Analysis of fiat currencies pegged to US dollar and comparison to stable coins

As the media questions whether Tether has enough US dollar reserve to support its value in the recent USDT/Bitfinex drama (April 2019), people seem to forget that in the fiat world, a dozen of countries/regions have been doing similar business for quite some time.

Fiat Currencies with Fixed Exchange Rate

The central banks of some countries/regions choose to fix the exchange rate of their fiat currency to US dollar at a fixed peg rate (or within a range in some cases). The reasons are varied: geopolitical, commercial, or historical.

To achieve this, these central banks have to prepare sufficient foreign exchange reserves (mostly in US dollar) to be able to smooth out the market fluctuations caused by supply and demand, and to boost confidence in their fiat currencies.

Key questions for pegged fiat currencies

How much foreign exchange reserve (relative to the amount of fiat currency in circulation) do these central banks keep? How much do these currencies deviate from their peg rate? How much fluctuation do these currencies have?

These questions by themselves are interesting. Moreover, they can shed some light on how “stable coins” in the crypto world, which are also pegged to US dollars, works. More on that later.

Reserve, M2 & Price Deviation

Essentially, we need to collect data on two different aspects. for these fiat currencies:

First, we need data that specify the monetary status of each country/region, specifically, their foreign exchange reserve and M2. Here we use M2 as the representation the amount of currencies issued, as it is the most commonly used factor in the forecasting of issues like inflation rate. Most of the M2 money can be quickly converted into the fiat currency for purchasing/trading, and hence can directly affect the exchange rate. Luckily, we can find reserve and M2 data from tradingeconomics.com.

Next, to measure how well these currencies peg to US dollar, we measure the worst deviation from the claimed peg rate of these fiat currencies with respect to US dollar. For these forex data, we resort to tradingview.com.

Foreign Exchange Reserve vs M2

On investopedia.com, all USD-pegging fiat currencies are listed in this table:

List of fixed-rate currencies pegged to USD. Source: Investopedia.com

It seems that for most of the countries/regions, the reserve/M2 ratios are around 1/3, with the exception of Saudi Arabia, which over reserves recently (more forex reserve than M2), and iota economies like Bahrain and Belize, which reserves only 10% or less, as shown in the table below.

Deviation from Peg Rate

If these 30%-40% reserve/M2 number are analogies for the USD-reserve/coin-market-cap for stable coins, it should be an alarming sign and investors should start to worry about the capability for these stable coins to maintain their 1:1 peg. In reality, however, how far are these fiat currencies deviating from their claimed peg exchange rate?

The table on the left demonstrates the actual deviations. It turns out that all of them deviate less than half of a percent from the claimed pegging ratio. For almost all practical purposes, these currencies are doing a great job.

It seems that in the fiat world, “fractional reserve” system may just work fine. With about 30%-40% reserve/M2 ratio, these pegging currencies have been exceptionally stable. However, there might be other reasons for the confidence in these currencies. For example, they may have a lending source to easily borrow dollars to weather a small-scale squeeze.

Similarities to Stable Coin

In some sense, these pegged currencies are just US dollar tokens with a fixed conversion ratio. They promise to be able to convert into USD at that ratio at any time. In this sense, they are very similar to USD-pegging stable coins. Now let us take a look at the same statistics for the major crypto stable coins to see how they actually perform and if they are treated fairly.

Reserves & Volatility of Stable Coins

Most of the major stable coins claim to have a 1:1 US dollar cash reserve, including Tether a few years ago, although they have recently updated it to allow other assets as reserve.

However, in the wild frontier stable coins, there are no established rules for the ratio of reserve. For example, if we believe that Tether did lend $0.75B to Bitfinex for operations, or a major portion of its asset is susceptible to be frozen by the government, then by the 1:1 US-dollar-cash-reserve standard, it is under-reserves. However, ironically, it is still better than the case of most pegging fiat currencies.

Therefore, let us ask another question instead: how much reserve do these stable coins need to effectively avoid being squeezed, assuming there is no easy source to borrow US dollars from the banks, peers or competitors.

