The Bitfinex Tether Conspiracy

Tether is a unique blockchain token that aims to maintain a peg to the United States Dollar.  That is, 1USDT (one Tether) is 1USD.  The claim is that they’re striving to bridge the world of fiat and crypto currencies by mapping the dollar onto a blockchain-based token.  In practice, the basic appeal to users is that you can use Tether as a haven of stability during (extra) volatile market periods or possibly try to avoid the taxable event of converting cryptocurrency to government fiat currency.  For the record, we’ve never recommended trying to do either of these things.

First, regardless of other issues, basic economics says this is difficult. Any currency peg requires the institution that maintains the fixed exchange rate to satisfy all buyers above the peg price and take any sales below it.  That is, they have to step in and fill the order book any time market forces push the price from the pegged rate.  Famously, George Soros made a fortune betting that the government of the UK would abandon their peg to the Deutschmark and the Swiss central bank gave up on a short-lived currency peg to the Euro in 2015 after taking savage losses.

Tether avoids this problem entirely by not supporting free USD/USDT exchanges, rather they simply assert that 1USDT = 1USD because there is a full reserve of USD.  It’s also important to note that there’s no withdrawal mechanism; Tether will not redeem Tether tokens for dollars.  When the Kraken exchange opened a true USD/USDT exchange all Tether did was sell them lots of the token, they did not actively intervene to guarantee price parity, so as of April of this year, you can track the risk and utility premium on the Tokens.  

Unlike a truly decentralized blockchain-based coin or token, Tether must have special relationships with the reserve bank holding the USD and the Tether-issuing exchanges.  Until March of 2017 Tether’s reserve bank was Wells Fargo and Tether’s sister company Bitfinex was the exchange on which new Tethers entered the market.

In March of 2017 the scheme started to unravel.  To begin with, huge capital inflows into the cryptocurrency space stressed all of the exchanges.  Then Wells Fargo stopped taking incoming transfers from the Taiwanese banks which were loaning money to Tether/Bitfinex.  A lawsuit and notice of voluntary dismissal followed shortly.  Tether initially claimed that it would not issue new tokens until a new banking partner could be found.  Within a few months, however, new Tether tokens were being released on Bitfinex.

Timeline of Tether’s price action and issuance (market cap)

Throughout the summer, many people active in the cryptocurrency space pointed out that without audits or announcements containing verifiable specifics, there was no way of knowing if or how Tether was maintaining the 1-1 USD reserve.  Regardless, new Tether tokens started entering the market in multi-million dollar lots, taking the total number from around $50 million to over $650 million at the time of writing this.  If there is no backing on the new Tethers, why commit such open and gluttonous fraud?  The simplest answer is that they’re being exchanged for actual crypto and real currencies on the Bitfinex exchange.  Further, the raging bull market in cryptocurrencies over this time means they’re exchanging the tokens they fabricate out of thin air for appreciating assets.  Pretty good scam as long as, (1) they’re solvent, (2) haven’t violated any banking or securities regulations, and (3) don’t face any litigation from users when the music stops.  

In parallel, a few anonymous, dedicated twitter and medium handles started making the case that the hundreds of millions of dollars of new Tethers were not simply being exchanged for Bitcoin and held as the price climbed.  Their contention is that exchange manipulation via wash trading and spoofing large orders was taking place.  In general, the claim is that this market manipulation is used to raise the price of Bitcoin, the main asset acquired for the now unbacked fiat-Tether tokens.  The chief self-appointed Tether watchdog writes and gives interviews under the pseudonym “Bitfinex’ed” and whoever operates the Bitfinex’ed handle has a deep enough knowledge of the mechanics of the corporate and exchange structure, that it’s conceivable that they’re a whistleblower instead of an outside party.

This week, the Tether exchange wallet was hacked for $31 million USDT.  In a sense, it’s incredibly irrelevant since Tether can simply freeze out those tokens and the only place where you can truly exchange USDT for USD is on Kraken.  Further, the market (non-)reaction recent Ethereum Parity wallet bug that blackholed around $300 million means that crypto users understand the difference in between third-party wallet software being insecure and the blockchain itself being sound.  …Or that the market is in such a solid upward trend that it shrugs off bad news like warm summer raindrops.  What the Tether wallet hack does do, however, is bring a lot of bright light into a situation that has been festering in darkness for half a year.  Yesterday’s NYT article not only saw a large mainstream publication pick up the story, but correctly conclude that the exchange was at risk.

What does this all mean?  The two issues are the exchange itself or entire Tether project being exposed as insolvent or fraudulent.  It’s hard to see how Bitfinex could lose money since turning unbacked tokens into Bitcoin is hardly malinvestment, but it’s also hard to underestimate the power of greed in making bad decisions.  If Bitfinex goes down, taking a majority of user funds with it, it would definitely be a step backwards in courting public opinion, as was Silk Road and Mt. Gox.  From an institutional financial perspective, the overall health of the cryptocurrency ecosystem is much better than during the Mt. Gox days –  there are over 15 reasonably liquid Bitcoin exchanges in the world.  As far as the Tether project blowing up, the notional value of Tether tokens at the moment is about $650 million, about 7% of the daily volume of Bitcoin transactions, so also not much.  If there’s a systemic risk from loss of confidence in Tether it’s the fact that Tether is frequently used to facilitate transfers between exchanges, but that’s the basic function of any cryptocurrency, so you don’t need Tether to do that.

The Kraken USD/USDT market should be something of a canary in the coal mine, but preparing for the worst really just means not using Bitfinex or double-checking your portfolio against best practices.

With that, it’s broken record time.  The best security is to trust the blockchain; hold your own keys, use cold-storage, use a hardware or other physical wallet.  If you do trade or rebalance actively, know your exchange.  Proof of reserves is one of the simplest blockchain transactions possible, good exchanges do it regularly.  More philosophically, if the Bitfinex allegations turn out to be correct, it is worth noting that the private citizens using public data were able to sound the alarm over six months ago.