plz 6


About two months ago we talked all about Bitcoin. I presented some background on the currency and the way it functions, as well as some aspects of Bitcoin and the surrounding ecosystem that make me skeptical. I identified two systemic risks with Bitcoin: 1) that a double-spending attack (or ‘51% attack’) could destroy confidence in the currency and 2) that a popular exchange (e.g. Coinbase) might do some fraud or simply collapse in a ‘bank run’ situation. In the footnotes, I identified a third risk:

There is a third systemic risk, which is that maybe the ‘stablecoin’ Tether has fraudulently inflated Bitcoin’s price and will eventually cause a tremendous crash. It is a fascinating and scary and real possibility but merits another 1,500 words and we just can’t fit that here.

Well today I have words to spare. Tether is a cryptocurrency issued by a central authority (an organization called Tether Limited, though often referred to simply as Tether). A problem with cryptocurrencies broadly is that they are volatile. If you want to exchange your USD for e.g. Bitcoin in order to do transactions on the blockchain then you simply have to accept wild swings in the value of your coins as the cost of doing business. There are different ways around this problem but Tether’s solution is to issue coins in its own currency that are ‘backed’ by USD. You hand Tether a dollar and they hand you a coin, promising to keep your dollar in reserve. The intended effect is that every Tether is ‘backed’ by deposited USD which should cause it to trade at parity with the dollar. In a similar way to Bitcoin, Tether represents an interesting conceptual solution to a difficult problem.

Unfortunately there is some fraud-y type stuff going on. I’d like to get to the latest from this week but first we need the background. Tether has been around since 2012 and its history has been rehashed many times. I like this piece from Patrick McKenzie which I’ll stitch together to paint an abridged picture:

The cryptocurrency community includes many exchanges, each a group of affiliated companies, but it is sometimes clearer to view it as an single entity. It would have a series of ledgers, some mechanism for exchanging between the ledgers (taking a cut for each ledger hop and sometimes for bookkeeping within a ledger), and onramps and offramps to traditional currencies (which the community calls “fiat”). From the point of view of the ecosystem, it doesn’t matter which company has those ramps, because value flows unimpeded within the ecosystem.

Within the cryptocurrency ecosystem everything is smooth sailing but the interface with the traditional financial system is messy.

The cryptocurrency ecosystem’s purported raison d’être is building permissionless money, and (descriptively) large sums of money flow between pseudonymous identities without any Compliance Department having asked any questions about them. Financial institutions, which are extremely heavily regulated by a global consensus that [anti-money-laundering]/[Know Your Customer] are core responsibilities for their industry, are extremely reluctant to bank cryptocurrency exchanges, even ones which (by the standards of the industry) are aboveboard.

Getting USD into/out of your crypto exchange is difficult because banks will refuse to work with you if you can’t convince them that you’re not enabling money laundering or other crimes. This is a hard task for a crypto exchange since cryptocurrencies are really great tools for laundering money and doing crimes.

The Tether drama begins with an exchange called Bitfinex:

Bitfinex, founded in 2012, became the largest international cryptocurrency exchange after Mt. Gox imploded in 2013/2014. It has the sort of complicated backstory you’d expect of a Bond villain cryptocurrency exchange.

The most relevant fact in the backstory: in 2016, Bitfinex suffered what Matt Levine describes (facetiously but not inaccurately) as the inevitable fate of Bitcoin exchanges: they lost $70 million of Bitcoin (~120k bitcoins) to hackers.

Tether and Bitfinex have the same CEO and appear to be controlled by the same group of people. From Bloomberg in 2018:

While Tether and Bitfinex don’t disclose on their websites or in public documents where they’re located or who’s in charge, Ronn Torossian, a spokesman for the firms, said in a Dec. 3 email that Jan Ludovicus van der Velde is the CEO of both. Phil Potter is a Tether director, according to documents – dubbed the Paradise Papers – recently leaked by the International Consortium of Investigative Journalists. He’s also the chief strategy officer at Bitfinex.

This, combined with Bitfinex’s financial troubles, is where things got weird (weirder? It’s relative). Until 2017, Tether/Bitfinex had been banking with various Taiwanese banks which provided access to the U.S. financial system via Wells Fargo. After the Bitfinex hack, Wells Fargo began blocking Bitfinex-related wire transfers. Back to Patrick:

Since people believed Tether’s representations that a Tether was as good as a dollar, and could be surrendered for a dollar at any time, it quickly became the unit of account for most of the cryptocurrency community. At the point Bitfinex/Tether lost access to high-quality banking, there were about $55 million of Tethers in circulation. Tether claims there are now more than $4 billion.

Patrick wrote that in 2019. The amount of Tethers in circulation has since ballooned to nearly $60 billion, but we’ll get to that. At this point, Bitfinex and Tether began doing business with a company named Crypto Capital Corp (CCC).

CCC’s modus operandi was identifying banks with poor compliance controls and opening shell entities which it represented were engaged in real estate transactions, shuffling money in and out until the bank closed the account, then doing it again.

In order to transfer money to Bitfinex via CCC, customers were given instructions on how to wire money to various shell companies that CCC had established. Customers were advised to keep the details confidential. This was done to prevent banks from realizing that they were managing deposits for a crypto exchange and freezing the assets, though Bitfinex didn’t mention this part to customers. Just ‘keep it to yourself, k?’.

