The Breakdown - Will the US Default on Its Debt? Circle Ditches Treasuries and Tether Buys BTC

Episode Date: May 18, 2023

Oh the irony. For most of the last few years, the US political establishment has been concerned about the risk that stablecoins might have for the mainstream financial system. This year, however, it's been the mainstream financial system wreaking havoc on stablecoins. On today's episode, NLW discusses Circle's move from longer-dated Treasuries to repo agreements, as well as Tether's new Bitcoin purchase plan.  Enjoying this content? SUBSCRIBE to the Podcast: https://pod.link/1438693620 Watch on YouTube: https://www.youtube.com/nathanielwhittemorecrypto Subscribeto the newsletter: https://breakdown.beehiiv.com/ Join the discussion: https://discord.gg/VrKRrfKCz8 Follow on Twitter: NLW: https://twitter.com/nlw Breakdown: https://twitter.com/BreakdownNLW

Welcome back to The Breakdown with me, NLW. It's a daily podcast on macro, Bitcoin, and the big picture power shifts remaking our world. What's going on, guys? It is Thursday, May 18th, and today, somehow we are discussing the question of the U.S. defaulting on its debt, and specifically what U.S.D.C. issuer circle has prepared to do in that eventuality. Before we dive into that, a quick note. If you are enjoying the breakdown, please go support. subscribe to it, give it a rating, leave it a review. This is how people discover the show. It makes a big difference, and I appreciate each and every one. You can also check out the Breakdown Network's other shows, including Bitcoin Builders and the AI breakdown, which is obviously very timely right now. When you're ready to come discuss all the things that you are hearing about, join us on the

Breakers Discord. You can find it at bit.ly slash breakdown pod. Today we are very much in the realm of where macro and the crypto industry intersect. The story of USC's reserves and Circle's relationship with the U.S. government has been one of the weirdest aspects of this cycle and frankly explains a lot about it for people who are observing from the outside. Circle is, of course, the company that has been arguably as or even more conscientious as any in the crypto space when it comes to U.S. regulations and, and it comes to U.S. regulations and trying to play within the system. The obvious reason for that is that they positioned themselves very early to be the anti-tether,

right? To be the company that was safe, compliant, and easy for the U.S. establishment to get behind. Circle was betting that stablecoins were going to be a big part of the future financial infrastructure, and they wanted to build the version that Tradfai and other big enterprise actors and just citizens of the United States in general could interact with. They've been trying to build, for all intents and purposes, a privately created digital dollar. In fact, in some ways, I think they wanted to position themselves

as potentially a reason not to need a CBDC because you already had this synthetic dollar that could be more formally roped into the existing system. Now, part of the plan for all of that was moving almost all of their reserves into cash and US treasuries. They were betting that eventually, when we finally got stablecoin regulations, which of course we still don't have,

that would be one of the requirements to keep everything in treasuries and cash-like instruments. Now, as part of their risk management, they also tried to diversify where they actually held those assets. And so then, irony of ironies, when earlier this year, during the banking crisis, Silicon Valley Bank goes down and Circle has to reveal that a few billion dollars of USDC reserves are potentially stuck there. Now, you'll remember the weekend before the Fed and the FDIC announced their plans to make everyone at Silicon Valley Bank whole, USDC was trading at a a meaningful discount at less than 90 cents on the dollar. Of course, that eventually resolved

once the U.S. government said that they weren't going to let Silicon Valley Bank depositors out to dry, but money still started flowing out of U.S.D.C. and in to Tether. Tether is actually up 24% on the year. Now, what makes this ironic is that many in the U.S. establishment, the political establishment in particular, have gone to pains to discuss how stable coins could be a threat to financial stability in the U.S. financial system. And yet in practice, it was the other way around. The U.S. financial system, specifically the banking system in this case, was a risk to the stable coin trying to do most right by it. I think that experience must color Circle's recent actions around its reserves. On Wednesday, Circle disclosed that it had cut all

exposure to U.S. Treasury bills that are expiring after the end of this month. The move is intended to protect Circle's reserves from a potential U.S. government default related to complications as debt-sealing negotiations come to a head. The Circle Reserve Fund, which is managed by investment management mega-firm BlackRock, now has $8.7 billion in overnight repurchase agreements or repo agreements in the portfolio. So these repo arrangements functionally allow Circle to lend its treasuries on a collateralized basis overnight.

