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After the crisis of Terra projects, including its UST token, serious concerns arose regarding other stablecoins, in particular, the leader of this segment, Tether. We will consider the main processes in the crypto market, as well as objectively assess the criticism of the main stablecoin. On this basis, it will be possible to formulate recommendations for traders and investors.
Impact of the UST collapse on stablecoins and DeFi
We have already talked about the collapse of Terra, its causes and consequences in detail in previous articles. Let us dwell briefly only on those aspects that are directly related to assessing the prospects for Tether and the feasibility of investing in stablecoins at this stage. Prior to the Terra crisis, many investors mistook stablecoins as being near-risk-free and could also bring significant returns when investing in DeFi protocols. For example, Anchor Protocol offered UST holders an extremely high 19.5% per annum. But, due to the simultaneous collapse of the LUNA token and the UST stablecoin, investors were forced to reconsider their attitude to the risks associated with investing in stablecoins, especially after the bankruptcy of several leading landing protocols such as Three Arrows Capital, Voyager Digital and Celsius. The main issue became clear: Do any stablecoins have enough reserves to maintain 1:1 parity with the US dollar? In particular, many USDT holders immediately expressed their concerns about Tether’s backing, especially in connection with the 2019 trial, which confirmed only 74% backing of the stablecoin instead of the claimed 100%, according to The Verge. As a result of the panic, some investors began to rapidly withdraw funds from USDT, which led to its short-term deviation from the ratio of 1 USDT = $1.
USDT/USD exchange rate dynamics during the Terra crisis (05/12/22–05/14/22): short-term drop to $0.99. Source – CoinGecko
Despite the stabilization of the USDT rate in the following days, some experts express various criticisms of Tether, and we will consider the main arguments in more detail.
Criticism of Tether: is it justified?
The arguments against USDT sustainability boil down to the following main claims.
01. Tether may repeat the fate of UST and lending protocols.
Some analysts (for example, Pavel Komarovsky from The Bell) draw analogies between the loss of the UST dollar peg and the subsequent bankruptcy of lending channels, on the one hand, and possible problems with maintaining parity for Tether, on the other. However, this analogy is incorrect because Tether is a fiat-backed stablecoin and UST was an algorithmic stablecoin, and the principles for maintaining their exchange rate stability are different. As for lending protocols, they invested client funds in high-risk instruments (including LUNA) and, in the event of negative market events, were unable to fulfill their obligations and maintain solvency. At the same time, Tether adheres to a more conservative strategy and avoids investments in high-risk assets that may adversely affect its liquidity and solvency.
02. “Hole” (low quality) in Tether assets.
The aforementioned Pavel Komarovsky argues that 15% of Tether reserves from the “Other Assets” category can be considered as poor coverage of liabilities, and this “hole” will only increase in the future. But, firstly, not all assets (including cryptocurrency) can be classified as low-quality assets. The example of DAI as a successful algorithmic stablecoin confirms the ability to use excess cryptocurrency reserves to ensure parity with the US dollar. Secondly, Tether reporting (supported by independent monitoring) confirms that the quality and liquidity of assets is systematically increasing, not decreasing. Thus, the volume of reserves in more risky commercial securities will decrease to $3.5 billion by the end of July this year (from last year’s value of $24 billion), reports CryptoPotato.
03. Falling capitalization of Tether in recent months.
This argument has some grounds, since Tether’s capitalization has actually decreased by 20% – to $65.9 billion over the past 3 months, especially in the context of the strengthening position (+7% over the period) of its main competitor – USDC.
Dynamics of market capitalization of USDT and USDC for the last 3 months: converging positions of the main competitors. Source – Trading View
But there is one important point that needs to be emphasized in this context: a drop in stablecoin capitalization does not mean that the risks of its collapse are increasing (for example, UST capitalization grew rapidly for several months before its subsequent collapse to below 10 cents). As long as 100% liquid coverage of liabilities is maintained, the project will be able to operate sustainably despite fluctuations in demand and its capitalization. In addition, it is also wrong to talk about a significant weakening of Tether’s positions due to the general fall of the crypto market: for example, BTC has lost more than 40% of its capitalization over the past 3 months (according to TradingView), and the total share of stablecoins has grown to 15%. A certain amount of pressure from some hedge funds that played down the USDT rate also failed.
