There is perhaps no other crypto asset more subject to scrutiny and accusations of impropriety than the Tether stablecoin. The startup behind the coin has been blamed for market manipulation while its business dealings and accounting practices have stirred up many concerns. Critics argue that Tether lacks transparency, possibly engages in criminal activity and does not have the financial backing that it claims.

These accusations are somewhat vindicated by the current case by the New York Attorney General (NYAG) against the business and its owner, iFinex, which is also the owner of the Bitfinex cryptocurrency exchange. Potentially adding fuel to this, which Cointelegraph has covered in detail, was the news that Bitfinex has recently repaid $100 million to Tether that the exchange took as a loan. Simultaneously, over the past 18 months, several alternative stablecoins have emerged — and seemingly with far stronger fundamentals. Despite this, Tether remains the dominant stablecoin. So, why does Tether continue to be successful in light of the threat it allegedly presents to the industry?

Problems abound

There is an abundance of stablecoins available on the market. Each one comes with its respective trade-offs and is competing based on several variables. The most important of these are liquidity, volatility, security, trust, transparency, legality, censorship-resistance and privacy. Tether lacks several of these, according to various sources and experts.

Audit history

The main accusation leveled at Tether is that it does not have the United States dollars backing the outstanding number of Tether tokens (USDT) on the market. Detractors believe that the stablecoin is operating on a fractional reserve basis, whereby it only holds a fraction of the dollars that it should in order to back the currency 1:1 with USD. This accusation has been partly vindicated. Tether recently disclosed that, while it still has 100% of the reserves needed, it is not 1:1 collateralized with fiat currency — let alone 1:1 with USD. Problematically, the true extent of Tether’s collateralization can only be unveiled through a physical audit by a reputable third party.

Related: Will PwC’s New Software Solve the Cryptocurrency Auditing Problem?

Tether has had a dogged past with auditors, however. In January 2018, Friedman LLP abruptly ended its audit after initially being hired in response to community concerns. Tether subsequently responded, laying the blame with Friedman for its “excruciatingly detailed procedures.” The company expanded, saying that, due to this complexity, the audit could not be finished in a “reasonable time frame.” These rather opaque explanations did little to alleviate concerns.

Prior to this, Friedman had confirmed that Tether did have the required USD balances, although it did not disclose where these funds were held and explicitly stated that it could not guarantee that it was not being used for other purposes.

Reliance on the banking system

The repeated issues surrounding a satisfactory audit have been further compounded by Tether’s banking relationships. Tether is reliant on the traditional banking system to hold its reserve assets. On account of the 1:1 peg, Tether should be using full-reserve banking, where none of the collateral is lent out. Since the birth of fractional reserve banking, full-reserve banks are now quite rare. As such, Tether has a limited number of banks that can deliver the required services. Added to this problem is that most banks are wary of serving a business that is both in the crypto space and is subject to so much controversy.

The project has had a chequered history with banks. Its relationship with the Puerto Rican-based Noble Bank came to an end in October 2018, and it has since changed partners multiple times. Defenders of the company have claimed that, by disclosing its banking information, it would make the bank subject to intense scrutiny and investigation by regulators, and likely result in the termination of any relationship.

This is indeed a compelling argument, as Tether seems to be involved in a catch-22 situation. By failing to disclose its banking situation, it fuels concerns and conspiracies. Conversely, in being transparent, it runs the high risk of losing its banking support as well as undermining the security and stability of the cryptocurrency.

Transparency

Tether’s reserves and banking relationships, while concerning enough, have been scrutinized far more on account of the business’s overall lack of transparency. It has long been speculated that both Tether and iFinex were one and the same. This was confirmed by the leak of the Paradise Papers in November 2017, which showed that the chief financial officer and the chief security officer of Bitfinex were also senior partners of Tether.

According to Bitfinex’s and Tether’s websites, Tether’s CEO, J.L. van der Velde, its CFO, Giancarlo Devasini and its General Counsel, Stuart Hoegner all currently hold the exact same positions at Bitfinex. While it appears clear that the same top management controls both businesses, it is less clear which company takes precedence in terms of decision-making. The NYAG’s case against iFinex, as well as the inferred profitability of each project, would imply that iFinex is at the top of the hierarchy, in which Tether and Bitfinex are most likely branches of iFinex. The fact that these disclosures were forced — rather than a voluntary decision — raises questions as to why iFinex’s leadership wanted to conceal this dynamic.

