Thursday, June 30, 2022

Watching Tether


This is a quick post to share some of the things I've learnt from watching Tether over the last two months. I'm hoping other Tether watchers find this information useful and share some of their own Tether watching tricks in the comments section. (No conspiracy theories, please. Just analysis).

There's two sides to watching Tether. You can observe its real-world activity like its attestation reports, press releases, brushes with the law, and its social media accounts. Or you can follow its life on the blockchain, where it issues digital stablecoins. This post focuses on the latter. In particular, I'm going to analyze the blockchain for redemptions: those on-chain transactions in which Tether units move from Tether customers back to Tether itself.

I'm going to assume some basic knowledge of Tether and blockchain analysis.

To understand how Tether works on-chain, the most important wallets to track are Tether's two treasury wallets. Tether's Tron-based treasury wallet is located here, and the Ethereum-based wallet is here. (Tether also issues tokens onto other blockchains, but the amounts are relatively small, so for simplicity's sake I'm going to focus on Ethereum and Tron-based Tether activity.)

All Tether units begin and end their life in Tether's treasury wallets.

They begin life when Tether creates, or mints, new units. As long as they remain in Tether's two treasury wallets, these new units are not yet officially in circulation. Tether tokens only enter circulation when Tether issues them—or transfers them—from its treasury wallet to a customer.

Tether mints new units only rarely, and when it does, in large sizes.

In the 350 days from July 1, 2021 to June 15, 2022, Tether minted 24 times on Tron and 9 times on Ethereum. That's around one minting every ten days.

Tether almost always mints in $1 billion increments. This $1 billion balance gets slowly drawn down as customers submit requests to Tether for small batches of Tether units, often in the $10 million to $100 million range. Effectively, this means that Tether's two treasury wallet usually hold a large multi-million working inventory of non-circulating Tether units.

These balances of freshly-minted non-circulating Tether are regularly augmented by inflows of redeemed Tether units. Redemptions occur when customers transfer their unwanted Tether tokens to Tether's treasury wallet to be redeemed for a wire transfer of regular dollars. Each redemption reduces the quantity of Tether in circulation while increasing the quantity of non-circulating Tether units sitting in Tether's treasury wallets.

In the 350 days from July 1, 2021 to June 15, 2022, I count 432 redemptions (177 Tron, 255 Ethereum). That's an average of over one redemption per day.

Tether doesn't destroy, or burn, each incoming Tether redemption. It waits for a number of redemptions to accumulate in its treasury wallet and then burns them all in one big batch.

In the 350 days from July 2021 to June 15, 2022, I count just 12 burns (11 Tron, 1 Ethereum). The amounts burnt are large, often over 1 billion.

So to summarize, the inventory of Tether tokens held in Tether's treasury wallets is determined by the number of incoming Tether tokens (from occasional mintings and frequent redemptions), and outgoing Tether (from occasional burns and frequent issuance).

I've charted out what this treasury working balance looks like going back to late 2021. Note that the chart combines both Tether's Tron and Ethereum treasury balances.

You can see that in 2021 and early 2022 Tether typically let its treasury wallet balances rise to $2-4 billion before burning them. In May and June 2022 it altered this practice by allowing them to balloon to over $10 billion. (Tether recently burnt 11.1 billion Tether units, bringing its working balance back to more normal levels.)

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Having worked out how treasury wallets function, I want to focus a bit more on the redemptions themselves. Of the 432 redemptions that I counted from July 2021 to June 15, 2022, a total of 133, or 31%, come from wallets tagged as being owned by Bitfinex, a cryptocurrency exchange owned by Tether's parent. (26 Tron, 107 Ethereum).

Bitfinex maintains two Ethereum addresses that hold Tether tokens (Bitfinex 2 and Bitfinex 3) and one Tron address.

Why do such a large proportion of transfers sent to Tether's treasury wallet originate from Bitfinex? 

What I believe is happening is that rather than sending redemptions directly to Tether's two treasury wallets, large traders often send them to Bitfinex instead. Once the Tether tokens arrive in Bitfinex's wallet, Bitfinex makes the trader whole by wiring them actual U.S. dollars. So from the trader's perspective, the redemption process is complete. They have cashed out their Tether units.

From Bitfinex's perspective, however, the redemption process is not done. 

