The LUNA/UST Debacle — My Thoughts.
It has taken me a while to put my thoughts together about the crash of LUNA and UST; I have been personally grieving the avoidable loss caused by the entire debacle. I wasn’t a big fan of the LUNA and UST stablecoin/stabilizing asset mechanism; I thought it was flawed and would eventually have death spiraled. Before the enormous losses from the LUNA crash, I had written about my thoughts on LUNA and algorithmic stablecoins here.
While I did not like the algorithmic stablecoin, I lost some money in the LUNA crash as I invested in Prism, a terra-based project that refracts digital assets into yield-bearing and principal tokens. Nevertheless, I still think it is a brilliant idea and would still like to see it implemented on the LUNA 2.0 layer-one (L1) or another suitable L1.
Thus to anyone reading this who might have lost some money to the LUNA crash, I encourage you not to harm yourself, get closer to family and maybe take some time off the market to clear your head. Remember, you can replace money and earthly possessions, but you can’t replace life and time with family and loved ones. Be strong!
I also invite everyone to read the prognosis report by Nansen about the LUNA/UST crash to understand the intricacies leading up to the crash and other aspects of the events. You can see the report here. With the fall of LUNA/UST and the extent of the financial damages market participants suffered, I am compelled to publish information about what I think might be the next damaging project. I believe that Tether(USDT) is a stablecoin that will eventually lead to heavy financial losses. I hope to give enough market participants a heads up before their eventual demise. Before we start examining why I think Tether is a fraudulent coy, I would like to explore how much the markets are propped up by USDT vs. other stablecoins and currencies.
USDT — the stablecoin propping up the crypto market.
USDT is, without doubt, the stablecoin with the most profound reach across several layer-one networks and centralized exchanges. Tether's market cap rose to $83bn but sharply fell by about $11bn to $72bn. According to coinmarketcap, USDT has had 24-hour trading volumes between $30bn and $220bn on centralized and decentralized exchanges over the past year. USDT has a colossal effect on trading patterns in the market.
Tether has also consistently maintained more than 30% - 50% of the total supply of stablecoins, making it the leading stablecoin available.
Also, examining on-chain volumes of stablecoins, we can see USDT leading the pack with the highest volumes across varying layer-ones. For April and May 2022, we can see USDT constituting more than 50% of on-chain volumes.
We can also see USDT leading the pack of fiat-backed stablecoins.
We can also observe a trend if we conduct further research and examine the fund flow across the most significant cryptocurrencies. For example, using coinlib, we can observe the following:
In the 24 hours leading to the 28th of May, 2022, USDT made up more than $1.89bn compared to $200m US Dollars on bitcoin volumes.
We can also see that in the same period, on ethereum volumes, USDT makes up more than 50% of the money flow.
Considering how much USDT is intertwined with the well-being of the crypto markets, it becomes imperative to consider the consequences if USDT is indeed a fraudulent coy waiting to blow up. Let's examine why I think USDT is sketchy:
My Suspicions and Observations
USDT, like USDC, BUSD is a fiat-backed stablecoin. Before I begin outlining my thoughts on why I feel USDT is fraudulent, it is vital to understand the mechanism behind the issuance of fiat-backed stablecoins. Fiat-backed stablecoins are stablecoins that are backed 1:1 by the currency they represent. Thus, before one unit of a fiat-backed stablecoin can be created, the issuer must receive one unit of the base currency. Let’s illustrate this creation process pictorially:
In a reverse manner, stablecoins can be destroyed when a user returns stablecoins to the issuer and receives the monetary equivalent of stablecoins sent. Let's represent this destruction process pictorially:
The process of creating and destroying stablecoins is called a mint-burn process. Therefore, it is essential to understand the mechanism through which fiat-backed stablecoins are created to understand why USDT is most likely a fraud. Let’s examine the possible ways USDT is a potential fraud:
First Argument - Inorganic Mint and Burn Process
Considering the mint process of fiat-backed stablecoins, especially USDT, we can expect that USD was received by Tether before each existing unit of USDT was minted and sent into circulation. First, however, let us closely examine the USDT mint and burn process. I encourage you to conduct this research by yourself to confirm the integrity of what I am about to present. I will leave simple queries you can use to find the information provided.
For brevity, I will only be showing flaws in USDT by comparing the mint-burn process of USDC versus USDT. In your spare time, I urge you to examine the mint and burn process of quality stablecoins like GUSD and BUSD by tweaking the query parameters slightly.
