What would a Tetherpocalypse look like?

With news breaking yesterday of the subpoena issued to Tether and Bitfinex by US regulators, the bitcoin markets are jittery and USDT’s integrity is under more scrutiny than ever before. This is the single biggest issue facing crypto right now.

At the heart of the matter is whether Tether really hold the $2 billion they need to back every USDT 1:1. If not, they are running a fractional reserve and have artificially been pushing up the price of BTC by printing money.

If that turns out to be the case (and it’s still ‘if’ at this point), what would be the effect on the overall crypto landscape? Some critics fear a prolonged bear market, or suggest BTC would crash by up to 80%, ultimately trading at a value of nearer $2,000 than $10,000. That would be brutal.

It’s extremely difficult to know exactly what the overall impact would be, since the crypto markets are so highly sentiment driven. Sometimes it’s worth stepping back and using an analogy to figure out what the impact might be.

Goldfinex is a gold exchange, where users can come and trade their gold for dollars. Every day, customers walk in and trade shiny gold Krugerrands with each other in return for crisp, $100 bills. Business is good and everyone is happy. Goldfinex’s owners buy and sell gold in their own store themselves from time to time – after all, they like gold and think it has a future.

After a while, Goldfinex realise that using real $100 bills to buy gold is quite expensive. So they fire up a photocopier in the back and start churning out copies of hundreds instead. They use these to buy gold from their customers, who go home not knowing their pockets are full of worthless paper. Goldfinex get very rich and hold lots of shiny Krugerrands, which makes them very happy. From time to time they feel bad about defrauding their customers, but hey, gold is gold and it turns out that even if money can’t buy happiness, it can buy Lambos, cocaine and a variety of other distractions to numb the guilt.

Unfortunately, the party can’t go on forever and after a while, customers start thinking the $100 bills aren’t quite right somehow. They ask questions about the smell of fresh toner on the paper and the whirring noise coming from the back, but Goldfinex just says ‘Trust us’ and, for a while, most people do. Then someone hacks a hole in the wall and pokes around in the back office and realises what’s been going on. What happens next?

Well, gold is still gold and it still has value. What doesn’t have value is the $100 bills that have come off of Goldfinex’s photocopier. At this point, anyone who doesn’t trust Goldfinex or those bills will start to unload them at any cost. They will rush to Goldfinex and seek to minimise their losses by buying gold at any price they can. A few people still think the bills may be legit, or have some kind of value in applications such as decorating, space heating or personal hygiene, and so they have some little value, but the price of Krugerrands in ‘Goldfinex hundreds’ goes through the roof. People want gold: it’s worth something. They don’t want Goldfinex hundreds, because they’re not worth anything much.

The bottom line? Gold has value. The damage has already been done and it’s sitting in the pockets of all those people who sold their Krugerrands for Finex’s funny money. They unwittingly parted with their gold at insanely cheap prices – in other words, they were robbed. They’re not happy about it and a few of them use the gold they have left to hire a hitman off the darkweb, but that’s another story.

If Tether is a fractional reserve, and USDT isn’t backed 1:1, the first thing we can expect when the market finally accepts this is for it to come unpegged from the dollar. It will be subject to massive inflation as traders holding USDT use it to buy BTC and other safe haven assets at whatever price they can: they don’t want to be left holding the bag. If the market thinks Tether only has enough funds to back half the USDT issued, you’ll need twice as much to buy the same amount of BTC. If the market thinks Tether only has around $500 million for the 2+ billion USDT in existence, it will be four times as much – that’s 40,000 USDT per bitcoin. And when it happens, it will happen very quickly.

Of course, that won’t directly affect the price of bitcoin on regular exchanges where it trades against real money. There may be contagion – basically, people thinking this whole crypto thing is a scam and want out forever. And there may be further impacts as regulators take the whole sector in hand in response.

But this isn’t like the sub-prime mortgage crisis. We know what the bad money looks like and where it is. And it will primarily be the traders holding USDT who will take the hit for Tether’s policy of printing money without holding enough reserves.