Tether issues a widely accepted, highly liquid liability with a fixed nominal price of one. Its USDT tethers exist on several blockchains, including Bitcoin and Ethereum, and they are widely used in crypto transactions. USDT have been highly liquid: easily redeemed on demand for USD. Despite that success, I pointed out in a previous post that what Tether is doing is quite difficult.
The company stakes a lot on its claim that it is a "100% backed" narrow bank. This has always implicitly raised the question "100% backed by what?" Tether has now, at the polite request of the New York attorney-general's office, released some details about its balance sheet:
These (rather scant) details start to paint a much clearer picture of what they are doing. It matters because the liquidity (convertibility) of USDT depends, in the end, on the liquidity of the company's asset portfolio. Without knowing what that portfolio was, it was not possible to get a sense of its liquidity.
Why does the liquidity of its assets determine the liquidity of its liabilities? The fixed price makes a big difference here. If there is widespread selling of USDT, the company has to buy them to prevent the price from falling, or else it is failing on its central business proposition. In the event of a big redemption, Tether will have to sell assets to generate dollars to return to the holders of its liabilities.
Specifically, it can meet some $11 billion of cash outflow using its deposits. Those deposits are probably pretty liquid, but Tether has not said where they are kept, so we have to take their word for it as an intermediary.
After the first $11 billion, Tether has to start selling other assets, for example commercial paper, in which it holds about a $30 billion position. The $1 trillion CP market is, on most days, very liquid, which is of course why Tether has all of its money there in the first place. But it's also not like there have never been liquidity crises in the commercial paper markets.
With this balance sheet structure, it is fair to say that Tether is operating a constant net asset value (CNAV) money market mutual fund. Such a fund holds short-term money-like assets traded in markets that are generally highly liquid. Fund managers issue shares and adjust their portfolios so that the fund's net asset value is always equal to one unit of state money per share:
This might be a good time to recall the failure of the Reserve Primary Fund, a CNAV money market fund that broke the buck in 2008 (its NAV dropped to 97 cents) because of exposure to Lehman's commercial paper. Tether has not suffered a run yet, but it would be unwise to conclude that it has eliminated liquidity risk. Because liquidity crises tend to be all-or-nothing affairs, it is hard to draw conclusions about Tether's likely success from what it has done so far.
It is more helpful to look at the big picture. Tether's balance sheet, presumably those of other stablecoin issuers, and the crypto asset infrastructures that increasingly depend on them, assume that not everyone will cash in their stablecoins on the same day, or that if they do, it will not be the same day that the commercial paper market fails. This is not a good assumption, precisely because Tether's balance sheet structure connects the two markets. If there is a disruption in CP, people might worry about their Tethers and withdraw them. The more narrow banks like Tether issue, and the more financial structures are built on top of this issuance, the smaller will be the disruption needed to trigger a collapse of liquidity with systemic consequences.
One of my goals for Soon Parted is to separate genuine novelty, like distributed ledger technology, from ideas that have been around for a long time, like 100% reserve banking. Whether an idea is old or new may not have much to do with whether it is a good idea or a bad one, or whether it is usually a bad idea but occasionally a good one. But surely that history is relevant even if times continue to change. I will persist in calling stablecoins "narrow banks" as a reminder that the idea has a history.
Likewise, issuing a claim whose price is fixed at one is an old idea. It is helpful to give that price the name of "par." Calling it by its name is a reminder that that price, usually one, is the outcome of a social process, not a law of nature, and not a mathematical certainty. Most days, the banking system, a social phenomenon, manages to maintain par, so that bank deposits are easily redeemed one-for-one with state money. Because it usually works, the fact that par is a price is not usually relevant.
Indeed the banking system is, these days, set up so that if a bank ever does fail to honor its deposits, it triggers regulatory intervention rather than actually breaking par. That, I argue, is not evidence that the difference between reserves and deposits doesn't matter. It's evidence that the difference is so crucial that it is the very core of bank supervision.
In the same spirit, it could be helpful to note that there is also a name, basis risk, for the possibility of mistakenly believing that two things are substitutes when in fact they are not. Reserves and deposits are two different assets, between which there could be basis risk. But the banking regulatory system is set up to insure the basis risk, so that they function as good substitutes within that regulatory context. That is a context which does not, currently, apply to Tether.
Take Perry Mehrling’s online Money and Banking course with others this summer.
Is Tether really a narrow bank if it holds commercial paper? I thought narrow banks were more restricted than that.