Today we introduce a new contributor to welcome to Oliver Lucas, freelance crypto and finance blogger.

Oliver's piece today looks at the risks involved when investing in stablecoins, focusing on issues with Tether's reserves.

Oliver's contact detail are at the end of the article.

If there is anything we have learnt from the current economic climate it is the importance of a diversified portfolio. However, the traditional 60/40 split of stocks and bonds has fallen out of favour leaving investors to search for alternative diversifying assets. One such asset is stablecoins, which due to a perception of little to no risk, combined with the promise of market beating yields have caught the interest of many retail investors. However a more in-depth assessment reveals important warning signs that you should consider before investing.

Stablecoins are a cryptocurrency with a value that is matched, or ‘pegged’, to the price of another asset. The majority mirror the price of traditional ‘fiat’ currencies such as the dollar. However, they may just as easily be pegged to the price of commodities like gold or oil. Tether (USDT) is the most popular stablecoin and its market cap of over $67 billion has seen an increase of nearly 400% in the last two years. Stablecoins provide the potential to generate yield through athrough the lending of coins to cyrpto investment platforms which often offer generous interest rates. The combination of stability and attractive yields make it easy to see why stablecoins have become popular during this current period of economic uncertainty.

However, this stability is not guaranteed with previous incidents such as the collapse of Terra Luna serving as warnings to any would be investor. TerraUSD is a stablecoin that, like Tether, was pegged to the dollar. The peg was maintained through a dual token system which employed a computer algorithm to manage the balance of supply and demand. The two tokens involved were Terra and Luna. If the value of Terra rose above one dollar it is because demand for the coin was higher than its supply. When this happened users were incentivised to mint (buy) more Terra and burn (sell) Luna until the stablecoin returned to the value of its peg. On the other hand, if the price of Terra dropped below the peg it was because there was more supply than demand and users were incentivised to burn Terra and mint Luna again returning Terra’s value to the peg.

TerraUSD like Tether was viewed as a ‘risk free’ yield generating investment, a safe option for retail investors to enjoy a passive income on their savings. However, on the 9th of May 2022 Terra broke from its peg, falling from one dollar to a few cents in days and wiping out billions of dollars in value in the process. This ‘risk free’ investment resulted in disaster as retail investors watched their life savings evaporate before their eyes.

If this can happen to a market leader such as Terra Luna what is stopping a similar fate from befalling other popular stablecoins. Stablecoin advocates will claim that Terra Luna’s downfall was due to its reliance on computer algorithms which proved ineffective in maintaining stability, a problem coins such as Tether have avoided by being ‘asset backed’.

Asset backed stablecoins are supported by reserves allowing them to hold their value. Tether claim that their tokens are pegged ‘1 to 1 with a matching fiat currency and are backed 100% by Tether’s reserves’. The implication here being that for each Tether that is minted there is one matching fiat currency held in reserve. As a result Tether may always been withdrawn for the price of one dollar.

Tether claims to be fully collateralised, however if you are hoping to find $67 billion cash on their balance sheet you are in for an unpleasant surprise. The company’s latest audit reveals there is actually only $0.08 cash held in reserve for each existing Tether.

The majority of the reserves are made up of ‘cash equivalents’ a misleading term that refers to assets such as U.S. treasury bills and commercial paper. Both treasury bills and commercial paper are forms of short term loan used to fund projects in the near future. The main difference between the two is that while the former is issued by the U.S. government the latter may be issued by any institution with a good credit rating. Tether loan out their reserves through these ‘cash equivalents’ in return for the payment of interest upon their maturity. The average maturity rate for Tether’s treasury bills is around 60 days while its commercial paper matures in just under a month.

The problem is, unlike cash, the assets Tether refers to as ‘cash equivalents’ cannot be made immediately available to those looking to redeem their tokens. This is a problem shared by the vaguely named ‘other investments’ alongside the secured loans and corporate bonds that make up the remainder of the reserves. If Tether experiences dramatic sell pressure they may not have the available liquidity to pay all those looking to redeem their tokens and the price may crash as a result. This ‘run on the bank’ effect would result in Tether being forced to default on its payments with billions of dollars being lost in a catastrophic collapse of value that would have significant knock on effects on the rest of the crypto industry, not to mention on the lives of those affected.

The chances of this happening are slim, requiring the mass selling of Tether over a short period of time. However they are also not impossible, and as such it is important to be aware of the danger when investing. There is no such thing as a ‘risk free’ investment and it is important to understand that stablecoins are not immune from the dramatic volatility that affects the remainder of the crypto market.

Stablecoins: Not as sturdy as they seem?
Looking to invest in stablecoins? This article reveals important danger signs that you need to consider.

Author info

Oliver Lucas, freelance crypto and finance blogger


T: @Oli_J_Lucas


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