Saturday, July 30, 2022

How profitable is the world's largest stablecoin?

In a recent blog post, the world's largest stablecoin issuer Tether mocked its smaller competitor, Circle (which issues USD Coin), for being unprofitable. Tether isn't wrong. Circle is losing a lot of money. In Circle's first quarter of 2022, lost $113 million).

But what about Tether? How profitable is it? Unlike Circle, which has taken steps towards an IPO and therefore publishes its finances, Tether is privately-owned, and so information about it is hard to come by.

Luckily, we can get a feel for Tether's profitability by scanning Tether's six attestation reports, the first of which dates back to February 28, 2021. In each report Tether discloses the difference between its assets and its liabilities. For those who have slogged through Accounting 101, you'll know that the difference between a firm's assets and liabilities constitutes its equity. I've plotted out Tether's equity below:

From equity, we can get an approximation of profit. Whenever a firm earns a profit, that profit gets added to its equity. So roughly speaking, an increase in a firm's equity is a measure of the flow of profits it has made over that period.

From March 31, 2021 to March 31, 2022, Tether's equity -- the gap between its assets and liabilities -- increased from $149 million to $162 million, which means that it earned $13 million over that 12-month period. For most of us, $13 million is a fair chunk of change, but it's surprisingly low given that Tether is one of the crypto-economy's largest and most important pieces of infrastructure. I know dozens of small-cap stocks that earn more than $13 million a year.

There are a few caveats to this. The increase in equity might not be due to profits. When a firm raises new capital, this capital gets added to its equity. So any increase in Tether's equity over time could be due to the profit it earns, newly raised capital, or a combination of both.

As far as I know, Tether didn't announce any capital raises in 2021 or early 2022, so based on the reasonable assumption that no capital was raised that during the 12-months ended March 31, 2022, all of Tether's $13 million rise in equity stemmed from profits.

Another caveat is dividends. A firm's equity can also change if it pays out dividends to shareholders. Say that Tether paid out $10 million in dividends in the 12-months ended March 31, 2022. That would have removed $10 million in equity from the firm. In which case its profit was much higher than $13 million. If Tether did pay a series of undisclosed dividends, then we can't use its equity over time to get a feel for its profit.

However, courtesy of an interview with Paulo Ardoino, Tether's chief technical officer, we know that Tether doesn't pay any dividends:

So assuming that Ardoino is telling the truth, $13 million in profits over the 12-month period ending March 31, 2022 seems like an accurate estimate to me, given no dividends and the assumption that no capital has been raised.

For the accounting sticklers out there, I don't think that any of Tether's $13 million in profits comes from changes in the prices of the assets it owns. The category of assets most likely to have risen in value over the last twelve months is Tether's $5 billion or so in opaque other investments. However, in Tether's attestation reports it says that it has adopted the practice of valuing its other investments at their cost price (less impairments), not their market price. So even if those assets had appreciated, it would not be recognized on Tether's profit line.

How exactly did Tether earn $13 million in profits?

During the period lasting from March 31, 2021 to March 31, 2022, Tether had an average of around 60 billion stablecoins in circulation. That is, Tether's customers had deposited $60 billion with Tether, and Tether had issued its customers 60 billion Tether tokens. The company doesn't pay interest to coin holders, which means it gets to keep all of the income generated by this $60 billion in cash for itself. Assuming an average interest rate of around 0.25% over that period, Tether would have enjoyed interest revenues of around $150 million over those twelve months.

It also would have earned a few million from fees on redemptions and deposits. Each time a customer wants to convert Tether tokens into actual U.S. dollars, they must pay a 0.1% fee.

Out of this $150 million or so in revenue from interest, and another few million from fees, Tether paid expenses such as salaries, court settlements, rent, lawyer fees etc. after which it ended up with $13 million.

What can we expect going forward?

Thanks to research by Intel Jakal, we know that Tether has invested $62.8 million in the equity of collapsed lender Celsius (see spreadsheet). Presumably the Celsius investment is part of Tether's $5 billion in other investments. Shares in Celsius are likely be worthless now, which means that Tether will have to write off its Celsius investment as a complete loss. There's a good chance that this $62.8 million write-off will overwhelm whatever income Tether earned over the three months ending June 30, 2022, resulting in a negative quarter. So Tether's capital, which came in at $162 million at the end of March, could very well fall when it publishes its next attestation report.

Tether may have other risky assets in its other investments that are impaired, too, in which case its losses may be hefty enough to push its equity into negative territory. (Unless it raised equity, a possibility that Patrick Mackenzie considers).

