The economic gamble of digital dollarization

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2022 has seen high-profile scandals and collapses in the digital asset industry, TerraUSD and FTX, being the most prominent. However, emerging markets across Latin America continue to embrace the industry and the questionable foundation much of it is built on, Tether.

In May, Tether LTD, the company behind the U.S. dollar-pegged Tether (USDT), announced it would be adding to its roster of stablecoins by launching the MXNT token in Mexico, a peso-pegged Tether coin. Tether says the country is “a prime location for the next Latin American crypto hub.”

Not content with deepening its ties with the fourth largest economy in the Americas (by GDP) come November, the company announced plans to make USDT available at over 24,000 ATMs across Brazil.

In August, its neighbor Argentina, which was featured 13th in Chainalysis’ list of countries with the highest ‘cryptocurrency’ adoption in 2022, approved the payment of taxes in Mendoza using USDT.

Given Tether’s rocky history and dubious stability, this could prove a dangerous road to walk down for states looking to explore new avenue streams and innovative finance technologies. It also raises concerns about a new form of digital dollarization based on the USD-pegged stablecoin Tether rather than the U.S. dollar itself.

But why is USDT spreading its tendrils across Latin America, something citizens of those countries should be concerned about?

If the USD-backed Tether is becoming the currency de jour across the Americas, then it’s worth looking to the past to see where this dollarization-by-other-means, or Tetherization, might lead.

The poison chalice of dollarization

Dollarization is a concept with which Latin America is painfully familiar. The pervasive influence of the North American financial powerhouse and its currency is a well-known phenomenon, as is the idea of economic imperialism, often cited as the driving force behind it.

Countries tying their currencies to the dollar in an attempt to create a stable and secure economic investment climate often end up ceding control of their own finances and economy, meaning that when a crisis hits, they can feel it the hardest.

This is the Faustian pact made when linking one’s own fate to the continued success and strength of another entity, and we need to look no further than Argentina for a case study of how dollarization can go awry.

During a large portion of the 1990s, Argentina outperformed most other countries in Latin America in terms of growth, thanks to its hard currency peg to the U.S. dollar—which is when, in 1992, the Argentine Peso was fixed to a 1:1 exchange rate with the U.S. dollar, hence ‘pegged.’

However, when several economic shocks hit in the late 90s, the country was in a severe currency, sovereign debt, and banking crisis. Argentina went into recession in the autumn of 1998, and its policy of maintaining its peg left it unable to respond to the growing economic problems, as it could not apply monetary or exchange rate policy.

At the same time, neighboring Brazil ended its peg to the U.S. dollar in 1998, which resulted in a strong depreciation of its national currency, the Real. This helped the Brazilian economy to recover by creating favorable trade conditions, but further impacted the struggling Argentine economy as it reduced the competitiveness of Argentine producers.

Eventually, in January 2002, the country effectively de-pegged from the U.S. dollar, giving the government and central bank back control over its currency and economy, but in the process leading to inflation and the reduction in the value of millions of bank accounts across the country.

Since then, the Argentine economy and Peso have fluctuated wildly, rallying and then slumping, with the Peso’s worth in 2022 again plummeting and inflation reaching 88% in October. In contrast to Chile and Brazil, for example, both of whom did not go down the dollarization rabbit hole to the same extent and have had, pandemics aside, a comparatively less rocky economic time since the 90s.

Living in a permanent state of fiat uncertainty, partly due to its unadvised flirtation with dollarization, is, ironically, one of the key reasons Argentines are turning to digital assets, and ‘stablecoins’ in particular, as a perceivably more reliable and less volatile option.

Why Tetherization matters

Tether is the largest stablecoin by circulation, the third largest digital currency by market cap, and has made itself indispensable to almost every digital asset exchange as a tool for integrating new money, managing and growing liquidity, leveraged trading, and pricing digital assets. Tether LTD, the entity behind USDT and the proposed MXNT, promotes their use by claiming every coin is backed 1:1 by reserves, whether that’s dollars, pesos, or other assets.

