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This is a really good article that explains how USDT turned into a currency backed by credit, and derives it's value from the BTC ecosystem written by 矿工召北。Original link here. Please note that this is a translation and may include errors during the translation process.
The mainstream view of the market is that stable currencies require compliant, transparent, and sufficient dollar reserves.
Take USDT as an example: Imagine that Tether is a bank. It absorbs the user's USD and records it as a deposit, then gives the user USDT and records it as a liability. This process is a credit downgrade for users, downgrading from "Fed's liabilities" to "Tether's liabilities". In order to make up for the negative impact of credit downgrades, it is necessary to make the reserves behind stablecoins as compliant, transparent and sufficient as possible.
This is the starting point of the stablecoin story, but when it reaches a certain scale, it will encounter two irreconcilable conflicts in the underlying logic:
1. Contradiction of compliance:
The purpose of stablecoins is to be non-compliant, and 100% compliant dollar reserves mean that the regulator is the biggest risk.
If a stablecoin is found to be used for terrorist activities, even though this was definitely not the issuer's original intention, the regulator will freeze the issuer's reserves first before investigating. This will ruin the stablecoin completely.
Example: In 2018, Crypto Capital was determined to be money laundering by regulators, and accounts belonging to Tether and Bitfinex were frozen for $ 800 million. Those accounts have not been recovered so far.
2. Contradiction in stable currency value:
Looking back at the collapse of the gold standard and the Great Depression, there is a common reason: the money lacks adjustability. If a 100% dollar reserve is adopted, the issuer can only passively adjust the amount of money through the dollar market, and since stable currencies are generally used in non-dollar markets, there will always be a lag in this transmission. The serious mismatch between supply and demand will cause the stable currency exchange rate to become unstable.
Note: The lag of the monetary aggregation can be smoothed out by non-arbitrage parties.
Example: In 2017, the bull market USDT premium rose tremendously
Second, the paradigm shift
The Gospel of Matthew says that Jesus fasted forty days and nights, and he was hungry. The devil appeared to test Jesus saying, "If you are the Son of God, order these stones to become food!" Jesus replied: "Man lives not by food alone, but by every word that comes out of God's mouth."
In 2018, the New York Prosecutor ’s Office (NYAG) investigation of Tether and Bitfinex opened a $ 800 million funding hole. Tether said: Stone, you become food, so USDT ’s asset reserve has changed from "100% US dollars" "USD + debt".
Since then, USDT has broken away from the shackles of the gold standard and has become a credit currency.
There are three main points:
1. The US dollar reserve is not important anymore. The issuer's determination and ability to maintain currency stability done through credit, which resolves the compliance issues.
(1) Where does determination come from:
Logic: The essence of USDT is interest-free dollar financing. Maintaining the stability of the USDT currency means that the issuer becomes a sustainable cash cow, and its long-term benefits are expected to be infinite. By contrast, the risks of running a road are great and the benefits are limited.
In Practice: Tether and Bitfinex would prefer tough guys like NYAG rather than good ones.
(2) Where does the ability come from:
Logic: Cash cows are certainly capable of maintaining currency stability.
In Practice: Tether destroyed 500 million (2018), Bitfinex issued LEO to raise 1 billion to make up for the deficit (2019), and effectively promoted the exchange rate return.
2. Debt-based issuance of USDT gave Tether the ethical basis for additional issuance and destruction. Since then, Tether has become a currency reserve. With the tools to actively intervene in the market, the contradiction of currency stability has been resolved.
Logic: Tether can directly print USDT and then just call Bitfinex. Then, Bitfinex only needs to give Tether an IOU. Since Tether and Bitfinex are related parties, USDT / USD is always equal to 1, and there is no exchange friction. Risk-free arbitrage can be carried out while suppressing exchange rate fluctuations.
3. The most valuable thing about a credit currency is the expectation of it's value.
USDT passed the stress test of 10% plunge in 2018 and 2019. The market has formed a stable expectation of "the biggest risk of USDT is that you think it is at risk." Since USDT has no insurance, this event marked a paradigm shift of USDT being backed by USD like the old gold standard system to a new credit currency system.
3. Macroscopic view
In 2014-2017, the lack of USDT alternatives actually made USDT the most important piece of infrastructure for digital currency transactions.
Each digital currency has a liquidity counter with USDT.
If you want to redeem BTC, there are countless ways to do so. However, if you want to redeem the US dollar, it is cumbersome, requires long waits, and high fees. On the other hand, USDT has asymmetric liquidity, and this asymmetry is what made it the cornerstone credit currency:
Scenario 1: The bank's reserve ratio is about 10%, and it is running smoothly.
End Result 1: No bank run, a 10% reserve is enough.
Scenario 2: The so-called 100% reserve of stablecoins is actually placed in the bank, which is limited by the mismatch of bank deposit and loan terms.
End Result 2: There is a bank run and the 100% reserve is not enough.
Scenario 3: Fiat currency is the liability of the central bank, but no one can hold fiat currency to get assets back from the central bank. If you have doubts about fiat currency, the only way to rid yourself of fiat is to go to the market and exchange for other assets.
End Result 3: There is no way a bank run can occur. System can't be broken.
On the surface, the fiat currency's credit is guaranteed by the asset side of the central bank's balance sheet (gold, national debt, etc.), but the collateral is not redeemable, which means such guarantees are meaningless. In fact, the fiat currency ’s credit is guaranteed by the value of all assets that can be purchased in fiat currency under the guarantee of “forfeit”. (See the stub: "What is Fiat Currency").
In the same way, USDT, which is a credit currency, is apparently linked to Tether's balance sheet, but in fact, under asymmetric liquidity, it is linked to the value of all assets that USDT can buy. The strength of this depends on how valuable the USDT ecosystem is.
Simple and crude conclusion: the stronger the USDT's ecosystem, the stronger its credit. The reverse deduction is also true: the strength of the USDT ecosystem is itself a reflection of the market's credit. So what is the ecosystem of USDT:
Fourth, the holy grail
Credit derivation is the cornerstone of the modern business society, and currencies such as precious metals and bitcoin cannot be derived on their own. The reason is that there is no “issuer” in this currency, and the derived credit cannot find its origins.
Taking silver as an example, silver under the silver standard is recognized as valuable by consensus, but the credit derivation of silver can only be done by issuing bank notes at the bank.
All users accept USDT as a store of value and circulate it around, not because USDT can be redeemed from Tether for US dollars, but because USDT is based on the credit of the entire digital currency world. In other words, the credit issued by USDT outside the currency circle comes from BTC. The reason why USDT wears the US dollar as it's skin and BTC as it's soul is because it is more orderly in the world outside crypto than that of crypto.
Maybe in the future, the relationship will reverse, BTCT will be issued, and it will open the door to the credit derivation of Bitcoin.