Legality

Until recently, all the suspicions and allegations surrounding Tether had little authority. That was until the New York Attorney General unveiled its case against the project, including accusations of commingling funds and abandoning the 1:1 USD to USDT peg.

The NYAG has stated that Bitfinex lost $850 million in funds and covertly attempted to plug the loss with funds from Tether. The judge presiding over the case claimed that Tether essentially undermined the entire validity of the stablecoin by the admission that it no longer maintains its 1:1 peg. The case has forced Tether to admit that the coin has only been backed by 74% of the reserves it should be. Furthermore, it has been revealed that this 74% includes assets other than USD and even includes a small amount of Bitcoin (BTC). By using Bitcoin in its reserves, Tether undermined of its collateralization, given that the coin is intended to be used as a hedge against the volatility of crypto assets.

It does, however, appear that iFinex is trying to amend these problems. Just this week, Bitfinex announced that it had prematurely repaid $100 million of an outstanding loan to Tether. Notwithstanding this recent announcement, the case by the NYAG has legitimized many of the claims critics have had over the past few years. There is no underestimating how important this case is, according to founder of Weiss Ratings Juan Villaverde, who told Cointelegraph:

“It has confirmed every suspicion we’ve had with USDT for some time now. Namely that the stablecoin isn’t backed 100% by USD and other fiat currencies. It also confirmed this money was being lent out to third parties for a profit, and even that part of the funds was used at times to buy crypto assets such as Bitcoin. All of these things already seemed obvious to us, but we had no hard evidence. Now, the NYAG has exposed all of these practices to the public at large.”

Waiting for a punch?

Tether is centralized in almost every part of its system. The company is subject to government action, as are its fiat reserves — so long as they are held in banks. Furthermore, while many assume that the Tether currency itself is decentralized, the company has shown that it can reverse transactions and force hard forks.

Of course, the above criticism is equally applicable to the majority of other stablecoins. However, it does not undermine the validity of the threat to USDT holders. Given the current legal problems the company is facing, compounded by the concerns of solvency and trustworthiness, Tether is a far larger target for law enforcement than its other centralized competitors.

Conversely, decentralized stablecoins — such as DAI and Reserve — are in a position to capitalize on this weakness and offer a much more robust option in the true censorship-resistant spirit of crypto assets. Nevin Freeman from Reserve, in an interview with Cointelegraph, highlighted the current problem:

“Right now, centralized stablecoins like USDT, USDC, TUSD, and so on are handling the need for stability in crypto. Decentralized stablecoins like Dai and Reserve aren’t really needed. But when the centralized coins start getting more restricted or all-out shut-down, decentralized stablecoins will be much more important. Libra is another instance of a centralized asset-backed coin. As long as governments allow it, it will be great. But if they decide to shut it off, they can do that.”

The response from governments to the announcement of the Facebook-promoted Libra stablecoin is a testament to this threat. Libra is not particularly different from Tether. The sheer size and power of Facebook right now appear to be the only factors making it a target. These recent responses highlight that it is only the relatively small size of Tether that is guarding it against a full-on conflict with regulators.

Competitive advantages

In contrast to Tether’s many deficiencies, there are a plethora of stablecoin competitors with multiple advantages.

Transparency

Virtually all competing stablecoins can boast superior transparency to Tether. Projects such as USD Coin (USDC), True USD (TUSD) and Paxos Standard (PAX) have clear records of their management and contact details and in the case of USDC, for instance, are involved with major legacy institutions like Goldman Sachs. Communications are frequent, complaints are responded to and operations are conducted in a highly professional manner.

Proper backing

This transparency crucially extends to the collateralization and backing of the coins. Consider USDC, which conducts frequent audits with a reputable firm, Grant Thornton LLP. Some stablecoins like PAX go a step further and segregate clients’ funds, ensuring a higher level of transparency and security, as Chad Cascarilla, CEO of PAX, told Cointelegraph:

“PAX offers customers a simple guarantee: their dollars are always there and always safe. We’ve made it easy for people to create or redeem PAX almost instantaneously without any fees, maximums or minimums. And we’ve done it as a regulated Trust company. As a custodian and fiduciary, our customers’ assets are their assets alone, held segregated and bankruptcy remote, which is different from all other stablecoins.”

