On the Relationship between Tether and Other Cryptocurrencies

Abstract

Tether is a stablecoin that is widely used to trade crypto assets. Using Tether's price volatility, characterized by two distinct regimes, we identify the structural relationship between Tether and Bitcoin price and the circulating supply of Tether. This study delves into the intricate dynamics of Tether (USDT) and its interactions with Bitcoin (BTC), providing valuable insights into the mechanisms that underpin stability. We propose a new hypothesis based on triangular arbitrage to explain the underlying market structure and the relationship between our variables of interest. We then compare the statistically identified model with the theoretically driven restricted models. Our findings highlight the critical role of the arbitrage mechanism, particularly triangular arbitrage, in maintaining the stability of the Tether price. Consequently, Tether demand shocks can inflate the Bitcoin price in the short run. Contrary to conventional wisdom, our results show that the circulating supply of Tether responds to price differentials in Bitcoin markets rather than its own market conditions.

Keywords: C32, D40, E44, Regime Switching, Pegging Mechanism, Price Volatility, G10, Stablecoins