Warning: this is not a short post.
TL;DR The price of Bitcoin is likely to fall at least 15%, and as much as 75%, if it turns out that Tether has been improperly minting Tethers that are not backed 1:1 by USD. Again, IF.
As I’m sure everyone is aware by now, Tether has been in a multi-year legal battle over its legitimacy. However, there seems to be a lot of disagreement about the potential consequences of Tether folding, so I decided to do some analysis. Please know that this analysis is not infallible, as it makes many assumptions and is based on an economic concept that may not translate directly to the crypto market. It is simply an attempt to gauge the potential impact of Tether imploding.
Method and Analysis
The analysis is based on the premise that the velocity of money, or how many times a dollar circulates through the market, has a direct impact on the nominal price level of transactions. The velocity of money, V, is defined as
V = PT/M
P = nominal price level T = aggregate real value of transactions in a given time frame M = money supply
The wiki page on velocity of money offers a good description: wiki
In our case, however, we already know how many times each dollar is spent in the Bitcoin market, defined here as the market cap of Bitcoin. It is simply the annualized 24-hour volume of bitcoin transactions divided by the market cap. To do this, I used CoinGecko. In fact, I also used the Wayback Machine at https://archive.org/web/ to pull data from every six months or so (depending on availability) going back to November 2018. It appears CoinGecko lumps Bitcoin transactions other than spot in with total Bitcoin volume, so I calculated velocities for both stated (all) and specified (spot only) transactions. Here are the results for velocity calculations.
For the sake of this analysis, I will only talk about the specified volume as we're only interested in spot transactions. As you can see, July 2019 is a bit of an outlier in terms of Tether volume, but overall the numbers are remarkably steady over more than two years. This has been accompanied by a slow but steady decrease in velocity, which makes sense as more and more bitcoin are held rather than actively traded or spent. What we will focus on is the fact that in general, more than half of all bitcoin trade volume is conducted in Tether. That is the root of the problem.
Going back to our formula now, we can assume that T – the real value of transactions – can be held constant regardless of the other variables. Doing so, and moving things around a bit, we get
P = VM
And consequently, the change in P is equal to the change in V*M. Now, we need to make some assumption about the supply of money in the Bitcoin market, to which Tether adds about $25b at the time of writing ($24b just a week ago when I grabbed all my data). I have made the simple assumption of one trillion dollars. I will show you that this is a relatively conservative estimate in regard to the question at hand, regardless of the actual value, but for now just go with it. From here, we can calculate the total multiplier impact of Tether on the price of Bitcoin, by multiplying Tether’s velocity multiplier by its money supply multiplier.
V multiplier = 100%/45% = 2.22 M multiplier = 1t/(1t - 25b) = 1.025 P multiplier = 2.22 * 1.025 = 2.28
And there we have it. Tether, primarily through vastly increased trading volume, has more than doubled the price of Bitcoin.
But wait! This is totally fine as long as all Tethers are legitimate. If they were, then even if Tether itself didn’t exist, other stablecoins could have picked up the slack to meet trade demand and the market would look the same today. It only becomes a problem if it turns out that money flowing into Bitcoin, and cycling through the market more than 11 times this year, is fraudulent money. So, what do we do? We calculate the V*M multiplier effect on P in scenarios in which less than 100% of Tether is legitimate. Then, we can compare the resulting multiplier to the base case multiplier and see how much lower the price would be. Here is a sample of how that is done.
Now, which scenarios are realistic? I’m sure many of you have read that Tether’s lawyer stated in April of 2019 that Tether was only about 74% backed by cash equivalents (source). That was when there were only 2.8b tethers in circulation! That number has increased nearly 10x in less than two years(!!), and it seems Tether’s printing has only ramped up over that time, as reflected in Tether’s market cap. As such, I doubt Tether is any more than 74% backed currently, and I personally believe it’s much less than that. So, let’s take a look a few different scenarios of Tether backing, which we interpret in the model as the amount of legitimate Tether’s and the amount of trade conducted in fully backed Tether: initial analysis
As you can see, increasing the money supply above $1t has very limited impact on the estimated Bitcoin price reduction, whereas lower money supply assumptions start making Tether’s $25b contribution to supply more relevant. For reference, $20t money supply is the total US money supply in its broader interpretation (M2). Regardless, it’s very clear that the less Tether is truly backed by USD, the bigger the potential price drop.
We’re not done yet though. In our current model, we assume that the 55/45 volume split applies to money flowing into Bitcoin. However, the 55% is Tether’s representation among all Bitcoin transactions. This includes pairs like ETH/BTC, LTC/BTC, DOT/BTC, and Bitcoin being sold for USDT. This article on the same topic, posted to Medium a week ago, estimates that the closer to 70% of all Bitcoin purchases are made in USDT. Let’s take another look at the same analysis if we start changing that assumption, holding market supply steady at $1t: sensitivity analysis
Clearly, this assumption has massive impact on the results.
So, what do I do?
That is the question. What we’ve shown here is that, regardless of Bitcoin’s price, it is subject to drop significantly if it is revealed that Tether has been improperly minting Tethers that are not backed 1:1 by USD. However, it is not unimaginable that the market could collectively shrug off the news and recover quickly after a small drop. On the other hand, this would certainly be the biggest fraud in recent crypto history, which could shake out all confidence built up in the market since the 2017 bubble and bust. In such a scenario, I wouldn’t be surprised if prices fell below that maximum drop predicted here. It could also be the case that somehow, against all odds, Tether is actually fully 1:1 backed and will escape from its legal woes exonerated and unblemished. In short, there’s really no telling what the hell is going to happen, but any rational person should be wary of this situation. For what it’s worth, I spent the last week selling off about 20% of my portfolio, and plan to sell off progressively more as (and if) the market continues to bubble up.
The article referenced above is really worth a read. It’s what inspired me to undertake this project. One of the things the author points out is that you can’t trade USD for Tether very easily, and it’s common knowledge that redeeming USD from Tether (the company) is extremely difficult, to the point of being prohibitive. According to CoinGecko, USDT/USD made up less than 1% of Tether volume. This isn’t all that surprising on its own, but it gets a little weird when only one out of the top 10 Bitcoin exchanges has both USDT and USD trading (see here). Even more weird, that one exchange is Bitfinex, which is owned and managed by the same people as Tether. Bitfinex is the exchange that was accused of manipulating Bitcoin’s price in 2017, using Tether. Spooky stuff.
As I mentioned, my analysis is not infallible. Any criticisms or follow-ons are welcome. Here is a link to the Excel file containing all data and analysis.