It's cheaper to pretend
Earlier this year, crypto company Tether reached a settlement with the New York State attorney-general's office over misrepresentations as to their finances. The company, along with crypto exchange Bitfinex, had claimed to have access to dollar reserves when in fact they had none, and had concealed a $600 million loan.
Tether has issued some $43 billion of its so-called stablecoin, a blockchain-based currency whose price in dollars is fixed. One unit of Tether is meant always to trade at one USD. The company has also issued much smaller volumes of Tethers pegged to other state-issued currencies.
How does this work? It is, as Tether's travails suggest, not a straightforward job to control prices, particularly if users are free to arrange transactions privately. To understand the difficulty, it is helpful to ask how prices get made in the first place. For that we need the economics of the dealer function.
A dealer, or market-maker, Tether Inc. in this case, is an entity that sets prices for a particular asset or commodity. In financial markets, most dealers make two-sided markets: they buy and sell. Dealers post buying and selling prices for an asset, and offer to trade with the public at those prices. By doing so, they make the market, creating trading possibilities for others.
What prices do they post? Others are free to buy from whomever they like. So for the dealer's selling price to be effective, they have to charge less than everyone else's selling price (the "outside ask"). If the dealer sells out, they will have to replenish their inventory from someone else, and the outside ask is the price the dealer will have to pay to do so.
Others are free also to sell to whomever they like. So for the dealer's buying price to be effective, they have to pay more than everyone else's buying price (the "outside bid"). If the dealer cannot afford to buy any more, they will have to sell off inventory to someone else, and the outside bid is the price the dealer will get for that excess inventory.
The situation is depicted in this diagram, with the dealer's inventory of the asset it is trading going across, and price going up and down. The dealer's buy and sell prices are the "inside" bid and ask, respectively.
The dealer can offer any price between the outside bid and the outside ask. Moving across is the dealer's inventory: when the dealer buys, inventory rises and the dealer lowers the price to try to unload the new inventory. When the dealer reaches their maximum position, any further purchases have to be sold off immediately, at the outside bid. Similarly at the lower position limit.
Tether makes a market by acting as a dealer in its own stablecoin. But they want it to have a fixed price: flat lines rather than downward-sloping. What can the dealer do to keep its price function flat? They can allow a bigger inventory:
If the dealer can tolerate a bigger position, they can offer a flatter price curve. In other words: the dealer gets control of the price by giving up control of the size of their balance sheet. The reverse is also true: if the dealer doesn't allow its balance sheet to flex, then they lose control of the price.
To get a constant price, like that of a stablecoin, the dealer must make its price function horizontal. To do that, they have to be willing to buy and sell at any quantity at that price. If they can't or won't keep that commitment, then sooner or later they will break the buck. Some seller who holds stablecoins but is desperate for dollars, turned away by Tether, will sell elsewhere for less than a dollar. Or some buyer who is—for whatever reason—desperate to add to their holdings of stablecoin, turned away by Tether, will buy elsewhere for more than a dollar.
What makes it hard to fix a price is limits to the size of the balance sheet of the entity that is acting as dealer. So it isn't too surprising that Tether found itself inflating its claims about its dollar resources: it's cheaper to pretend.
Note that none of this has anything to do with blockchain or crypto. Implementing a fixed price is about buying, selling and prices, and doesn't much depend on what is being bought or sold. There are other assets that trade at fixed price: constant-NAV money-market fund shares, for example, normally trade at a fixed price of one dollar per share. Many countries operate fixed exchange-rate regimes that hold the price of local money constant in terms of dollars. Under the gold standard, the dollar price of gold was held fixed. All of these work in pretty much the same way, and face the same limitations. The question is just who exactly is doing the work of holding the price fixed, and whether they are willing to do what it takes.
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Dan- insightful application of the Treynor framework to Tether. It's interesting that you say the dealer's inventory is entirely dictated by their balance sheet, since in Tether's case they are a fully collateralized dollar bearer asset and cannot borrow (or so they've managed to convince the NY AG). The thing is that stablecoin issuers of fully collateralized tokens have to make good on their ability to redeem tokens for USD at any point in time.
I've found that dealers in the actual crypto markets here are institutions minting Tethers with their dollars to bring the price of the asset back to par (a dollar) and close the arbitrage available. Spreads are almost entirely deliniated in stablecoin markets by transaction costs to create/redeem the bearer asset, and in severe liquidity scenarios where dollars are so highly coveted they trade far above par.
Is the Outside Bid/Ask what I observe in my online broker's quotes for stocks or options? Is the inside spread what they see, i.e. unobservable unless you have privileged access?