Decentralized finance (DeFi) has exploded in popularity over the past few years, allowing users to access financial services without centralized entities. Many DeFi apps rely heavily on stablecoins, especially Tether (USDT), to enable trading, lending and borrowing. However, this dependence on Tether carries risks that DeFi users should understand.
What is Tether?
Tether is a popular stablecoin pegged to the US dollar, meaning each Tether token is intended to be worth $1 USD. Tether Limited, the organization behind USDT, claims to back each token 1:1 with fiat currency reserves. However, Tether has faced questions about its reserves and whether it is truly 100% backed.
Tether aims to combine the price stability of fiat currency with the operational capability of cryptocurrency. This makes it appealing for crypto trading and DeFi apps that want to offer stable pricing. As of September 2022, Tether has a market capitalization around $70 billion, making it the third-largest cryptocurrency.
Why Do DeFi Apps Rely on Tether?
There are several reasons why Tether became integral to many DeFi apps:
- Liquidity - Tether has much higher trading volumes across crypto exchanges than other stablecoins. This makes it easy for DeFi apps to integrate Tether and access ample liquidity.
- First mover advantage - Tether was one of the first widely adopted stablecoins, so it developed dominance before competitors arrived.
- Brand recognition - The Tether name carries weight in crypto markets, providing a sense of trust and stability to DeFi users.
- Code compatibility - Many DeFi apps were developed to easily integrate with Tether's ERC-20 token standard on Ethereum.
Essentially, Tether provided the liquidity, ease of integration, and convenience that DeFi apps needed from a stablecoin. It continues benefiting from early mover advantage.
Risks of Relying on Tether
However, concentrating DeFi activity around Tether introduces risks including:
Lack of Transparency Around Reserves
There are long-standing questions about whether Tether reserves fully back the USDT in circulation. Tether settled charges in 2021 that it made false claims about full USD reserves. Without transparency, DeFi apps have exposure if Tether is less backed than claimed.
"As a DeFi founder, I worry about our platform's dependence on Tether. Trust is essential in this industry, so I hope Tether will provide meaningful transparency soon."
Potential Price Instability
If doubts around Tether's reserves continue, it could lead to falling confidence in USDT's $1 peg. If Tether lost its peg and dropped below $1, it would severely disrupt DeFi apps for trading, lending, derivatives and more. Even temporary instability can be damaging.
Tether has faced regulatory scrutiny over its reserve claims and whether USDT should be considered a security. If regulators enforced legal action against Tether, it could impact its circulation or operation. This top-down risk creates uncertainty for DeFi apps relying on Tether.
- Regulatory enforcement could restrict Tether's flow.
- Regulators may target DeFi integrations with USDT.
One appeal of DeFi is its decentralization. However, dependence on Tether reintroduces centralization risk as Tether controls USDT's issuance and operation. If Tether froze transactions, modified policies, or was otherwise restricted, it would immediately cascade across DeFi.
How Can DeFi Apps Mitigate Risks?
Here are some ways DeFi platforms can reduce overreliance on Tether:
- Integrate other stablecoin options like USDC or DAI to diversify and prevent sole dependence on USDT.
- Proactively communicate with users about Tether risks and transition plans in case of Tether instability.
- Develop smart contract logic to seamlessly switch between different stablecoins as needed.
- Encourage users to transition toward decentralized stablecoin options.
- Carefully monitor latest news around Tether reserves, regulation, and market perceptions.
- Implement contingency plans if Tether loses its peg or faces restrictions that limit DeFi activity.
Should DeFi Go Beyond Stablecoins Altogether?
Given reliance risks like the above, some argue DeFi should move beyond stablecoins altogether. Two alternatives worth considering are:
1. Algorithmic stablecoins
These try to programmatically maintain a peg without any underlying reserves. For example, Ampleforth uses rebasing to increase or decrease token supply to keep its price stable. The jury is still out on whether algorithms alone can reliably maintain pegs long-term.
2. Non-pegged assets
Another option is avoiding pegged stablecoins by using floating cryptocurrencies directly for borrowing, lending, trading, etc. For example, Aave allows using ETH as collateral instead of stablecoins. This provides volatility, but avoids stablecoin dependence.
Ultimately there is no perfect solution yet. DeFi developers have to assess options and risks closely when structuring their apps. Reducing Tether dependence can be prudent, but Tether still dominates liquidity. The ideal path forward will likely involve a slow transition rather than abrupt abandonment of stablecoins like Tether.