Tether’s Fractional Reserve Dilemma And the Future of the Controversial USDT Stablecoin


Tether has been in the middle of a raging controversy which started with Bitfinex Exchange covering their losses worth $850 million through their Tether reserves. The news of Bitfinex manipulating their financial footprint was followed by Tether accepting that their total USDT supply is not backed by 100% liquidity in US dollar. Tether using fractional reserve brought it a lot of heat from the decentralized world for the stable coin.

However, this was not the first time when Tether's USDT has been at the center of the controversy, the unregulated nature of the crypto token and the lack of transparency has often troubled the stable coin in the past. The fractional reserve is not an alien concept and most of the governments and banking system work on the same policy. Fiat currencies kind of work on a similar basis, where a portion of the circulation supply is backed by certain reserves while the rest is only on the trust. This is the reason banks can always print new money in accordance with the inflation to maintain the circulation supply.

Most of the stable coins are pegged against a real-world entity or backed by some form of fiat, but the main reason for the outrage against Tether is that they have always maintained that every USDT is backed by one US dollar at all times. Thus, the news of fractional reserve came as a shocker to many investor and firms who have accumulated USDT as their liquidity reserve. Some Tether proponents have come in defense of the stable coin citing the same example of modern day banking systems working on the principle of fractional reserves and the need for trust.

However, those proponents must realize that USDT is no bank, and it has always been considered as crypto, plus the lack of transparency and unregulated nature only add to the worries. Cryptocurrencies were invented in the first place to get rid of the very problem we are discussing, i.e do not trust the bank, trust the technology and maths.

There are various stable coins which work on the same principle of fractional reserves, however, most of them have been transparent about this aspect, while Tether hogged the limelight by claiming to be completely backed by 100% USD reserves. The latest revelation makes stable coin and Tether, in particular, a fiat banking system in a nutshell.

Stable Coins Have Often Been The Odd One Out

The nature and functionality of Tether and all other stable coins have often been the reason for the controversy, as these coins follow the same old-age model of banking systems covered through a layer of modern technology, in this case, blockchain. Investors are buying into a fractional reserve system with notes that exist in another fractional reserve system is not lost on its defenders.

Banks are functioning on similar principles but with far lower capital ratios than Tether. However, banks are fully regulated and as a consumer, we do not have any other option than taking bank for their face value.

The current debate is not much on why Tether has fractional reserves, but mostly because both Tether and Bitfinex involved in the ongoing controversy have the same parent company in the form of DigiFinex. In order to cover the losses of Bitfinex, the parent company collateralized the debt with 60,000,000 shares in itself. Which basically means that the exchange took out a loan from itself against their own shares. This is not just unethical but criminal and brings the legitimacy of both Tether and Bitfinex under clouds.

The deal between Tether and Bitfinex is worryingly recursive — the value of DigiFinex declines as Tether risks insolvency, causing the collateral to be worthless. Banking systems put out their loan against collateral which in this case does not exist. This is why the banking systems have been able to withstand the test of time.

Elle Frost a former investment banker at Deutsche Bank-turned cryptocurrency professional explains why the current case of Tether using fractional reserves cannot be seen in the same light as that of traditional banking systems. She explained that using liquid assets such as the securities, government bonds help in generating capital in the form of debt which is the backbone of the current banking systems, and the transparency, as well as the regulations, play a major role in that.

Intercompany loaning like the current Bitfinex-Tether deal is not an uncommon or illegal practice, however, it is not as simple as DigiFinex might have thought, Frost explains,

“a loan connected to a subsidiary would immediately be flagged, have extra vetting and would likely have to go through shareholder approval on the company's end.”

This loan also circumvented the usual risk procedures and “credit process” that banks conduct when signing off on a loan.

“There is incredibly stringent regulation around practices like this (particularly post-2008, when banks so royally screwed up their risk management around derivatives like CDOs [collateralized debt obligations]) and banks have shareholders to be held accountable to. Banks not only release filings, but every single large debt obligation that is loaned out via investment banking goes through multiple regulation procedures.”

She even explained that it is very common for a parent company to rescue its subsidiaries, however, the current fiasco of Bitfinex-Tether cannot be deemed under the traditional banking loaning category as it does not have any risk-management which is the basic need for the functioning of such operations.

Frost concluded her explanation by saying,

“in no way think that traditional banking is perfect, but I think that it is important that these stable coin companies are upfront with their risks and do not try to compare themselves to these ‘safe’ institutional players”

Conclusion

The Bitfinex-Tether Fiasco has ripped opened a very important aspect of the stable coin, and how they are mimicking the traditional banking systems without the necessary advantages of it. The current fiasco also emphasizes on the need for regulations and more transparency in the consensus of crypto tokens operating under the blanket of secrecy and privacy.

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