Preface
The recent collapse of FTX (and the market as a whole) has reminded me of a topic that has been on mind my for the past several years. I don’t own any crypto, although I consume plenty of crypto content and think Bitcoin is awesome. I think that gives me a unique perspective to discuss the $70 billion elephant in the room.
At the time FTX froze customer withdrawals, they claimed to have about $14 billion on their balance sheet, most of which was the value of its own token $FTT. Sam Bankman-Fried, the owner of FTX, loaned money to his failing hedge fund (run by a 28-year-old with less than two years of trading experience), in order to save the sinking ship. The problem was that they loaned their customers’ money, and after the price of FTT lost even more value, their assets were worth about $8 billion less than what customers had deposited. Because lending has become a foundation of the crypto industry, this caused a chain reaction of margin calls and forced selling, bringing the entire market down. The shock crushed asset prices even outside of crypto, wiping out nearly $150 billion over two days (and counting).
What if I told you that there was an even sketchier company that shared ownership with an even sketchier crypto exchange, that was over five times larger than Alameda Research and FTX? That’s Tether: the single most critical institution in the cryptocurrency industry and a financial bomb waiting to go off.
What is Tether
Tether, also known by its U.S. currency code USDT, is an asset-backed cryptocurrency stablecoin. The idea is simple: it’s a cryptocurrency that will always be worth $1.
This simplifies the process of trading dollars for cryptocurrencies, and is a safe way for people in underdeveloped economies to own and exchange the world’s reserve currency.
The value of USDT is “pegged” at $1 because for every 1 USDT that Tether issues, supposedly they take dollar you paid and put it in a bank account, ready to be redeemed for 1 USDT. I say supposedly because over the past ~7 years they’ve consistently avoided transparency and outright lied, while growing their market cap and becoming the largest unregulated holder of U.S. dollars ever.
Tether’s sketchy history
Tether has been sketchy since it was first released on Bitfinex in 2015.
Bitfinex, one of the first cryptocurrency exchanges, launched in 2012. The company has moved between a series of banks, never disclosing to customers where the money is kept. The same is true for Tether, which was created two years later.
Representatives from both Bitfinex and Tether claimed that the two companies were separate. We now know from the Paradise Papers that Tether was established in the British Virgin Islands in 2014 by Philip Potter and Giancarlo Devasini. Potter was Bitfinex’s chief strategy officer, Devasini was Bitfinex’s CEO. Mr. Potter served as the first director of Tether alongside Jean-Louis Van Der Velde, who is also the CEO of both Bitfinex and Tether. So yeah, no conflict of interest.
Chief strategy officer Philip Potter seems to be the most public-facing of the founders. He worked for Morgan Stanley in the 90s but was fired after he was featured in a (surprisingly satirical) NYT article about how expensive his lifestyle was. Mr. Devasini, a former plastic surgeon, has a track record of screwing clients in the hardware industry and was fined 100 million Italian lira for selling pirated copies of Microsoft software. The CEO of Bitfinex and Tether, Ludovicus Jan Van Der Velde (or also Jean-Louis van der Velde?), barely even exists. There’s almost nothing about him online, and only one or two pictures.
It’s difficult to find information about the location and employees at either company; their banks and servers seem to move every couple years from Hong Kong to the British Virgin Islands, to Taiwan, to Switzerland. It’s like the company’s mission is to survive, built with an eject button to disappear when shit hits the fan.
Market Manipulation
In 2020, researchers John Griffin and Amin Shams wrote a paper describing the flow of money between Tether and crypto exchanges, alleging that Tether used its reserves to artificially inflation crypto prices during the 2017 boom.
Using algorithms to analyze blockchain data, we find that purchases with Tether are timed following market downturns and result in sizable increases in Bitcoin prices. The flow is attributable to one entity, clusters below round prices, induces asymmetric autocorrelations in Bitcoin, and suggests insufficient Tether reserves before month-ends. Rather than demand from cash investors, these patterns are most consistent with the supply-based hypothesis of unbacked digital money inflating cryptocurrency prices.