Repo agreements are, of course, the lifeblood of bank funding with Circle now transacting with globally significant banks, including B&P Parabas, Goldman Sachs, Barclays, Bank of America, and the Royal Bank of Canada. Effectively, what Circle has done then is exchanged part of its exposure to the creditworthiness of the U.S. government for the creditworthiness of some of the largest banks in the world.

A Circle spokesperson said, quote, while this plan has been underway for many months, the inclusion of these highly liquid assets also provides additional protection for the U.S.DC Reserve in the unlikely event of a U.S. debt default. In an interview last week, Circle CEO Jeremy Aller told Politico, quote,

we don't want to carry exposure through a potential breach of the ability of the U.S. government to pay its debts. Now, it seems likely that Circle is more worried about illiquidity than real default. Circle has always been very short-term liquidity focused, bunching up in three-month-and-under Treasury bills. What's more, Circle has seen recently what happens when Twitter gets a hold of a narrative around lack of access to liquidity even for just a day. That means this is likely much more about an abundance of caution rather than Circle

thinking that they're actually going to suffer an impairment on behalf of the U.S. government. Now, you also have to think that this will impact stablecoin reserve requirement debates. One of the things that is frequently included in those types of discussions is the idea that Treasury bills have to be the main or even sole reserve asset. You can see now circle pushing back around being handcuffed to T-bills rather than having access to a diversified range of cash-like instruments. Earlier this week, U.S. Treasury Secretary Janet Yellen confirmed her warning that the debt ceiling would be hit by early June unless an increase in the debt limit was agreed to. Negotiations have been ongoing between lawmakers with President Biden on Wednesday saying that the talks have been productive.

He declared that, quote, I'm confident that we'll get the agreement on the budget and America will not default. Back over at Circle, assets managed by BlackRock now account for 26.7 billion of Circle's reserves, with the USDC market cap currently around $29.5 billion. The funds held with BlackRock are currently split roughly 65% in Treasury Bill, and 35% in repo agreements. Investor Mike Dudas writes, I commend Circle for being extremely prudent with their stable coin reserves

and protecting themselves from the risk of U.S. government debt default. Post-Tenebras writes, that's honestly hilarious. A few months ago, it was, how can we trust these nasty stable coin issuers with their reserves? And now we've moved to, how can we trust the U.S. government

won't rugpole their own treasury bills? Absolutely wild. Investor Adam Cochran writes, short-term bills and overnight reserve funds managed by leading entities. Circle gets some stupid flack on crypto Twitter right now, but they do play in the big leagues when it comes to partner quality and asset safety. Block Tower CIO, Ari Paul, says we just saw several U.S. banks fail from quote-unquote toxic long-dated U.S. Treasury and mortgage-backed security losses. Ironic that crypto-native startups have to consider

default risk of the U.S. government. Would seem insane if Coinbase and Uniswap hadn't outlasted so many giant established regulated U.S. banks. It's easy to say, don't worry about it if U.S. false, it's the end of the world anyway, but people said the same about a prime broker failing in 2008, or more recently, FTX and DCG and crypto. Almost always a middle ground worth considering. Cryptotrater, the cryptos, made the point that this is reflective of a broader sentiment in the markets. They write, and this is why short-term interest rates have gone up in the treasury markets. No one wants to take on that risk, no matter how small or unlikely. Cryptot trader Lindyhan says,

So both the major USD stablecoins, USD, and USDC, have revealed publicly that they have lost faith in the very currency they are pegged to, and now moving in the direction from being Fiat backed to anything other than Fiat backed. What's a dirty four-letter word starting with F? Now, Lindyhand is obviously talking not just about USDC, but about Tether, so let's move to that part of our story. Tether announced a slightly different decision around their reserves. On Wednesday, Tether said that they will be allocating up to 15% of net realized profits moving forward into purchasing Bitcoin.