Rather than sending traders' redeemed Tether tokens immediately to Tether for cancellation, Bitfinex generally holds them for a period of time. I suspect that Bitfinex delays these transfers so that it can meet incoming requests from traders for new Tether issuance out of its own inventory. A delay also allows Bitfinex to accumulate additional redeemed Tether tokens so that it can send the balance in one convenient end-of-period batch to Tether's treasury rather than multiple small transfers.
 
We have evidence that redemptions are happening via the intermediation of Bitfinex. In a 2021 article. Alameda Research—a crypto trading firms—points to a set of Tether redemptions that it claims to have completed. They were all processed through Bitfinex rather than Tether. (ht @ Matt Ranger)

To get a feel for how Bitfinex manages its Tether balances, I've charted out the quantity of Tether balances held in Bitfinex's #2 wallet below. The chart covers May 1 to June 15, 2022. 

Admittedly, this was an unusual period of time for Tether due to record-high redemptions. (At one point in May it had built a balance of over 1.7 billion Tether units!) In any case, you can see how Bitfinex steadily accumulates Tether tokens as traders redeem Tether units. In the chart, each dot is a transfer into Bitfinex's #2 wallet. Once Bitfinex deems that balance to be large enough, it sends it all back to Tether's Ethereum treasury wallet for cancellation. The large collapses in the chart are when these transfers occur.

If you are interested in investigating Bitfinex's involvement in the redemption process closer, I've noticed that Bitfinex's #2 and #3 Ethereum wallets work together to manage Bitfinex's inventory of Ethereum-based Tether tokens.

The #3 wallets interfaces with the public. When the public wants to withdraw Tether units, Bitfinex sources the Tether units from its #3 wallet. Conversely, when the public makes deposits of Tether units they flow into Bitfinex's #3 wallet. When the balance of the #3 wallet rises above 105 million units, Bitfinex waterfalls all amounts in excess of $105 million into its #2 wallet. The inventory in the #2 wallet builds until it is deemed large enough by Bitfinex to be sent to Tether's treasury. (It's not always that cut and dried. I've seen Bitfinex transfer Tether units out of its #3 wallet to Tether's treasury wallet, thus bypassing the #3 wallet.)

Note that while Bitfinex manages its Ethereum-based Tether units using two wallets, it only uses one for Tron, which makes Tron-based analysis of Tether much more simple.

So let's sum up the on-chain Tether redemption process. There appear to be two routes by which Tether units can be redeemed. Some redemptions get sent directly to one of the Tether treasury wallets. Others get sent to Bitfinex. After a period of accumulating redeemed Tether units, Bitfinex eventually transmits the entire batch to Tether's treasury wallets for cancellation. At this point they fall out of circulation. After a period of time passes the quantity of Tether units sitting in treasury reaches a high enough trigger point that Tether burns it all, leaving its treasury wallets close to empty.

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To finish off, I want to provide a quick look at who is doing the redeeming, and why.

From May 12 to June 30, Tether has contracted by almost 17 billion units, or 20%, which means that a massive amount of redemptions have occurred. A single Tron wallet has been responsible for 3.3 billion worth of redemptions alone. We'll call it the 6DNE wallet after the last four digits in its address.

We can surmise why these redemptions have been occurring by looking more closely at 6DNE's transactions. 

Created on May 12, 2022, the 6DNE wallet has made 3.3 billion worth of transfers to Bitfinex in 108 separate deposits (as of June 30). The average deposit size is 30.5 million Tether units. Most of the Tether units that 6DNE acquires are sourced from wallets associated with three major exchanges: Kraken, Binance, and FTX. (It also acquires Tether units from these two wallets, which I suspect are Binance-satellite exchanges.)

Through much of May and June 2022, the U.S. dollar price of Tether units has regularly fallen below $0.999 on major exchanges like FTX and Kraken. Put differently, one Tether unit is worth a little bit less than an actual U.S. dollar. Prior to May 2022, Tether had clung quite closely to $1.00. To illustrate, I've included a chart of the trading price of Tether units in terms of U.S. dollars on FTX:

Tether's fall in price occurred because large amounts of Tether units were being desperately sold on markets like FTX as the crypto-economy deflated. Tether sets a redemption minimum of $100,000, which means that most Tether owners can't directly redeem unwanted Tether units via Tether's treasury wallets. That leaves them with no choice but to sell on exchanges.