Counterbalancing Tether's losses on its other investments is the improvement in interest rates. Treasury bill rates are at 2% or so these days, much higher right than the mushy 0.25% reward they offered in 2021. This jump in rates comes courtesy of a big pick up in inflation. This means that going forward, Tether will earn much more interest income on its base of customer deposits.

For instance, recall that my best guess was that over the 12-months ended March 31, 2022, Tether brought in $150 million in revenue at 0.25% on a base of 60 billion Tether tokens in circulation. Crank this rate up to 2% and revenues rise to $1.2 billion per year. Assuming costs don't rise much, Tether's profits will jump by quite a bit over the 3-months ended June 30, 2022, and subsequent quarters as well.

However, if inflation is beneficial to stablecoins like Tether, it will also be problematic, for the following reason:

Inflation is a double-edged sword for stablecoins. The yield on their backing assets rises to keep up with inflation, so they earn more. Offsetting this is user flight from stablecoins. A 0% yield doesn't offer any inflation protection, so float shrinks and stablecoins earn less.
— John Paul Koning (@jp_koning) June 20, 2022

Because Tether only pays 0% to those who own Tether stablecoins, but market interest rates are currently at 2%, people will do there best to cut their holdings of Tether in order to invest elsewhere, say in Treasury bills. This is already happening. MakerDAO, one of the largest single owners of USD Coin, is taking steps to sell its hoard of $3.5 billion USD Coin (which like Tether yields 0%), to buy higher yielding conventional fixed income securities such as bond ETFs.

At the same time, competing stablecoins will enter the market that do pay interest, stealing even more market share from the 0%-yielding stablecoins. This will result in a contraction in the size of 0%-yielding stablecoins Tether and USD Coin, and a smaller base over which their issuers can earn interest. (Unless they themselves pay interest, which will of course cut into their profits.)

As you can see, being a stablecoin issuer is a very tough business.

Friday, July 22, 2022

Improvements to stablecoin transparency

[This article originally appeared in CoinDesk. It explores some improvements to stablecoin transparency recently initiated by New York regulators. In my opinion, there are two key changes. Up till now, stablecoin issuers have typically been examined by their auditor at the end of the month. With the new guidance, management's assertions must now be tested not only at the end of the month but also on one randomly selected business day during the month. Secondly, stablecoin issuers will be required to submit their internal controls to audit. Both measures will improve the trustworthiness of attestation reports.]

New York Regulators Have Planted a Seed for Stablecoin Transparency

Good news for stablecoin users: Stablecoin transparency standards are set to improve.

This comes courtesy of the New York Department of Financial Services (NYDFS), which last month issued formal guidance for NYDFS-approved stablecoin issuers, including upgrades to the amount and quality of information that issuers must provide to the public.

Increased transparency is a welcome development. It means users will have a better ability to vet stablecoins, and with more eyeballs on them, stablecoins issuers will be pressured to provide a safer product.

The new regulations will directly apply to gemini dollar (GUSD), issued by Gemini Trust, and binance USD (BUSD) and paxos dollar (USDP), issued by Paxos Trust. Those stablecoins were introduced in 2018 when the NYDFS initiated its regulatory framework for stablecoins.

The NYDFS is one of the most influential financial regulators in the world. By dint of peer pressure and customer demand, one hopes these improvements spread to other large, non-NYDFS-regulated stablecoins like USD coin, tether, trueUSD – and also to stablecoins yet to emerge.

It’s all about the assets

When people debate the intricacies of stablecoins, the most pressing thing they want to know is what backs the stablecoin. There are good reasons for that.

With good old-fashioned bank deposits, a bank's deep layer of capital offers depositors a degree of protection should the bank's investments sour. Stablecoin issuers, however, lack the large amounts of capital that banks possess. Furthermore, unlike with bank deposits – which are insured by the government up to a certain amount – you're on your own if the stablecoin in your wallet fails.

So the safety of a stablecoin is highly dependent on the assets that are backing it. That's why the topic of stablecoin backing attracts so much attention in the press and on social media, and why transparency is so important.

The durability of a stablecoin’s underlying assets is important to more than just the people who own the stablecoin. It's also crucial to the broader crypto economy, because stablecoins act as the plumbing of crypto. If a major issuer like Tether were to fail, it would drive the entire ecosystem into a crisis.