The announcement comes on the back of the firm's Q1 Assurance Report, which claimed a $1.48 billion net operating profit for the quarter, and an excess of reserves now standing at $2.44 billion. Overall, Tether now has $82 billion worth of USD stable coins in circulation, which, according to their attestations, are fully backed, with an additional $490 million worth of gold peg stable coins in circulation. According to those latest reserve attestations performed when the total market cap of tether issued tokens was around $79 billion, the reserve now consists of $69 billion of cash and cash equivalents, which are primarily held in U.S. Treasury bills, with a smaller amount held in overnight reverse repurchase agreements and money market funds. Less than $500 million was held in bank deposits at the end of Q1,

representing a $5 billion withdrawal from the prior quarter. Overall, cash and cash equivalents make up 85% of reserves, with the remainder in less liquid hard assets, corporate bonds, secured loans, and other investments. Those assets include $1.5 billion worth of Bitcoin that already exists on Tether's books, alongside almost $3.4 billion in precious metals, which is well in excess of the holdings required to back their gold peg stable coin. Holdings of gold and Bitcoin represent approximately 4% and 1.8% of total reserves currently. Tether CTO Paulo Arduino explained more about the decision in his announcement tweet.

He writes, transparency is king. Tether today has 2.5 billion plus USD equivalent in company-owned excess reserves. What company-owned excess reserves mean? It means that Tether, on top of the 100% reserves necessary to back-issued tokens, has currently $2.5 billion plus USD equivalent more. This accounts to around 3% of additional value on top of the minimum 100% reserves. These excess reserves have been accrued through interest rates on our massive U.S.T bill portfolio and other investments like gold. Why does Tether keep excess reserves in the portfolio? While these excess reserves are part of Tether's own shareholder equity, Tether prefers to give priority to ensuring that its stablecoin

products are as resilient as possible. While banks can do fractional reserve, we believe that's not a viable strategy for a stablecoin, so it's crucial that Tether keep an additional cushion to further protect its user base. The decision to invest in Bitcoin, the world's first and largest cryptocurrency is underpinned by its strength and potential as an investment asset. Bitcoin has continually proven its resilience and has emerged as a long-term store of value with substantial growth potential. Its limited supply, decentralized nature, and widespread adoption have positioned Bitcoin as a favored choice among institutional and retail investors alike. Our investment in Bitcoin is not only a way to enhance the performance of our portfolio,

but it is also a method of aligning ourselves with a transformative technology that has the potential to reshape the way we conduct business and live our lives. Now, importantly, as part of their announcement, Tether also said that they would be taking possession of their own private keys rather than using a third-party custodian. The firm said that that strategy was, quote, part of its conservative and prudent approach to investment decisions aimed at strengthening, increasing, and diversifying its reserves. Finally, Tether said it would only be purchasing Bitcoin from realized profits, disregarding unrealized capital gains.

The community had some interesting reactions. One of them inevitably was that there were echoes of Luna's Foundation Guard. DC investor writes, Bloomberg reports Tether will be buying Bitcoin with profits. Man, I don't know. Gives me a bit too much in the way of Terra Luna LFG flashbacks, to be quite honest. Pala Arduino responded to this type of question, saying, How is this strategy similar or different from Luna Foundation Guard's Bitcoin buying strategy?

Bitcoin acquisition strategy is performed using only up to 15% of net realized operating profits that are accruing to company excess reserves. Excess reserves are company-owned shareholder equity accrued historical profits that were never distributed that is on top of the 100% reserve assets that Tether maintains in order to fully back its stable coin products, of which the majority is in U.S. Tether decided to maintain this excess reserves as part of its portfolio to add additional cushion and stability to its stable coin products. This approach is 100% different from Luna Foundation, where a huge portion of Terra Luna collateral itself was held in Bitcoin. Effectively, he's saying that these holdings