Of course, all of this was illegal. Bitfinex and Tether couldn’t satisfy the rules of the legitimate financial system so they outsourced their problems to someone (CCC) who didn’t mind breaking the rules. But like every good money-launderer/fraudster/financial criminal, CCC was playing both sides: the head of CCC was skimming 10% of deposits for his personal use to the tune of $60 million.

How did Tether not notice this? Well, in classic Ponzi scheme fashion as long as there are more new deposits than withdrawals you can perpetuate the fraud.

A function of Tether is to encourage far more actual money to flow into the ecosystem than flows out (“Why withdrawal all the way to a bank account when you can just withdrawal to Tether? It’s easier to invest back in, a much faster round-trip, and why would you trust banks.”), and so to the extent Tether’s balance was going up, the fact that it was being repeatedly siphoned off would not be noticed unless you were either a) the thieves or b) asking to get more money than inflows would cover.

That liquidity crisis happened in 2018, after regulators froze some CCC’s shell corporation bank accounts. By August 2018, CCC couldn’t pay outflows out of inflows and had exhausted their cash on hand. They explained that this was because they had some temporary liquidity problems caused by regulators.

That was a lie; CCC had liquidity problems, alright, but a major part of it was that the money they had embezzled was illiquid.

In order to continue to satisfy withdrawal requests (or at least to an extent where they didn’t appear insolvent) Tether and Bitfinex (remember, controlled by the same small group of people) did some accounting dances where they traded each other cash deposits of $625 million at a real bank for claims on an equivalent amount of money held by CCC. Ostensibly that is a money-for-money transaction, but a reasonable observer would question whether anyone could expect to retrieve that money from CCC given their regulatory situation.

In 2019 New York Attorney General Letitia James sued Bitfinex for not disclosing to investors when they (officially) suspected that CCC had absconded with their money. That suit was settled in February with Bitfinex and Tether paying a $19 million fine and admitting no wrongdoing. There was also a delicious press release from the Office of the Attorney General:

The OAG’s investigation found that, starting no later than mid-2017, Tether had no access to banking, anywhere in the world, and so for periods of time held no reserves to back tethers in circulation at the rate of one dollar for every tether, contrary to its representations. In the face of persistent questions about whether the company actually held sufficient funds, Tether published a self-proclaimed ‘verification’ of its cash reserves, in 2017, that it characterized as “a good faith effort on our behalf to provide an interim analysis of our cash position.” In reality, however, the cash ostensibly backing tethers had only been placed in Tether’s account as of the very morning of the company’s ‘verification.’

On November 1, 2018, Tether publicized another self-proclaimed ‘verification’ of its cash reserve; this time at Deltec Bank & Trust Ltd. of the Bahamas. The announcement linked to a letter dated November 1, 2018, which stated that tethers were fully backed by cash, at one dollar for every one tether. However, the very next day, on November 2, 2018, Tether began to transfer funds out of its account, ultimately moving hundreds of millions of dollars from Tether’s bank accounts to Bitfinex’s accounts. And so, as of November 2, 2018 — one day after their latest ‘verification’ — tethers were again no longer backed one-to-one by U.S. dollars in a Tether bank account.

Which brings us to the present! A requirement of the settlement was that Tether publish quarterly disclosures of the assets that ‘back’ the Tethers in circulation. On Thursday that report was released, showing that Tethers reserves are now far from the one dollar, one Tether model that we initially discussed. About half of the reserves are ‘commercial paper’, which means an unsecured short-term loan to another company. Loans like these are marked at their face value, but their true value rests on the credit-worthiness of the borrower. Can you think of any times where Tether held a loan where it wasn’t clear that their counterparty could pay it back? Like maybe a loan secured by cash held by a mysterious Panamanian company that doesn’t return your calls?

From Tether’s website:

Every Tether token is always 100% backed by our reserves, which include 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 (collectively, “reserves”).

The cash and treasury bills in Tether’s disclosure amount to 5% of its reserves so that statement, while true, is more than a little misleading. With nearly $60 billion of Tether in circulation, are we to believe that Tether’s assets (in particular those receivables and loans) are even close to commensurate? $50 billion of Tethers have been created in the last year alone. Bitcoin is up nearly 500% in the same period. In the context of everything that has happened with Tether, does that smell more like honest dollar inflows to crypto or market manipulation?

Look, I do not know what the future holds. But if there are Tethers being minted out of thin air then the unwinding is going to be catastrophic. Let’s end with a nice section from the 2012 Tether white paper:

Here is a summary of the weaknesses in our approach:

It starts to feel like… a checklist?

Military Infographics

This sort of thing would normally be in the ‘Bookmarks’ section but it’s too good not to quote. From Paul Ford on Medium:

Some nights I like to get the kids to bed, pour a drink, and search the web for military-produced PDFs in order to look at the amazing graphics within them.

That’s an incredible first sentence and the rest of the article does not disappoint. Go read it! There’s all sorts of zany military infographics to ponder. Under one particularly abstract one, Paul writes:

Take some time with that graphic. After a while you realize that this image could be used anywhere in any paper or presentation and make perfect sense. This is a graphic that defines a way of describing anything that has ever existed and everything that has ever happened, in any situation. The United States Military is operating at a conceptual level beyond every other school of thought except perhaps academic philosophy, because it has a much larger budget.

I love it.


Editor’s Note: Crypto troubles special edition!

Microsoft is shutting down its Azure Blockchain Service. Missing line in a smart contract leads to $10M hack. DeFi hack leads to a different $10 million loss (for the second time).