For a primary source, check out this Reddit post in April 2017, where a user questioned the legitimacy of Tether and their relationship to Bitfinex, as the price of Bitcoin exploded while USDT lost its peg to the US dollar:
Some time ago, certain bitcoin exchanges (particularly Bitfinex and Poloniex) have started quoting their Cryptocurrencies in a unit known as "USDT" or Tether. Apparently Bitfinex has an ownership interest in this "tether" and back in late december the market cap of this USDT cryptocurrency has ballooned by about $50M. […]The legitimacy of their operations has been questioned in the past and over the past few days the market has started to discount the true value of USDT tether significantly; it is currently quoting around $0.925. The problem here is that this is creating a very large price spread between exchanges that quote ACTUAL dollars and those that quote tether. This distinction is not being made clear, which I think is having an unhealthy influence on price rallies in cryptocurrencies. Furthermore, I have doubts that this tether is backed by dollars at all and in all likelihood is a fractional reserve.
In the 9 months that followed, questions about Tether and their reserves never stopped, while the market cap of USDT grew 4000%.
Security
Tether had a tough time dealing with withdrawals in 2017, which was most likely due to Wells Fargo cutting off U.S. wire transfers for Bitfinex.
Bitfinex has been hacked several times. A hacker stole 1,500 Bitcoin in 2015 and in August of 2016 someone stole 120,000 Bitcoin, which was worth around $75 million at the time or over $2 billion today.
The company spread out the losses to all customers by essentially removing 36% from everyone’s wallet, even those who were not holding Bitcoin.
Tether has also been hacked; they lost $31 million in 2017. To combat the lost money, they suspended trading and created a “hard fork”, which meant anyone who integrated with Tether had to update their software to make sure that the stolen funds couldn’t be redeemed.
Is it really 1-to-1?
For the first couple years, Tether never released any information on its reserves and claimed they were routinely audited, although they never released information on the audits. And in 2018, they were transparent in announcing they had fired their auditor.
As questions raised about Tether, the company realized it was too large to avoid attention. They published a memorandum from a third-party accounting firm, which was a 6-page document filled with lawyer jargon alongside tables where user deposits = amount in bank accounts, without disclosing any details. Eventually, government agencies had enough.
The CFTC
In December of 2017, the U.S. Commodity Futures Trading Commission issued a subpoena to Tether and Bitfinex concerning the backing of USDT. After all, before February 25th 2019, Tether’s website claimed that “Every tether is always backed 1-to-1, by traditional currency held in our reserves. So 1 USDT is always equivalent to 1 USD”.
After February 25, 2019, Tether updated their terms and conditions to say "Tether Tokens are 100% backed by Tether’s Reserves”. They define reserves as “traditional currency and cash equivalents and, from time to time, may include other assets and receivables from loans made by Tether to third parties, which may include affiliated entities”.
On October 15, 2021, Tether Limited paid a fine of $41.6 million to the CFTC for their original claim that USDT were 100% backed by dollars.
The New York Attorney General
In the Spring of 2019, the New York Attorney General’s office (NYAG) launched an inquiry into Bitfinex and Tether. They alleged that Bitfinex lost almost a billion dollars in customer funds, mostly through a sketchy crypto payment processor called Crypto Capital Corp. Then in order to cover it up, they asked Tether - which shares ownership and executives with Bitfinex - to loan them $550 million of their own customers’ money.
💡 In hindsight this is exactly what regulation and oversight is for, because it’s precisely what caused the recent collapse of FTX. FTX loaned customer deposits to a hedge fund Alameda Research, which similarly shared ownership with FTX, and when they couldn’t pay it back it collapsed the entire market.
This meant that Tether did not always have a 1-to-1 backing of dollars, which is concerning given the giant market cap of USDT. They also took fault with a blog post Bitfinex wrote after the NYAG’s inquiry announcement, where they claimed the money had been “seized and safeguarded”. In reality, the money was confiscated from Portuguese, American and British officials who are still in legal battles about what to do with it.
From New York Attorney General Letitia James:
"Bitfinex and Tether recklessly and unlawfully covered up massive financial losses to keep their scheme going and protect their bottom lines. Tether’s claims that its virtual currency was fully backed by U.S. dollars at all times was a lie.”