Tether USDT Minting
Circle USDC Minting
Examining the amounts minted per time by USDC and USDT, we can see that tether consistently mints chunks of 1bn USDT, while Circle — the issuers of USDC mints an amount far smaller. Thinking about the mint illustrated above, this will mean that a user consistently sends tether chunks of $1bn and sometimes even more than $1bn per time. This is highly improbable. There are very few institutions globally that have this type of cash handy, and I highly doubt they will be sending it to Tether instead of just using their Dollars to buy digital assets directly.
If we also examine the burn process of USDT vs. USDC, we can also notice certain discrepancies:
Circle USDC Burns
Tether USDT Burns
It is easy to notice how inorganic the mint-burn mechanism of USDT is compared to USDC. We can also see that even though the tether treasury receives USDT tokens from various sources that reduce the circulating supply of USDT, they do not conduct USDT burns.
This is reflected in billions of USDT in the tether treasury on several layer one networks. Meanwhile, those tokens have been redeemed and should have supposedly been burnt. Examine the tether treasury addresses for yourself:
Tether Tron treasury address - https://tronscan.org/#/address/TKHuVq1oKVruCGLvqVexFs6dawKv6fQgFs
Tether ethereum treasury address - https://etherscan.io/address/5754284f345afc66a98fbb0a0afe71e0f007b949
Currently, there’s $6bn sitting between these two treasury addresses that should have been burnt. Often, these tokens are sent back to different exchanges and used to buy digital assets even though they have already been redeemed and should have been burnt.
If we also examine the current market cap of Tether, at $71bn, it will mean that Tether has more cash at hand than General Electricity. I also find this highly improbable.
If Tether does not mint and burn USDT tokens appropriately, we can then agree that Tether is creating counterfeit dollars, a federal crime in the United States of America.
Second Argument - Tether Reserve Analysis
Examining Tethers reserves, I worry about the truthfulness stated in these reserves. In the first instance, Tether has historically claimed to hold up to 40% of its reserves as commercial paper; however, brokers in the commercial paper market have not seen the footprints of transactions conducted by Tether. Listen to Jim Cramer affirm this here.
Tether, in recent attestations, has started claiming that a certain amount of its reserves is denominated in tokens and other digital assets. This is very problematic as it introduces a Ponzi element to the crypto ecosystem. USDT should be backed by USD and not crypto assets already majorly priced in USDT.
We should also consider the nature of auditors tether has opted for over the years. I find it incredibly sketchy that tether cannot enlist the service of one of the big fours - Deloitte, Ernst & Young (EY), PricewaterhouseCoopers (PwC), and Klynveld Peat Marwick Goerdeler (KPMG). If these four auditors are beyond reach, I struggle to understand why Tether opts for auditors outside of the United States especially considering that their most significant product is USDT, a stablecoin pegged to the US dollar. Severally, tethers executives have claimed they are too large to be audited by these reputable auditors. However, Fidelity SPAXX, with a similar operating mechanism to fiat-backed stablecoins, has more than $250bn in assets under management and consistently publishes audits.
MHA Cayman, Tether's chosen auditor, is a cayman based auditing firm currently under investigation by financial authorities in the United Kingdom.
The nature of the reserves provided by tether and the auditor carrying out the audits for tether are screaming red flags for me.
Third Argument - Regulator Comments, Legal Rulings, and Historical Precedents
Tether has consistently been a subject of regulatory scrutiny. For example, in a 2019 court case between bitfinex, tether, and the New York Supreme court, Bitfinex consistently commingled customer funds. Eventually, these funds were seized by the United States government. In addition, in court filings and the New York Supreme court ruling, bitfinex executives stated that bitcoin might fall below $1k if crypto capital did not provide funds for the iFinex management to shuffle between Tether and bitfinex.
Source: 2019_Legal_Case-00f8979c-2959-49b5-9495-de51496293e3.pdf
In 2021, the Commodities Futures Trading Commission(CFTC) ordered Tether to pay a fine totaling $42.5 million. The fine is minuscule and might give a false impression of a settlement. However, examining the accompanying statement issued by the CFTC chairman, Commissioner Dawn D. Stump, we can see that the fine is not the end of the matter. Consider the following statement by the CFTC chairman:
“However, because this is the first time the CFTC has applied the CEA’s broad definition of “commodity” to a stablecoin, I wish to reiterate my concern that enforcement actions such as this involving digital assets may cause confusion about the CFTC’s role in this area. While the definition of a “commodity” is relied upon in applying the anti-fraud provisions in CEA Section 6(c), we should seek to ensure the public understands that we do not regulate stablecoins and we do not have daily insight into the businesses of those who issue such. But in pursuing and settling this matter, do we provide users of stablecoins with a false sense of comfort that we are overseeing those who issue and sell these coins such that they are protected from wrongdoing?”