One way for people to gain sufficient confidence in a stablecoin is by getting a peek at its internal workings. A stablecoin issuer accommodates that by providing public information about the assets backing the stablecoin. By doing so, the issuer gives a stablecoin credibility, which may help it grow and earn more profits – but only if the public approves of what it has seen in the sausage-making process.

To ensure the information about its assets can be trusted by the public, stablecoin issuers first pass it through the hands of an independent auditor. The auditor examines the information and offers its opinion on whether the numbers are accurately stated.

The practice of providing the public with independently verified insights into stablecoin assets emerged in 2018 when the issuers of newly created stablecoins USD coin, gemini dollar and paxos dollar began to work with auditors to publish monthly "attestation" reports. Three years later, in 2021, Tether – issuer of the largest stablecoin – began to publish its own attestation reports, albeit quarterly.

This glance behind the curtains through the mediation of an independent auditor ultimately provides users like you and me with useful information.

But the glance that the public is afforded is good only if it is 1) timely, 2) provides a broad amount of useful information and 3) can be trusted.

The NYDFS's new standards address those three issues.

Timeliness

The utility of information degrades as it gets older, especially in the fast-moving crypto economy. The NYDFS new guidance requires attestation reports to be published monthly and no later than 30 days after the end of the month.

Stale attestation reports have been a problem among stablecoins issuers. In 2021, attestations for USDC were arriving 50 days after the attestation date. Tether's latest attestation was published 49 days after its March 31 attestation date. Users of this tardy information were left to speculate how the crypto declines of April, May and June may have affected Tether's finances.

Tether and USD coin aren't NYDFS-regulated coins and thus their issuers aren’t required to conform to the NYDFS’ standards on timeliness. However, given that competitor Paxos is implementing the standards for binance USD, Tether and Circle, the issuer of USD coin, may have no choice but to conform.

Completeness

A long look behind the curtains is better than a quick glimpse.

The NYDFS will broaden the amount of information available in attestation reports by requiring that stablecoin's assets be reported not only in aggregate, but also by asset class. So a stablecoin issuer would have to list how much commercial paper it owns, its allocation to money-market mutual funds, its deposits, its bonds and its quantity of Treasurys. That is, separately, instead of lumping it all together.

Some stablecoin issuers like Tether already do that. But others don't. The attestations for binance USD, for instance, inform us that Paxos may own deposits at banks, Treasury bills or Treasury bonds, but doesn't reveal what the proportions are.

Trustworthiness

An auditor's approval isn't worth much if the stablecoin can game the system. Of the updates to NYDFS' guidance, the most important ones will improve the trustworthiness of stablecoin reports. There are two ways it will do that.

First, the NYDFS will require auditors to not only examine a stablecoin’s end-of-the-month asset count, but also run a check on "at least one randomly selected business day during the period." Requiring a random in-between day examination prevents a stablecoin issuer from holding one set of risky assets for most of the month only to switch into safer assets the day before the auditor examines it.

Tether in particular should consider adopting the NYDFS’ random in-between day test as a best practice. Tether's three-month interlude between examinations is much longer than its competitors. By having its auditor test one random day during that period in addition to the end-of-period day, Tether would provide users with much needed assurance.

Second, the NYDFS will require that a stablecoin auditor provide an opinion on the effectiveness of a stablecoin issuer's internal controls. That must occur once a year.

Internal controls are the rules and procedures that companies adopt to prevent mistakes and fraud. They include separation of duties, verification of invoices, reconciliation and controlled access to financial reporting systems. After the Enron and WorldCom scandals of the early 2000s, the Sarbanes-Oxley Act made it necessary for U.S. public companies to undergo regular audits of internal controls.

At the present time, auditors that attest to the investments underlying stablecoins issued don't examine the effectiveness of an issuer's internal controls. An auditor need only acquire whatever "degree of understanding" of an issuer's internal controls that is necessary in order to carry out their assessment of its assets.

That's why all attestation reports contain something to the effect that "we did not test the operating effectiveness of such controls and express no such opinion on such controls." (That's from the attestation for paxos dollar.)

This is a black hole in current attestation practices. If internal controls aren't adequate, the numbers can’t be trusted. By requiring an auditor to examine a stablecoin issuer's internal controls every year to assure those controls are effective at promoting compliance with regulations, the NYDFS addresses this shortcoming.

Circle and Tether should consider voluntarily submitting their internal controls to annual examination and so reach the standards being met by their New York competitors. Because an organization's internal controls offer vital protection against fraud, anyone who owns stablecoins that conforms to NYDFS standards will be able to sleep soundly at night.