are not collateral for the actual Stablecoin USDT. They are simply equity holdings on top of that from realized gains. Venture coinist Luke Martin writes, if you think tether buying Bitcoin is the same thing as Luna UST buying Bitcoin, I have two words for you. Turn your brain on. Still, for others, there were lingering questions around transparency. DC investor again said, we are buying Bitcoin as an additional reserve for our stablecoin, which is 100% fully backed by USD. This is just extra backing for no reason. Our books are not public, but trust us. We're using profits to buy the Bitcoin, not principal. This is 2023. No one asks questions anymore. Zero X Fubar writes, isn't it pretty clear where the profits come from? Treasury yields. DC investors says, is their book public? Why say that it's

part of the USDT reserve? The reality for Tether is that there will always be these types of questions around whether they can be trusted and how true their reserve attestations are, with the only real way to defray them to continue to proceed towards as much transparency as possible. Now, there was surprisingly little discussion about whether this was good treasury management. Crypto investor Sean Farrell said Tether is more profitable when the dollar is strong. Bitcoin is strongest when the dollar is weak. This isn't some marketing grift. It's a sound approach to treasury management that I think other companies should take note of. Now, the other big discussion was what would the impact, if any, be on Bitcoin itself? And the analysis that

there was kind of mixed. Reflexivity research co-founder Will Clemente wrote, Tether rolling 15% of its profit into Bitcoin essentially transmutes demand for U.S. dollars into Bitcoin. Pretty cool. Separately, he wrote, Tether allocating 15% of its profits towards Bitcoin is extremely interesting because with tether benefiting from high interest rates, back stablecoins with short-term treasuries and pocket yield, this now counteract some of Bitcoin's correlation to tightening monetary policy. Still, others were more skeptical that this amount of buying would actually have an impact. Algod Trading wrote, Daily inflation is $25 million a day.

Tether annual buying pressure is only one month of emissions. Not sure why it's such a big deal. North Rock LP, Hal Press, writes, Tether yields at 4% on 80 billion equals $3.2 billion annually. 15% of this is $480 million or $120 million a quarter. At most, this is enough to offset 1.5 days of minor cell pressure per month. It's not nothing, but it doesn't materially change the flow picture. I'd still rather own ETH where you have net demand,

instead of miners, government, and gocks, all dumping on you in the next six months. Howl then went on? There is approximately $6.7 billion of Bitcoin supply coming to market over the next six months. 1.1 government, two, gocks, and 3.6 miners. Tether can absorb around 300 million of it, who will absorb the other $6.4 billion. It's easy to ignore this stuff while it's just numbers in a tweet, but once supply actually starts coming to market, any day now, it will become harder to ignore. Good Lord, do I think there is a lot wrong with that analysis. Like, a lot. First of all, the assumption of Gok sales I continue to find hugely problematic. I've always found hugely problematic. The idea that people would have held this long, not sold claims, seen Bitcoin continue to rise despite

everything else going on, only to dump the second it's available, is just so patently absurd on the face of it to me that it's remarkable that it gets the type of traction on Twitter that it does. It's also frankly extra rich coming from the same type of people who were convinced, correctly, by the way, that staked eth unlocks wouldn't lead to mass selling. I'm not even really calling out Hal here specifically. This is an endemic opinion across crypto Twitter. I just fundamentally disagree. Bigger than that, though, I also think that in these super thin markets, we tend to

radically underestimate how relatively small new pockets of buying pressure can lead to price changes that incite narrative fires. One of the under-discussed parts of the March rally around the time of banking collapses was that it seems to have been started not necessarily by a bunch of people going out to buy Bitcoin as a hedge against banks, but by Binance transferring a billion dollars of its insurance fund from BUSD to Bitcoin. That small amount of buy pressure telegraphed, by the way, to the market, in the same way that Tether has just telegraphed this to market, helped push prices up, which helps set a narrative opportunity, which came to fruition with the banking crisis.

The point is, small buying pressure, especially amplified by public announcements, can make a big difference in this type of bear market. Anyways, the broader point does come back to this irony of stable coin issuers racing to hedge against risk in U.S. dollars. But that's the world we live in, so here we are. Until next time, guys, be safe and take care of each other. Peace.