Trustlessness

Given the proven fragility of centralized infrastructure in the crypto ecosystem, as the countless exchange hacks have shown, the centralized framework of Tether provides greater risk. This risk is compounded by its link to Bitfinex. As shown, the exchange is more than happy to compensate its losses with Tether’s reserves. Most of the other stablecoins share much of the same problem, and there are still just a few decentralized stablecoins. However, decentralized stablecoins arguably present the ideal solution for the market, assuming they can scale, as well as provide the requisite liquidity and a high level of user experience. The benefits of such projects are undeniable, as Villaverde of Weiss, told Cointelegraph: “DAI, in particular, offers no counterparty risk as it’s based on algorithms rather than a centralized custodian model.”

Resilience of Tether

Despite the countless issues with Tether and the apparent advantages that its competitors can boast, the business still dominates the stablecoin market. The most recent data from Stablecoins War, a stablecoin data aggregation site, shows that Tether accounts for 97.5% of all stablecoin volume and 81.1% of the entire stablecoin market cap. The only real competitors with any significant volume are TUSD, USDC, and PAX, with only TUSD accounting for over 1% of total volume. This raises the question: Why?

Network effects

Aside from compounding interest, there is perhaps no more powerful force in economics than a network effect. A network effect refers to the growing value of anything that is used by an increasing number of people. All crypto assets are subject to this force, and stablecoins are no exception.

Once a critical mass of users starts using an asset, usage tends to increase in an exponential or nonlinear manner. This is exactly what happened to Tether. Launched in 2014, Tether’s usage did not begin to explode until 2017. The project benefited from the growing bull run and the total lack of competition, becoming the single benefactor of all traders who wanted price stability.

Virtually all of Tether’s competitors emerged in 2018, by which point Tether had already sunken its teeth into the market. It is likely that, at this point, it will take something of immense force to unseat Tether’s dominance, such as a seizure of funds by an aggressive government agency or a serious breach of Tether’s OmniLayer.

Overall, the growing network effect has resulted in improving liquidity and reduced volatility, in turn making it more desirable for traders. The effect then becomes self-perpetuating, whereby the results fuels the original effect. This is the principal reason why, despite its numerous failings, Tether continues to dominate the market.

Blockchain agnosticism

The company is augmenting its existing momentum by utilizing other blockchains aside from Bitcoin. Until recently, almost all of Tether operated on top of the Bitcoin blockchain via the Omni Layer. Aware of the congestion a serious bull run could place on Bitcoin, as happened in December 2017, the project is introducing support for EOS, Tron and the Lightning Network.

By transitioning toward blockchain agnosticism, Tether can cement its superiority and prevent Bitcoin congestion from hindering its success. Such a response is likely due to the increased pressure its competitors are applying. While the project might not be prepared to offer the level of transparency some might like, it hopes that this increased interoperability will compensate.

Impact on liquidity and volatility

Tether’s lead and network effect have allowed it to gain immense liquidity. Larger traders and institutions depend on high liquidity to move in and out of positions without experiencing slippage. As such, Tether is still the most attractive stablecoin for larger players, who do not require regulatory compliance or who are not worried about Tether’s other issues. The first mover advantage has proven invaluable, as Villaverde told Cointelegraph:

“The reason this asset has been so successful is none other than the fact it was the first. It’s inferior to its competitors in every other way, yet it maintains a solid lead over all other stablecoins.”

East Asian demand

The usage figures are heavily skewed by demand from East Asia. Indeed, competitors such as USDC, TUSD, and PAX have gained significant traction in the U.S. and other Western markets, but this adoption has been dwarfed by Tether’s popularity in the East. Crypto and global macro trader Alex Krüger told Cointelegraph that “Tether continues to dominate the stablecoin market due to demand from Asia.”

Research from Diar, a crypto asset newsletter, recently showed that Chinese exchanges are responsible for 60% of USDT trade volumes. While these exchanges have accounted for $10 billion in USDT trading so far in 2019, U.S. exchanges have accounted for just $450 million of this. The remaining volume has come from Binance and Bitfinex, both of which cater to East Asian clients. Diar stressed that these figures are accurate and do not represent fake volumes.

This dynamic is peculiar, given that Tether is denominated in USD. Perhaps part of the reason is its lack of oversight and opaqueness that may be attractive to Asian investors and traders wishing to avoid surveillance and action from their respective governments. This is further compounded by the absence of a highly liquid or viable stablecoin denominated in Chinese yuan, Japanese yen or Korean won.