This is where arbitrageurs like 6DNE step in. The owner of 6DNE appears to be buying Tether units in large multi-million batches on exchanges like Binance and FTX at prices of $0.9985 or so, and sending them to Bitfinex to be redeemed at $0.999. By harvesting the tiny $0.0005 difference between the purchase and sale price, the owner of 6DNE earns a near risk-free profit.

Arbitrage conducted by traders like 6DNE helps to prevent Tether's price from falling much below $0.9982 or $0.9981 on exchanges like FTX and Binance. This process doesn't work perfectly, though. On May 12 the price of Tether collapsed to 95¢ on major exchanges, as the chart above shows.

Note that I said that the trader is redeeming at $0.999, and not $1. This is because Bitfinex and Tether both charge a 0.1% wire fee. This fee reduces Tether's effective redemption price from $1 to $0.999.

Let's work out an actual trade. If the owner of the 6DNE wallet purchases 30 million Tether units on FTX at $0.9985 and sends them to Bitfinex to be redeemed at $0.999, the trader earns a profit of $15,000 ($0.0005 x 30 million). The owner of 6DNE may have to pay fees to FTX, which will eat into the bottom line. However, if the trader was making liquidity rather than taking it, fees may be zero to negligible. 

6DNE completed 3.3 billion in redemptions, which assuming a profit of $0.0005 per Tether unit translates into around $1.5 million in gains. Not bad for a two month's work.

After 6DNE's Tether units arrive at Bitfinex, Bitfinex holds them for a while and ultimately sends them to Tether's treasury wallet. At this point 6DNE's formerly-owned Tether units are officially out of circulation. And then after a few days or weeks, Tether burns them. They have ceased to exist.

And that, in short, is how and why Tether tokens flow from the market back to their issuer.

Update (June 15, 2023): Since I wrote this blog post, Bitfinex has almost entirely stopped using the Bitfinex 3 Ethereum wallet. In its place, it is using this wallet as its hot wallet.

Also, Bitfinex has added an extra Tron wallet to its redemption & withdrawal process:

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Monday, June 6, 2022

Thoughts on Tether's $10.5 billion contraction

As the world's largest stablecoin, Tether has attracted its share of critics. There are several strains of Tether criticism.

Under one strain, Tether is a black box used to manipulate the price of bitcoin higher. I've never subscribed to this critique. It seems far-fetched to me, much like the theories about gold price suppression.

Other critics see Tether as a fraud, say like Madoff or Enron. They stress many of Tether's documented past transgressions. They could be right. But I hope they're not, since that would inevitably mean a lot of people getting hurt.

For my part, I'm not a skilled enough financial bloodhound to be able to sniff out fraud. I've generally started from the assumption that the public information that Tether has disclosed, most importantly its attestation reports, is accurate. A stablecoin attestation report is an examination of a stablecoins reserves, or assets, by an external auditor.

Having generally based my analysis of Tether on its assets, that analysis has always suggested that Tether (in its current incarnation) is doomed, at least in the long term. I suppose that this gets me to a similar ending-point as the Tether-as-fraud critics, albeit via a different route.

The stablecoin competitive dynamic is best characterized as a jog to the top (rather than a race to the bottom). Over a long enough period of time, the safest and most transparent issuers will be the winners. Let me explain why.

Because stablecoins don’t pay interest to customers, customers aren’t compensated for bearing the risk of the issuer’s underlying investments. This incentivizes users to migrate towards the stablecoins with the safest investments and most transparency, the good money eventually displacing the not-so-good.

Of the big three stablecoins (Tether, USD Coin, and Binance USD), Tether has always had the riskiest investment profile. As of Tether's last attestation report, for instance, 14.4% of its assets were comprised of an opaque collection of secured loans, other investments, and corporate bonds & funds (see list below). Meanwhile, Tether's competitors USD Coin and Binance USD are currently 100% invested in Treasury bills, cash, and money market funds.

List of Tether's assets from its March 2022 attestation report [pdf]


In addition to a difference in asset quality, I'd argue that USD Coin and Binance USD have better legal protections for users in the event of failure. Binance USD in particular operates under the New York stablecoin regulatory framework, which obliges Binance USD's issuer, Paxos, to operate as a trust. Trusts are effective mechanisms for ring-fencing customer funds from an issuer's other creditors.

