT to serve as collateral for loans. Compound's decision is based on reports that tether is "undercollateralized" and has the "potential to collapse at any time." Compound has over $2 billion in USDC. But it has just $320 million in USDT.

Against its wishes, Tether is now a New York-regulated financial firm. It will grudgingly have to make its financials public. Assuming they like what they see come reporting time, Tether skeptics may start to rethink their distaste. DeFi protocols like Maker and Compound may even lighten their tether penalties, thus gobbling up more tether.

And who knows, maybe Tether will, after a taste of oversight, try to come in from the cold and apply for a money transmitter license like everyone else. Whether it will qualify is another matter. But stranger things have happened.

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