This article originally ran on PitchBook.
It's been rough for crypto enthusiasts lately. The heady days of December are quickly fading from memory. When bitcoin approached the $20,000 threshold and a brave new future of digital, decentralized currency not backed by banks or states seemed all but assured.
Months of persistent price weakness, exchange hacks and fears that many bitcoin miners are operating at a loss have brought back the fear, uncertainty and doubt. (Or "FUD," in crypto-speak.) Bitcoin tested a low of $6,252 this week—returning to levels not seen since November.
And now, a new paper by finance professor John Griffin and graduate student Amin Shams of the University of Texas at Austin suggests that bitcoin's Icarus-like rise could've been built on a lie. That Tether, a "stable coin" that claims to be redeemable (not just tradeable, via an exchange) into US dollars, was a source of fraudulent buying demand that drove about half of the rise in bitcoin in late 2017.
A charge that plays into the critics' concerns about the risks of an unregulated, opaque industry that got its start facilitating dark-web transactions in drugs on Silk Road.
Using algorithms to analyze blockchain data, the researchers found that bitcoin purchases with Tether "are timed following market downturns and result in sizable increases in Bitcoin prices." Less than 1% of hours with heavy Tether-into-bitcoin transactions are associated with periods when bitcoin prices were rising. Moreover, the purchases were clustered below round prices (e.g., $10,000) and suggest "incomplete Tether backing."
Translation: It looks like the people behind Tether were using freshly created Tethers to bolster the price of bitcoin. Often, with Tethers that weren't backed, one-for-one, by US dollars held in reserve.
Untangling the story is a trip down a binary rabbit hole.
One, Tether is a stable coin because it seeks to solve one of the main criticisms of free-floating cryptocurrencies like bitcoin: Intense price volatility limits its ability to be a medium of exchange and store of value. How are you going to buy a burger, or a car, with crypto if the price could be 20% different tomorrow?
Instead, bitcoin and its ilk tend to act as speculative assets. Like penny stocks. Created out of the ether.
Tether aimed to solve this by promising conversion into and out of the US dollar. But there was never a legal right to do so. Right on the website, the company admits Tethers are not money and are not monetary instrument: "There is no contractual right or other right or legal claim against us to redeem or exchange your tethers for money. We do not guarantee any right of redemption or exchange of tethers by us for money."
Two, the people behind Tether are the same people behind the scandal-ridden Bitfinex exchange, the two being connected since at least 2014, as revealed by the leaked "Paradise Papers" in late 2017. Bitfinix was the target of hack thefts in 2015 and 2016, with the latter resulting in a loss of bitcoin worth $72 million at the time. Tether was hit with a $31 million hack in late 2017. Until that point, the two insisted they were separate operations.
Three, the group lost their banking relationship with Wells Fargo in April 2017 for multiple reasons, limiting the ability to convert Tethers into dollars. Around the time Wells Fargo pulled the plug, a pseudonymous character known as "Bitfinex'ed" debuted online, claiming the company was creating Tether out of thin air to repay debts. The company subsequently changed its auditor and was subpoenaed by the Commodity Futures Trading Commission in the United States.
In response to the report by the Texas researchers, Bitfinex CEO JL van der Velde refuted the claims in an emailed statement to the Financial Times, saying, "Bitfinex nor Tether [sic] is, or has ever, engaged in any sort of market or price manipulation. Tether issuances cannot be used to prop up the price of Bitcoin or any other coin/token on Bitfinex."
The rise and fall of Tether's price versus the US dollar tells the story of what happened next. Tether fell to around 91 cents in April 2017 before the hiring of a new auditor (who never actually delivered their audit, by the way) stabilized prices.
Yet without Wells Fargo, and amid a struggle to reestablish a link to the traditional financial system to accept dollars, the company was limited in the number of Tethers it could print to meet demand. On May 26, Tether peaked at $1.05. It's being argued that the company would print Tether, and buy bitcoin, to push Tethers into circulation and lower their price relative to the dollar, thus leaving an inventory of bitcoins in the hands of Tether/Bitfinex.
The chart above shows the connection, charting how the number of Tethers in circulation mirrored bitcoin's price rise. Correlation isn't causation, of course, since bitcoin's price rise triggered broad interest in crypto currencies late last year. But it's a strong indication something more could be in play.
The dynamic would then repeat when Tether's price rose above par with the dollar in December 2017—thus creating a source of bitcoin-buying demand. And all this, if done in keeping with the amount of actual US dollars being held in reserve by Tether/Bitfinex ready to be redeemed, would be on the up and up.
But Tether's market cap is currently more than $2.5 billion. And the last "Proof of funds" on its website—a redacted memo from accountants at Friedman LLP intended for the use of Tether's management only and "not intended to be, and should not be, used or relied upon by any other party"—showed a USD balance of just $443 million.
That suggests a lot of extra Tethers floating around, unbacked by dollars, risking a Gold Standard Era bank run should Tether holders lose confidence and sell en masse, overwhelming the Singapore-based arbitrage traders that are holding the value of the Tethers stable. Tethers that were indeed likely used to bolster bitcoin prices as one lie (all Tethers are backed by dollars) perpetuated another lie (bitcoin is the future of money) that caught many out.