The inquiry lasted 22 months and during that time, USDT’s market cap grew from $2 billion to over $34 billion.
Transparency
To respond to the NYAG’s inquiry, Bitfinex announced that they paid back the $550 from Tether, and Tether released a detailed look into their reserves for the first time.
According to the disclosure, roughly 76% of their reserves are made up cash and cash equivalents. The majority of that is in commercial paper, which is short-term debt which is treated similar to cash. This would make Tether one of the largest holders of commercial paper in the world, with the likes of Vanguard and dwarfing the investments of Google and Apple. About 10% of Tether’s money is in corporate bonds, funds and precious metals. 12% is in secured loans, none of which are to “affiliated entities”, which we can take to mean crypto exchanges. They claim only 1.64% is in digital tokens.
You gotta trust a pie chart that uses the default Excel color scheme. These numbers could be completely legitimate, I have no idea. The point is that the entire crypto industry hinges on their validity, which is a lot to ask of a company that doesn’t tell you where the assets are stored.
A few days later, Bitfinex’s general counsel Stuart Hoegner wrote a blog post explaining Tether’s legal and financial position.
The settlement with the New York Attorney General’s Office is far more notable for what was not found than for what was found. Tether explicitly admitted no wrongdoing. And, after an extensive investigation for more than two years and reviewing more than 1M pages of documents provided by Tether and Bitfinex, the New York Attorney General’s Office made no negative findings whatsoever that tethers were not fully backed…
Whenever a company gets caught breaking the law they typically pay millions in fines and use the phrase “admitted no wrongdoing”. No matter if a company exposed customer information, a CEO misled investors or the government caused deaths - they never admit wrongdoing. If fact, that’s probably why they pay millions of dollars. Paying the NYAG is much better than admitting to fraud, and opening themselves up to lawsuits from millions of customers.
In that post Hoegner also vowed the company would release periodic assurance opinions conducted by an independent accounting firm to assure their customers . That firm is Moore Cayman, which if you click on that link (the one that Hoegner provided in his blog post), the website is for a UK company’s Cayman Islands office and makes no mention of the name “Moore Cayman”, but that’s par for the course with Tether. Either way, when I think of regulation and transparency, of course the first country that comes to mind is the Cayman Islands.
And in the name of transparency, I should point out that periodic reporting of their reserves was a part of the settlement. Along with a $18.5 million fine for damages to the state of New York, the AG mandated Bitfinex and Tether to report their current reserve status and budget and any transactions between the two companies, as well as provide public reports (the “Transparency” tab on their website) for the composition of their cash and non-cash reserves every quarter for the next two years.
Ironically, if the NYAG’s lawsuit forced Tether to take its money out of risky assets, it did so at the market top. Assuming these numbers are accurate, if Tether had been using customer funds to buy Bitcoin around 2017 and sold it to buy treasury bills during the inquiry, they would’ve been up around 700%. They put together the breakdown of their reserves in the winter of 2021, released it in the Spring, and the market has cratered ever since.
Conclusion
When the LUNA token and its associated stablecoin UST collapsed in May, it caused almost every token’s price to fall 30% and sent several companies out of business (3AC, Voyager, BlockFi, and eventually Celsius). At the peak, Terra (UST) had an $18.75B market cap and averaged $120M in volume. Tether has ~ $70B in market cap and averages ~$90B in volume per day.
If Tether doesn’t have the reserves that they claim, we are doing the biggest stress test in financial history to determine if that’s true.
Most American users trust Coinbase because it’s a publicly-traded US stock, but that doesn’t mean it can’t go bankrupt. The shady companies that don’t disclose where they’re located our who even runs the company? Those collapse all the time. Sadly for the entire history of crypto, losing millions of dollars in customers’ deposits is par for the course.
Crypto enthusiasts can mostly be split into two groups: (1) the Bitcoin fanatics who believe decentralization is the most important aspect of cryptocurrencies, and (2) those who want to see the value of their coins go up. Most people fall into the latter group.
I hope Tether doesn’t collapse. But if it does, the entire market will collapse, and we’ll be hearing a lot more about decentralization.