You can examine the CFTC Commisioners' statement here.
Finally, over the years, the crypto industry has tried unsuccessfully to push for a Bitcoin Spot exchange-traded fund (ETF). Several key stakeholders within the sector have attacked Gary Gensler and the Securities and Exchange Commission. However, I think crypto stakeholders intentionally or unintentionally fail to review the notes issued by the SEC upon rejection of these spot bitcoin ETFs. Let's examine two of these rejection notes:
VanEck Bitcoin Trust rejection - The reasons provided by the SEC for the rejection of this ETF included the following:
You can view the complete rejection note here
The OneRiver Spot ETF rejection: The OneRiver spot ETF is the latest rejection by the SEC; let us examine the rejection note for possible causes of the rejection:
You can view the complete rejection note here.
Thus, it is fair to assume that if the SEC rejects all bitcoin spot ETF applications in the USA, we should consider how badly they view tether and other participants to reject these ETFs continuously.
Famous Myths and My Rebuttals
In presenting my findings to other people, I have encountered some counter-arguments. I do not want to let these persist, and I will be outlining these arguments and why I think they are severely flawed.
First Argument - “If USDT is minting unbacked tokens, why is the peg still intact?”
I come across this argument a lot, and it is essential to note that the crucial thing in maintaining stablecoin pegs is a really efficient market maker. If the market makers come under severe strain, as occurred during the UST depeg event, the peg can break, leaving USDT holders with financial losses.
Second Argument - “There have been multiple settlements between the US government and Tether? Does this not mean that all is well?”
This argument misses the fact that stablecoins are a nascent industry, and in my opinion, regulators are merely struggling to identify how to regulate stablecoins without harming market participants. I, however, do not see how market participants will not incur some losses except if the government or another financial player steps in to provide the funds that should be backing USDT. However, I always wonder what incentive any entity will have to bail out an off-shore, hazy financial company like Tether?
Third Argument - “But if regulation or a depeg event occurs, market participants will just buy bitcoin, and BTC price will go up.”
Albeit naive, this argument persists because several market participants do not truly understand how the markets operate. Consider the following image:
During the UST depeg event, the BTCUST price spiked as high as 140,000 UST; however, this did not raise the BTCUSD price to similar heights. If there is a depeg event or a demise of USDT, asset prices will have to be repriced in real dollar terms, and this will be a valuation model far different from when prices were denominated in USDT. Even if holders of USDT immediately flee to BTC and other crypto assets, those assets will be undergoing price re-evaluation in real US dollar terms by other market participants.
What will be affected?
In the case of demise or depeg of USDT, I can imagine all assets denominated in USDT being automatically repriced. I also expect centralized exchanges, yield farms, and other decentralized finance applications holding large quantities of USDT to suffer liquidity crises and possible bankruptcy. Futures markets denominated in USDT will also suffer losses, and I expect market participants will put some strain on other stablecoins as there is a rush towards the exits.
Final Words
I am very hopeful about the crypto markets, but I believe there needs to be complete regulation of fiat on-ramps for the safety of participants in the crypto markets. I have also been circulating a warning about USDT in my private circles for a while now. However, considering financial losses from the LUNA/UST fallout, I think more people need to be aware of the impending risks and crisis. I encourage crypto market participants to hold fiat-backed stablecoins from reputable issuers. In my opinion, these are:
Paxos Standard Stablecoins - These are stablecoins issued and managed by Paxos. They include Binance USD (BUSD), Pax Dollar(USDP), and Pax Gold (PAXG).
USDC - USDC is issued by Circle, an American-based company headed by Jeremy Allaire.
GUSD - Gemini issues GUSD. They have stringent anti-money laundering mechanisms and are the only fiat-backed stablecoin issuer that conducts routine audits with a US-based auditor.
While I do not think USDT will depeg from any other event except regulation, it is essential to understand the existential risks inherent in the crypto market as you invest. I am also happy to be wrong if Tether, by some miracle has the equivalent backing for USDT. I sincerely want progress in the digital asset space and want all stumbling blocks removed as soon as possible.
On a final note, I urge you to protect yourself; it is foolish to believe anything is too big to fail in the digital asset market, especially after the LUNA/UST crash. Also, do not be naive to minimize how you think the demise of tether(USDT) can affect the cryptomarkets. Act accordingly.