Because the digital asset space is now so reliant on USDT, if it was to lose this peg and people were unwilling or unable to use Tether tokens, the likely result would be a liquidity shockwave that would impact the whole digital asset industry, including the largest currencies by market cap—BTC and Ethereum.

The fate of Tether is of particular importance to BTC.

A 2020 study by the Journal of Finance showed the symbiotic link between Tether and BTC, demonstrating that large amounts of newly minted USDT were being used by primarily one entity to purchase BTC during the market downturn, in turn, boosted the price of BTC. So rather than demand from cash investors, the pattern was more consistent with “unbacked digital money inflating cryptocurrency prices.”

This is not the only hint that Tether might not be the reliable industry bedrock it claims.

In 2019 Tether LTD was sued, along with its sister company Bitfinex, by the New York Attorney General Leticia James, who suggested Tether was printing unbacked money to cover up an $850 million loss suffered by Bitfinex—Tether and Bitfinex eventually settled, but crucially the settlement agreement notes that for periods Tether LTD didn’t have the reserves to back the USDT in circulation.

If such an incident was to occur again and USDT was revealed to be unbacked, causing it to lose its peg to the dollar, people across Latin America, and the world, who have invested in the ‘stable’ currency as an alternative to their own unreliable fiat would stand to lose their savings.

BTC’s reliance on Tether is also why questions around the solidity of the ‘stablecoin‘ are of crucial importance to countries opening their markets to digital assets, the most prominent example being EL Salvador—another fly in the dollarization web, having adopted the U.S. dollar as its national currency in 2001.

El Salvador staring into the void

In 2021 Nayib Bukele, the ‘crypto-bro’ president of El Salvador and self-proclaimed “coolest dictator in the whole world,” made BTC legal tender, where it joins the U.S. dollar as the co-national currency of the country. This radical move came alongside issuing subsidies to rural Salvadorians via hot wallets, subsidized Bitcoin mining efforts using renewable energy, and the icing on the cake, a volcano-fueled planned city, shaped like the Bitcoin (BTC) symbol.

This top-down, all-in approach to digital asset policy resulted in El Salvador’s negotiations with the International Monetary Fund (IMF) for a much-needed $1.3 billion loan being stalled—the executive board of the IMF urged the government in its Article IV Consultation with El Salvador “to narrow the scope of the Bitcoin law,” a plea which fell on deaf ears.

This drive from the crypto-dictator also seems to go against popular feelings toward digital assets in the country. An in-person survey of 1,269 residents by the José Simeón Cañas Central American University (UCA) in October found that less than a quarter of respondents had used the digital assets in 2022, with only 17% saying the Bitcoin rollout had been a success, while 66% said it was a failure, and 77% wanted Bukele to stop using public funds to buy Bitcoin.

Unfortunately for these respondents, in the wake of FTX’s insolvency, Bukele doubled down, tweeting in November, “We are buying one #Bitcoin every day starting tomorrow.”

The Nayib Bukele Portfolio Tracker estimates that he has now spent over $107m on 2,381 BTC, an investment worth a little over $40 million, an eyewatering drop in value for a country already on the brink of economic crisis.

This is perhaps why it’s no coincidence that on November 10, when FTX declared bankruptcy, Bukele announced that the country would sign a free trade agreement with China. His vice-president, Félix Ulloa, said that China had offered to buy the country’s $21bn in foreign debt as part of the deal.

All of which means, thanks to legal tender BTC scaring away the IMF and a post-FTX slump in its value, El Salvador is now indebted to China for the foreseeable future.

Stuck between the rock of USD and the hard place of BTC, El Salvador has no room to maneuver. Without its own monetary policy, it cannot adjust its currency’s value to be competitive in trade. Now, having forced BTC on the country, Bukele has wrapped up precious reserves, and citizens’ savings, in the fluctuating fortunes of the Tether-reliant digital currency.

However, El Salvador is just the most extreme example. Countries across Latin America are inviting uncertainty in their bid to welcome BTC and Tether into generously regulated markets.