Percentage decline in USDT and BTC market capitalization over the last 3 months: bitcoin’s larger decline. Source – Trading View
The historical analogies that we cited in the material “Is the collapse of stablecoins possible?” and which were subsequently confirmed in the case of UST, show the following typical development of such crises. Against the background of general optimism and ignorance of risks, demand for stablecoin and related tokens (such as LUNA) is skyrocketing in an effort to reap disproportionately high profits. After the boom phase, suddenly there is a realization that the existing reserves are not enough – and there is a panic similar to a bank run (bank run), leading to a rapid collapse of the project in a matter of days, which happened with Terra. So if Tether experienced the risks of losing its peg to the US dollar, then they were maximum immediately after the LUNA and UST crisis, i.e. in mid-May.
So is USDT crashing possible?
We believe that the risks of losing parity with the US dollar for Tether, like other major stablecoins, are minimal in the medium term. By main stablecoins, we mean: three fiat-backed tokens: USDT, USDC and BUSD, as well as two algorithmic stablecoins: DAI and MIM.
The fact is that they have confirmed their resilience during the sharp collapse of the crypto market, as well as significantly improved their reserve coverage and increased liquidity in recent weeks. The increased concentration of the stablecoin segment shows that these projects will continue to dominate the crypto market, with independent auditors monitoring the matching of their assets and liabilities. It will be extremely problematic for new stablecoins to oust market leaders, because most investors will not sacrifice stability for questionable profits, as was the case with UST.
For what period of time can such a forecast be made?
The next major stablecoin crisis may occur after the end of a new wave of the cryptocurrency boom and a sharp transition to a correction and subsequent recession. Since the next halving is scheduled for April 2024, and the boom phase can take half a year or a year, it can be assumed that all major stablecoins will successfully maintain a peg to the US dollar for at least the next 2-3 years. Based on how the crypto market will change in the coming years, it will be possible to make a forecast for a longer period.
Can USDC beat Tether in terms of capitalization?
Despite a significant reduction in the gap in market capitalization between USDT and USDC, it cannot be unequivocally stated that USDC will become the new leader in this segment in the near future. In our opinion, everything will depend on the change in the structure of the crypto market. According to MoonPay and Crypto News, Tether is predominantly used in trading and payments between market participants, while USDC dominates DeFi transactions. If USDC successfully capitalizes on institutional loyalty and DeFi projects resume sustained growth in the near future, its market share could continue to grow. Accordingly, an increase in trading volumes on crypto exchanges will strengthen the role and capitalization of Tether. Thus, the competition between these fiat-backed stablecoins may become even more intense, and the final result will depend on the level and structure of the activity of the main stakeholders.
Should you hold funds in stablecoins?
The motivation of stablecoin holders can be different. In particular, they can be useful in trading or for investing in blockchain projects. With the leading cryptocurrencies (BTC, ETH, Ripple, etc.) rapidly falling, increasing the share of stablecoins in the crypto portfolio can also help preserve capital. But the feasibility of long-term placement of funds in stablecoins raises questions. And the main problem is not even the risks of the collapse of a particular stablecoin (since they are minimal for the main stablecoins), but the growth of inflation in the United States and the proportional depreciation of the dollar. The U.S. consumer price index reached a record high of 9.1%, according to Bloomberg. It is also worth noting that the strengthening of the dollar in comparison with other world currencies (the dollar index (or DXY) = 108 – a maximum of 20 years) does not mean an increase in its purchasing power in relation to goods and services from the real sector. Based on these considerations, each investor must independently develop a strategy for using stablecoins in their operations.
The precipitous collapse of UST and the stress test for many other stablecoins has raised serious concerns about the sustainability of the main stablecoin, Tether. However, a detailed analysis of the main arguments against USDT confirms their failure. The reserves and liquidity of Tether assets are increasing, and the security of liabilities is confirmed by state and independent audits. Most importantly, however, is its ability to regain parity with the dollar despite the short-term depreciation in the immediate aftermath of the Terra crisis. Therefore, the most negative realistic scenario for Tether is the loss of leadership in favor of its competitor USDC. However, the realization or non-realization of this scenario will depend on the dynamics of trading and the DeFi segment in the coming months. According to our estimates, all five leading stablecoins – USDT, USDC, BUSD, DAI and MIM – will successfully maintain parity with the US dollar for at least the next 2-3 years. In addition, the concentration of the market share of the leading projects in this area will only increase. And the use of stablecoins directly depends on the market strategy of traders or investors. They can be very useful in the implementation of short- and medium-term strategies. At the same time, high inflation in the US makes significant investments in stablecoins doubtful in the long term.
Sources: TradingView, CoinGecko, Bloomberg, Fool, The Bell, CryptoPotato, MoonPay, Crypto News
Disclaimer. Investing in any financial asset carries the risk of losing capital. Nothing in this text can be considered an investment recommendation or an offer to buy/sell any financial instruments. For all their actions in the stock market, each investor bears full responsibility independently.
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