Tether's Growing Bitcoin Exposure and the Risks to USDT Stability: Carry Trade Implications and the Looming Threat to Crypto Liquidity

Tether's USDT, the largest stablecoin by market capitalization, has long been a cornerstone of crypto liquidity. However, recent shifts in its reserve composition-particularly its growing allocation to Bitcoin-have sparked concerns about systemic risks and the stability of the dollar-pegged asset. As of September 30, 2025, Bitcoin accounted for 5.6% of USDT in circulation, surpassing the 3.9% overcollateralization margin implied by Tether's third-quarter attestation. This overexposure, coupled with a 7% year-over-year increase in high-risk assets like gold and corporate bonds (now 24% of total reserves), has prompted S&P Global Ratings to downgrade USDT's stability assessment to "weak". These developments not only challenge Tether's ability to maintain its peg but also amplify risks for carry trade strategies and broader crypto liquidity.

The Carry Trade Conundrum

The cryptocurrency carry trade-buying high-yield assets while shorting low-yield ones-has historically delivered outsized returns. A 2024 academic study found that cross-sectional carry trade strategies in crypto yielded annualized returns of 43.4%, with a Sharpe ratio of 0.74. However, these returns are increasingly tied to the stability of underlying collateral, such as USDT. Tether's growing Bitcoin allocation introduces volatility into this equation. If Bitcoin experiences a sharp drawdown, Tether's reserves may lack sufficient liquidity to absorb losses, potentially triggering a cascade of redemptions and destabilizing the stablecoin's peg.

This risk is compounded by the opaque nature of Tether's reserves. While the firm claims $9.9 billion in Bitcoin and $12.9 billion in gold reserves as of Q3 2025, the lack of real-time transparency leaves room for uncertainty. For carry traders, this ambiguity creates a "black swan" scenario: a sudden loss of confidence in USDT could force rapid unwinding of leveraged positions, exacerbating market stress. The European Central Bank has already flagged such risks, warning that unbacked crypto-assets and decentralized finance pose systemic threats to financial stability.

Liquidity Risks and Systemic Spillovers

Stablecoins like USDT are critical to crypto liquidity, acting as both a transactional medium and a safe haven during volatility. Yet Tether's reliance on volatile assets undermines this role. If Bitcoin's value plummets, Tether may be forced to liquidate reserves at fire-sale prices to meet redemption demands-a scenario that could trigger a self-fulfilling crisis. S&P's downgrade underscores this vulnerability, noting that Tether's reserves lack the buffer capacity to withstand prolonged market downturns.

The implications extend beyond USDT. A stablecoin collapse could ripple through the crypto ecosystem, destabilizing decentralized finance (DeFi) protocols and leveraged trading platforms that rely on USDT for liquidity. Historical precedents, such as the 2022 Terra-UST collapse, demonstrate how interconnected crypto markets can amplify contagion risks. Moreover, regulatory scrutiny is intensifying: the ECB has called for stricter oversight of stablecoins, emphasizing the need for transparent reserve structures and robust governance.

Investor Takeaways and the Path Forward

For investors, the risks are twofold. First, carry trade strategies dependent on USDT face heightened exposure to liquidity shocks. Second, the broader crypto market remains vulnerable to a stablecoin-driven crisis, particularly if Tether's reserves continue to prioritize yield over safety. While Tether's 2025 profits surpassed $10 billion, this financial success masks structural fragility.

Investors should diversify stablecoin exposure, favoring assets with transparent, overcollateralized reserves. Additionally, policymakers must address the lack of regulatory clarity surrounding stablecoin operations. Without systemic safeguards, the growing entanglement of Bitcoin and stablecoins could destabilize not just crypto markets but the broader financial system.

[1] Tether's USDT Downgraded To 'Weak' By S&P After Bitcoin ... [https://stocktwits.com/news-articles/markets/cryptocurrency/tether-usdt-downgraded-to-weak-after-bitcoin-exceed-reserve-cushion/cL53vojREWt]
[2] Tethers 2025 Profits Surpass $10 Billion as Stablecoin ... [https://bravenewcoin.com/insights/tethers-2025-profits-surpass-10-billion-as-stablecoin-dominance-grows]
[3] Decrypting financial stability risks in crypto-asset markets [https://www.ecb.europa.eu/press/financial-stability-publications/fsr/special/html/ecb.fsrart202205_02~1cc6b111b4.en.html]
[5] Tether's USDT stability score cut to 'weak' level as S&P says ... [https://www.theblock.co/post/380562/tether-usdt-stability-score-weak-sp-reserves-cant-absorb-bitcoin-drop]
[7] The Risk and Return of Cryptocurrency Carry Trade [https://papers.ssrn.com/sol3/Delivery.cfm/4666425.pdf?abstractid=4666425&mirid=1]