The regulatory landscape of LatAm

Several key reasons, amongst others, contribute to the embracing of a digital asset across large parts of Latin America:

• Economic turmoil and a reliance on the U.S. dollar, meaning in countries such as Venezuela and Argentina, seemingly ‘risky’ digital assets are often viewed as no less volatile than the local currencies.
• Citizens mistrustful of their own government and the central bank’s ability to manage their money.
• A significant population of unbanked individuals
• Access to sustainable and/or affordable energy for digital asset mining operations.
• A favorable regulatory environment, which tends towards a regulate-to-facilitate approach, rather than a regulation-by-enforcement approach criticized for stifling innovation (a hallmark of the U.S. Securities Exchange Commission)

Taking the latter point, a broad sweep across Latin America reveals wildly varying regulatory environments, from a complete ban on digital assets in Bolivia to Bitcoin as legal tender in El Salvador.

Looking at some indicative examples, though, the tendency is to the El Salvador side of the fence.

Panama is a case in point and is pushing to be the next digital currency paradise. The country has advantageous extradition laws (if you’re looking to stay off the U.S. radar), and a bill recently passed in Congress would allow for the private and public use of digital assets, making it possible for people to use them to pay their taxes. This was partially vetoed by the President, who seeks stronger Anti-Money Laundering (AML) rules before he will sign off on it, but considering its easy passage through Congress it seems likely to pass eventually.

Brazil and Chile have also been busy coming up with digital currency legislation. Both have bills that look set to pass into law and will clarify where digital assets stand under the countries’ current rules. The Chilean bill includes the oversight of digital currency exchanges and even differentiates between stablecoins and other digital assets in terms of how they should be treated legally, while the Brazilian legislation would specify with clarity the legal status of digital assets, provide an overall framework for monitoring activities and licenses to conduct transactions.

In addition, Brazil’s central bank is planning on launching a central bank digital currency (CBDC) by 2024. President of the Central Bank, Roberto Campos Neto, said in December that the aim was greater inclusiveness, lower cost, competition with lower entry barriers, efficiency in risk control, monetizing of data, and full tokenization of capital assets and contracts.

These two South American juggernauts are late to the regulatory game compared to Mexico. The country Tether has targeted for its new pegged token. In March 2018, the country passed a law regulating financial technology institutions (FTI) to address regulatory gaps and provide greater clarity to firms operating in the grey areas of existing law. Some key goals of this so-called ‘Fintech Law’ are to promote financial inclusion, provide legal security to technological financial services users, prevent money laundering and regulate transactions with digital assets.

All these bills aim to attract new investments and allow companies that are already operating to regulate their status in the countries—legitimizing digital asset players and encouraging the industry.

Argentina, by comparison, is relatively lacking in clear regulation despite the enthusiasm from many citizens for digital assets, driven by a distrust of traditional banking and finance. Currently, there is no specific regulation applicable to the sale of digital currencies or other tokens under securities laws or investment laws in Argentina, with the only specific rule related to digital assets being the ‘UIF Resolution,’ which implements additional reporting obligations to digital finance players under the Anti-Money Laundering Law and the Tax Reform Law.

Digital currencies are not yet considered legal money by the central bank of Argentina, but as of August 2022, the Argentine province of Mendoza—the country’s fifth largest (out of 23) in terms of economy—now allows taxpayers to pay in stablecoins.

Efforts to clearly define digital assets under the law are laudable and advisable, but regulation can only take you so far. The threat of dollarization lies in citizens and services becoming overly reliant on a particular asset that is out of their country’s control and beyond its ability to influence, whether that be USD, USDT, BTC, or another ‘asset of the moment.’

Argentina’s recent past shows the short-term gains and long-term losses that dollarization can offer, while El Salvador’s present precarious situation could take it down the same path or make it ground zero for a new form of digital dollarization. At the very least, both cases should warn countries and citizens considering Tether-ing their fates to uncontrollable, unreliable assets.

Follow CoinGeek’s Crypto Crime Cartel series, which delves into the stream of groups—from BitMEX to Binance, Bitcoin.com, Blockstream, ShapeShift, Coinbase, Ripple,
Ethereum, FTX and Tether—who have co-opted the digital asset revolution and turned the industry into a minefield for naïve (and even experienced) players in the market.