Malt Liquidity 22
Financial lexicon of the risqué variety
Tethering isn’t the same as pegging
Imagine, if you will, that I am offering you the ability to transact in a currency called Ven Neurons (VN), and I promise you that this currency will be worth precisely 1 USD no matter when you want to swap back and forth between them. In short, it is pegged to the US Dollar. You might have some obvious concerns, namely that nobody accepts VN outside of liquor stores, or instead of George Washington, the $1 VN note features a portrait of Ted Kaczynski, but most importantly, you’d be wary of whether I have the dollar supply to support operating the exchange of currency in the first place. While I do not necessarily need to hold amounts of USD in excess of total VN issued (a sandwich shop does not purchase freshly baked bread each day assuming every theoretical customer will walk in and consume, for example), the less ‘trustworthy’ I am as an institution - unless a fancy curved monitor and knowing that "lexicon” is a synonym for “vocabulary” substitutes for being an actual government - the more USD I will need to hold to support the notion that my currency is worthy of being used as a medium of exchange, and consequently, as a proxy of USD. Thus the stability of the peg is dependent on there being a very low probability of overwhelming demand for redemption of the proxy currency to the point that the peg’s redemption value is unsustainable.
This should indicate two things: one is that being the common, liquid currency of transaction biases exchange rates, and two, if you want to maintain a peg, you have to have reserves to maintain the peg. (As to point one - it is insane how people inside the US undervalue the empirical power of being the primary transactional currency of the world, which, in my eyes, is worth far more than any sort of direct rule ever was historically. Indeed, the fact that capital controls have to be explained to the US populace if the topic ever happens to show up in conversation is probably the biggest advantage of the blue passport, outside of the more intangible benefits of ease of residency). Consequently, point two implies that an overwhelming demand for the more liquid currency coming from the proxy end could blow out the peg entirely if reserves are exposed to not be sufficient.
Oddly enough, two of the major pegged currencies (not counting the Yuan, which is more political than financial) could not have more divergent circumstances. The first I’d like to focus on is the Hong Kong Dollar (HKD), which is pegged between HK7.75-7.85/USD. A core principle of finance I reference is that every product is tied to another product: as the HKD is tied to the USD, it must naturally reflect the policies that strengthen and weaken the US dollar, the political risk affecting the willingness of foreign entities to invest their capital in Hong Kong branches and real estate (and concurrently, being susceptible to the risk that those currencies strengthen and weaken against the dollar), and even SOFR/LIBOR transition liquidity (and consequently all dollar-denominated derivatives). But given the increasing control of the CCP over Hong Kong, one begins to wonder what the future of the peg is. Certainly, famous speculators have time and time again bet on the removal or restructuring of the peg in what could only be described as an “arrogance” trade (though, to be fair, if a hedge fund isn’t operating on the assumption that they know more than everyone else, why are they even able to raise money?), but increasingly it makes less and less sense to me for both the US and China to allow HKD to operate as a proxy USD and not testing the policy of the HK central bank to defend it. Both rationales depend on HK continuing as sort of an “Asia Financial Hub” - from China’s standpoint, why does it want the financial equivalent of Soviet military bases in Cuba in such close proximity in the form of a dollar proxy having influence over what it now considers its own responsibility? And from the US standpoint, aren’t any potential Magnitsky-esque individual sanctions rendered pointless if there is a liquid proxy USD (in the form of HKD) that sanctioned individuals can transact in to gain exposure and access to USD? The current market view, of course, is that HKD allows simple liquid access to USD, while concurrently allowing the US to still hold some influence over the region due to policy externalities. A steady, accurate peg is imperative for ensuring a constant quality of life, balance of internal production and imports, and usefulness of local currency. And anything can be tied to the USD - VN, Saudi Riyal, whatever. To peg your currency to USD is almost acquiescence, definitely a step beyond practical acceptance, that the slick transaction capacity and access to the risk-free return on USD is worth selling some influence.
The flip side of a China-proxy backed peg, however, is Tether, the 1-to-1 USD crypto-proxy (yes, as was the case in 2017, everything ties in to Crypto). To be honest, I was surprised that Tether was still so tightly banded to USD (which is currently part of the class of pegged crypto called stablecoins), as for eons in crypto-years (which I peg at 3:1 to ‘dog years’) there have been serious questions about its USD reserves:
But Tether has never produced an audit showing it has the purported reserves. The company that controls tether maintains it has the reserves, yet it has never named the banks it uses to hold these funds, nor said where they are based and regulated.
Last year, Tether hired accountants Friedman LLP, based in New York, to audit the reserves. The firm issued a preliminary report last year, but Tether says it released Friedman before a final audit was completed. Friedman declined to comment.
For example, Coinbase’s stablecoin has been extensively audited and will continue to be audited on its reserves as it goes public, but no such thing has been done with Tether. In fact, there have been lawsuits over the years claiming misstated reserves! So how is Tether’s peg still so tight? Well, remember that a peg can only be exposed by excess demand for conversion out of the less liquid proxy. While the flow of USD and other tightly controlled currencies through Coinbase has directly flown into crypto (as Coinbase would never hold up to an audit if it transacted Tether), offshore exchanges
(read: the ones banned from transacting with US banks) have no such limitations, and as such, conduct plenty of business through the Tether proxy.
The fact of the matter is that there is simply such little value in holding USD as long as your transaction capacity in it isn’t being questioned (or are trying to project that image) that there isn’t sufficient demand to incite a run on reserves to show whether Tether is closer to VN or HKD in terms of excess reserves, on top of extreme demand for what Tether can help transact in, namely other cryptocurrencies with high amounts of leverage in dollar-denominated amounts (for, as I mentioned earlier, capital controls are remarkably strict outside of the US). There is no government or federal bank protecting Tether - the only protection mechanism Tether has is cashing out Tether-to-USD transactions seamlessly and hoping nobody complains, and trying to raise as much USD as possible through token issuance while lawsuits and audits continue to pile up. Sounds a bit Madoffian, doesn’t it?
While the Randian ethos of cryptocurrency is certainly fun for one to speculate on and be entertained by, it is important to remember that the same constraints the ideologues of the “uproot the central bank” mentality face are the same global scale prisoner’s dilemma conditions that advocates for world peace, harmonious oil cartel policy, and global actionable climate change policy face - namely, that it is impossible for any rational actor to break their own kneecaps solely on the trust that the other actors will do the same. On a philosophical level, cryptocurrency undermines the financialization that is the point of a government-backed currency (and therefore the point of a military) in the first place, and on a practical level, when there is so much opportunity to act in self-enriching interest, can you really expect humans to behave in any other way?
On that note…