Chinese and Hong Kong crises

Tether has also likely benefited in recent months from the escalating Sino-American trade war. The escalation of tariffs by the Trump administration has coincided with and arguably contributed to a worsening economic picture in China. Major players in the industry such as the founder of Digital Currency Group, Barry Silbert, and chief market analyst at ChiefMarkets, Naeem Aslam, previously told Cointelegraph that the escalating trade war is contributing to the current crypto bull run.

Simultaneously, the Hong Kong protests and implications of the proposed Chinese extradition treaty may have Hong Kong nationals weary. Kyle Bass has pointed out that the banking system in Hong Kongis nearly at 900% leverage. He believes that the potential fallout of these protests could and already is resulting in significant capital outflows. This could in turn trigger a banking crisis in the region, resulting in further outflows. It is quite possible that Hong Kong nationals are, in part, driving Tether volumes, as the stablecoin presents a way to purchase crypto assets without going through Know Your Customer (KYC)-compliant, fiat-to-crypto exchanges or over-the-counter (OTC) desks.

Crypto assets present one of the easiest methods to both hedge risk and get capital out of vulnerable and less liquid assets, such as real estate. Also, there is currently a near-total absence of stablecoins pegged to East Asian currencies.

Systemic risk to the market

The problems concerning Tether are now better understood and formalized than ever before, due to the NYAG case. Considering this, Tether has continued to grow stronger and plays a pivotal role in the markets. This fact also highlights the risk the business may present to the entire crypto sphere. We spoke to experts to gauge the risk they perceived from Tether. Mati Greenspan, a senior market analyst at eToro, told Cointelegraph, “My feeling is that each exchange already has a contingency plan to cope with any Tether related issues that may arise.” Villaverde largely agreed with this position, telling Cointelegraph:

“We do not think USDT represents a systemic risk to the crypto-asset space in the long term. Let’s not forget that the rally we’ve seen in Bitcoin accelerated around late April, precisely when the market was concerned about the sustainability of USDT as an asset class. The same thing happened in October when Bitcoin shot up by more than 10% intraday on fears that things are not as they seem when it comes to the Tether stablecoin. The bottom line here is that the market has already spoken on this issue: It’s telling us that, even when in doubt about the sustainability of USDT, the markets are liquid enough to absorb that capital flight.”

It seems fair to assume, given the cost otherwise, that the major exchanges are actively working to mitigate much of the threat that a Tether collapse might cause. The resilience will likely also be partly dependent on the ability of rival stablecoins to compensate.

Stablecoin substitution

We may not know the readiness of USDC, TUSD, PAX and others until the situation is forced upon them. However, it appears relatively simple for investors to exchange their USD for these major stablecoins. Notwithstanding KYC and Anti-Money Laundering tests, there is nothing preventing investors from adopting these coins. In a crisis situation, if Tether theoretically collapses in a matter of days, it would be a question of whether these projects have the systems — technical and otherwise — to support the huge inflows of fiat currency that would happen. Cascarilla from Paxos assured Cointelegraph that PAX could take up this slack quite easily, sayingt:

“Since launching PAX in September 2018, we’ve built up liquidity and are able to create and redeem PAX easily. Currently, more than $1 billion in PAX is transacted weekly, and there is nothing limiting our ability to be 10x that size.”

It is of course equally possible that such an event may simply result in a surge in Bitcoin prices, as Villaverde believes, whereby USDT holders prefer to simply trade for BTC rather than a less liquid stablecoin. He told Cointelegraph, “The money moves to Bitcoin and stays in crypto, regardless of any short-term fluctuations that may be experienced.”

Broken but undefeated?

It seems that there is evidence to say that Tether is a business with several major deficiencies, particularly in regard to its transparency, trust, legality and centralization. Regardless, the market clearly sees the benefits it offers in terms of liquidity, price stability and usability as outweighing the notable risks.

The evidence clearly shows that it is Tether’s longer history and resulting network effects that enables its continued supremacy among stablecoins. This runaway network effect, recently bolstered by East Asian demand, has lent the project the high levels of liquidity and low volatility that traders and investors desire.

At this stage, it appears something monumental will be needed to dethrone Tether. Whether that capacity can be absorbed by its competitors remains to be seen. However, in the short term, it is equally likely that Bitcoin and other major crypto assets would benefit from such a crisis. Perhaps rather than presenting a systemic risk to the markets, a Tether collapse may present yet more bullish momentum for the markets.