Given Tether's outsized allocation to risky assets and fewer protections in the case of insolvency, Tether was always destined to be a victim of a jog to the top. That is, as the riskiest stablecoin it was fated to drip-drip market share to USD Coin and Binance USD until it shrunk into irrelevancy. And that's what has been happening. In the chart below, Tether's dominance has been steadily declining.



(For more on the jog to the top dynamic, I've written about it here, here, and here.)

On May 12, that slow drip turned into a rush, as the chart below shows. For the prior two years Tether had been growing, albeit at a slower rate than its competitors USD Coin and Binance USD. But over the ensuing two weeks, around 10.5 billion Tethers were quickly redeemed, a reduction of 12.6%. Meanwhile, USD Coin and Binance USD grew by around 5 billion units.

I'd argue that Tether's May contraction wasn't the product of the slow grinding attrition of a jog to the top. It was something more serious: an old-fashioned bank run. 

What might have brought the run on?

Once again, I blame Tether's weakest-link investments: the 14.4% of Tether's assets allocated to secured loans, other investments, and corporate bonds & funds.

What is the makeup of Tether's other investments? We don't know. Tether has never bothered disclosing these details. We also don't know what sort of collateral Tether has accepted for its secured loans, or the rating of the corporate bonds that it hold, or what kinds of "funds" it owns.

Combine this paucity of information with a big drop in cryptocurrency prices over the previous months, and I suspect that by May 12 financial market participants had begun to fill in the blanks with their own worst-case scenarios. A big enough hit to the value of Tether's other investments, for instance, would have meant that Tether was insolvent: that it didn't have enough assets to meet all redemption requests. (Here are Patrick Mackenzie's efforts, for instance, to run the accounting on Tether's solvency.)

For large Tether owners, there would have been two ways to approach a potential Tether insolvency. One option was to just ignore the problem. As long as everyone else does the same and holds on to their Tethers, then a strange sort of let's-all-pretend equilibrium emerges; Tether's peg holds and no one loses.

The other approach is to redeem now while Tether still has a large but limited supply of Treasuries and can easily meet redemption requests. If everyone else follows this same strategy, a run develops. No one wants to be the last one out, since the only assets remaining to support latecomers' redemption requests would be Tether's questionable assets, the ones potentially wiped-out during the prior crypto price crash. Being the last one out could mean only getting paid 30 or 40 cents per dollar.

The second of these two reactions likely took over on May 12, leading to the 10.5 billion contraction in Tether. Luckily for Tether, the big slide in bitcoin and crypto prices has halted. And with the pessimism surrounding all things crypto having dissipated, the run on Tether seems to have ended, at least for now.

Before another crypto market decline hits, I'm hoping that Tether seizes the opportunity to make a few changes.  

First, Tether should immediately disclose details about the nature and value of its weakest-link assets: its secured loans, other investments, and corporate bonds & funds. By doing so it would reassure the market and break the collective urge to flee Tether come the next big drop in crypto prices. Tether should also begin the process of unwinding and selling-off its weakest-link assets, investing the proceeds in Treasury bills and investment grade commercial paper. Without risky assets, Tether would be relatively immune to big falls in crypto prices, and this in turn would reduce the threat of a run on Tether.

If the value of Tether's weakest-link assets has been impaired, then mere disclosure isn't going reassure anyone. Tether needs to fill the vacuum by raising new funds. That is, it is insolvent and needs to recapitalize itself. If people who hold Tether stablecoins know that there's a load of new cash sitting in Tether coffers, that'll end their urge to get out the next time the crypto market falls.

The good things about these measures is that they won't only put an end to Tether's chances of facing another run. They'd also solve Tether's longer-term problem of being the victim of a jog to the top.

In my worst case scenario, Tether doesn't do any of these things. It doesn't disclose the nature of its weakest-link assets nor does it make any effort to sell them off. Then the crypto market begins another slide. Investors once again rush to make worst-case inferences about Tether's weakest link assets. A run on Tether develops, but much bigger than the run in May.

By then it may be too late for Tether to make any of the changes that would be necessary to stabilize. In a market rout, getting a recapitalization from other crypto firms may be difficult, if not impossible, and there may be no one willing or able to buy Tether's weakest-link investments. Better to fix things now than later.

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