Stablecoin Boom / Stabledollar Bust?

Investment Note #20 - 25th October 2024

Stablecoin Boom / Stabledollar Bust

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Synopsis

• Think Apple, Microsoft and Google are revenue machines? Think again. While Apple has pulled in $2.4 million per employee, Meta $2m and Google hit $1.7 million in 2024 thus far, one company stands head and shoulders above the rest: Tether. (Source: Bloomberg).

• The stablecoin giant generated a staggering $62 million in revenue per employee for the first half of 2024, translating into a net profit of $5.2 billion, cementing its position as a major player in the global financial ecosystem, where as much as $190 billion flows through its network every day (Source: Wall Street Journal).

• So, what is Tether? In this investment note, we will explore what stablecoins are and their impact on financial markets worldwide.

What Are Stablecoins?

• Stablecoins are a type of cryptocurrency designed to maintain a constant value, typically pegged to a real-world asset like the U.S. dollar. Unlike more volatile cryptocurrencies such as Bitcoin, stablecoins aim to avoid large price fluctuations, making them more reliable for everyday transactions.

• Here’s how it works: when someone buys a stablecoin, they exchange their real money, like U.S. dollars, for the cryptocurrency. Tether, one of many stablecoin companies, claims that for every stablecoin issued, they hold an equivalent amount of dollars or other dollar assets in reserve. This reserve is what gives the stablecoin its value and maintains a one-to-one peg with the US dollar. If you sell your token, the company gives you that dollar back – no volatility, no surprises.

• Holders often buy stablecoins like Tether because they offer a way to store value in the cryptocurrency world without being exposed to the price swings of more volatile crypto assets. Acting like digital dollars, they let traders move in and out of cryptocurrencies quickly and safely, without worrying about sudden price changes.

Gold Standard

• While Tether claims that every token is fully backed by reserves, transparency regarding the composition of those reserves has been a point of contention. Tether has faced fines in the past related to its reserve disclosures. Unlike traditional financial institutions, stablecoin issuers are not subject to regular, comprehensive audits by independent third parties. Instead, they typically provide quarterly attestations prepared by accounting firms, which only offer a snapshot of reserves at a specific point in time.

• Before 1971, the U.S. dollar was directly tied to gold through the Bretton Woods Agreement. Under this system, the U.S. government guaranteed that a fixed amount of gold could be exchanged for dollars, pegging the dollar's value at $35 per ounce of gold. This ensured a relatively stable value for international transactions.

• The stability of the U.S. dollar under the gold standard relied on trust that the U.S. had enough gold to redeem all dollars in circulation. However, the system strained over time as the supply of dollars outgrew US gold reserves. Similarly, the value of stablecoins hinges on the belief that they will always be redeemable for their underlying fiat currency value (i.e. one US dollar).

• While the gold standard was a global monetary system governed by state actors, stablecoins represent a digital evolution of this concept, managed by private entities, often operating in decentralised ecosystems.

The Unexpected Whale of U.S. Debt

• Reserves used by stablecoin issuers to maintain a 1:1 peg with fiat currencies are not just piles of cash sitting idly; they are a blend of liquid assets, including cash, term deposits and most predominately, US Treasury bills.

• Tether pays 0% on their stablecoin balances but earns approximately the upper bound of the Fed Funds rate. This is Tether’s net interest margin (NIM). As you can imagine, Tether is overjoyed that the Fed started raising rates in 2022, as their NIM went from 0% to close to 6% in under 18 months (March 2022 to September 2023).

• Tether holds $97.6 billion in U.S. Treasury securities (Source: Tether Q2 2024 Attestation Report), making it one of the top 22 largest holders of U.S. debt. While the U.S. government enjoys the extra demand for its debt, too much reliance on these digital giants could pose a risk if unexpected challenges arise. Could a future bond vigilante protesting at the scale of the U.S. deficit and a stablecoin issuer such as Tether be one and the same entity?

Eurodollar in Disguise?

• Beginning in the late 1950s, foreign banks, particularly in Europe, held U.S. dollars outside of the U.S. banking system, allowing international businesses to borrow and trade in dollars without needing to go through U.S. banks. Despite the name, Eurodollars don’t only refer to dollars held in Europe - they refer to any U.S. dollars held in foreign banks around the world. Companies preferred using U.S. dollars over their local currencies because the dollar was more stable and widely accepted internationally. This made it easier to conduct global trade, as the U.S. dollar was seen as a reliable and trusted currency.

• As Timothy G. Massad, former chairman of the Commodity Futures Trading Commission puts it, stablecoins are similar to Eurodollars - both represent dollar-denominated assets that operate outside U.S. borders.

• Eurodollars helped the U.S. dollar maintain its dominance during the Cold War and stablecoins are now reinforcing that same power in the digital age by providing easy access to U.S. dollar value, especially for people in countries with unstable economies.

Does Crypto Have a Use Case?

• While early Bitcoin exchanges, like the well-known 10,000 BTC pizza purchase, showcased its potential, stablecoins have since become the preferred choice for users seeking more practical and stable forms of digital currency.

• In inflation-ridden countries like Argentina, where inflation can exceed 100%, stablecoins like Tether allow people to convert their devaluing local currency into something stable, protecting their savings by pegging them to the U.S. dollar.

• By using stablecoins, people in emerging economies can bypass weak local banks and unreliable currencies, serving as "better money" for these economies. Instead of relying on local institutions or resorting to holding physical cash (which exposes them to devaluation), stablecoins offer a digital alternative to "stuffing cash under the mattress."

Conclusion

• Financial systems are rapidly evolving and stablecoins have emerged as a bridge between the old and the new. These digital assets aim to provide price stability in the highly volatile cryptocurrency market and offer access to digital currency in various regions. As the interaction between traditional finance and digital assets continues to develop, stablecoins are playing a growing role in financial markets, influencing trends and practices that are still unfolding.

• However, as stablecoins become more entrenched in the financial system, their rise draws increasing scrutiny. Executive Order 6102, which prohibited the hoarding of gold in 1933, forced individuals to exchange their gold for U.S. dollars to stabilise the economy during the Great Depression. This historical move reshaped the relationship between people and currency, raising the question of whether stablecoins could face similar regulatory action in the future. As governments look to maintain control in times of crisis, stablecoins may be subject to new rules that redefine their role in global finance.