Max Redemption Percentage

Since the US dollar value of stable coins are typically defined as 1, most of the change in their market caps are caused by creation/redemption. Here are the market cap changes of the most popular stable coins on coinmarketcap.com, including: USDT, USDC, TUSD, PAX, GUSD and DAI.

USDT: Max Redemption 40.5%

USDC: Max Redemption 39.3%

TUSD: Max Redemption 34.7%

PAX: Max Redemption 45.7%

GUSD: Max Redemption 50.4%

DAI: Max Redemption 28.5%

Summary of Max Redemption Percentage of Popular Stable Coins

Interestingly, USDT experienced similar max redemption percentage (around 40%) as other more regulated and transparent stable coins (ranging from 30% to 50%). Although people were worried about USDT’s solvency, due to its superior liquidity and wide acceptance in the crypto market, there was still a large amount of capital adhered to USDT even at time of crisis (Q4 2018).

On the other hand, these numbers also show that most stable coins did experience a high percentage of redemption (40%–50%) over a relatively short period of time like a few weeks. These new animals, unlike their fiat pegging counterparts, are still under serious doubts and scrutiny, and are also highly susceptible to the ebb and flow of the crypto hype. Consequently, what about their price deviations?

Stable Coin Price Deviations

There have been articles researching on this quite thoroughly. Here we quote the results from Coinmonks titled “How stable are the top stablecoins? A quantitative analysis”.

Deviations of top 6 stable coins. Source: Coinmonks

Downside deviations of top 6 stable coins. Source: Coinmonks

For a two-month period, they measure the deviation from the 1 US dollar par in two different ways:

(1) Deviation: the deviation from the 1 USD par;

(2) Downside deviation: the deviation from the 1 USD par when the stable coin devaluates against USD.

It turns out that the stable coins are doing a reasonable job, including the much doubted USDT, in terms of keeping their values stable around 1. It is true that they are not as stable as their fiat counterparts, whose fluctuations are one order of magnitude smaller. Nonetheless, for most practical purposes, i.e. as short-term liquidity and value preservation, these stable coins serve their purpose very well, especially considering the astronomical fluctuations that other digital currencies like Bitcoin and Ethereum have.

Is USDT Good Enough?

With all these discussions and comparisons of stable coins and their counterpart pegging fiats, let us step back and revisit what the scenarios for USDT look like.

New Controversies

The major controversies on USDT are: (1) Tether updated its website, claiming USDT is now backed by “reserves”, which could be other forms of assets, not just cash; and (2) Bitfinex may had borrowed about 750 million US dollars from Tether.

For (1), since it is on Tether’s own website, it is highly credible. The focus should be on whether the “asset backed” USDT is solvent or liquid enough to withstand redemption activities, and as we can see empirically, as long as the reserve can withstand a 40%–50% of redemption for a few weeks, the risk of a squeeze is low.

As for (2), since now one showed any concrete evidence yet, we should take this claim with a grain of salt due to the potential intent for market manipulation. Even if it is true, the lent-out fund is actually a form of “asset” (i.e. debt), and it is a relatively small fraction of Tethers total reserve.

Aftermath

In the weeks following yet another USDT controversy, the value of USDT bounced back from a 3%–4% devaluation, even momentarily exceeded US dollar and other stable coins in value. It seemed that some manipulators made some fortune, yet again.

USDT/USD price chart. Source: tradingview.com

In this drama, was USDT totally innocent and trustworthy, maybe not. Yet was it on the brink of crash and facing a serious squeeze, probably not either.

Conclusion

In this article, we discussed the reserve ratio and price deviation of both fiat currencies and stable coins that peg to US dollars.

Fiat pegging currencies usually have only 30%–40% reserves with respect to corresponding M2, yet they have very low price deviation (a few to tens of basis points). Empirically, stable coins require a high reserve ratio since most of them had experienced a 40%-50% redemption percentage. Nonetheless, most of the top stable coins have reasonable price deviation (a few percentage points) for most practical purposes.

Therefore, the accusation that some stable coins cannot keep their value on par with US dollar by simply claiming that they do not have an 1:1 all-cash reserve, is not well founded, or, even worse, potentially manipulative.