All the promise cryptoassets hold to redefine business as usual does not mean that basic business practices get thrown out the window. If certain checks and balances are not inherent to the blockchain solution, then one must fall back on traditional means to provide that accountability.
A good cryptoasset whitepaper acknowledges when this is the case. It illustrates how the team behind the blockchain solution proposes to be held accountable for delivering on their solution. In other words, a good whitepaper braids a long enough rope for the team to hang themselves if they fail to deliver. With respect to Tether, their whitepaper [1] clearly lays out how the team will provide accountability where their blockchain will not.
Tether’s rope: Unique stablecoin mechanisms
The principal behind Tether is simple — custody fiat currency in an omnibus account, whether U.S. dollars, Euros or Yen, and issue a cryptographic token, called tethers, that represents one unit of said fiat currency. The tokens are effectively interest-free cryptographic bearer bonds that can be exchanged like any other currency or if the holder of the token wants fiat, redeemed at any time for that same single unit of fiat currency. Thus, every U.S. dollar deposited in the custody account represents one USDT (U.S. Dollar Tether), every Euro deposited represents one EURT (Euro Tether), etc.
To me, a solution such as this is very important to the growth of cryptoassets. If done right, tokens backed by fully accounted for fiat currency deposits are a critical bridge to funding new projects and bringing liquidity from traditional assets to cryptoassets. As most everyone in this space is aware, this digital representation of assets is by no means limited to fiat currency, but what Tether claims to do is an important first step.
Note the words “fully accounted for” in the above paragraph. This is a necessary condition for trusting that the tokens can be redeemed at any time for their underlying currency. Also, note that I don’t go so far as to insist upon “fully backed”, which means that there must be equal amount currency units in custody as there are tokens in circulation. Fully-backed means the tokens are 100% fully reserved — a one-to-one ratio between tokens and fiat currency unit. Holding less currency than tokens is referred to as fractional reserves. In my view, fractional reserves are totally acceptable provided that is part of the expectation — and accounting.
In any case, 100% reserves require less trust and, according to the Tether whitepaper, this is precisely what Tether set out to do. On page four, it states “each tether unit issued into circulation is backed in a one-to-one (i.e., one Tether USDT is one US dollar) by the corresponding fiat currency unit held in deposit…”
So far…brilliant. All Tether needs to do is provide proof that U.S. dollars on deposit equal USDT in circulation. In the non-crypto world, proof means an auditor regularly provides an unqualified opinion that the proper number of U.S. dollars are indeed in custody and can be redeemed as prescribed in the agreement. Audits such as this are done so routinely that it hardly warrants mention.
Unqualified with respect to audits means the auditors have no qualifications surrounding their opinion, not that they were unqualified to perform the audit.
Validating how many USDT have been issued is an inherent feature of Tethers blockchain solution. Confirming the number of digital tokens created, validating the resulting transactions and eliminating the possibility of double spending those tokens is what blockchains do. However, for Tether, that only works for one-half of the ledger. The other half of the ledger lives in a traditional bank account.
Indeed, the whitepaper acknowledges that the checks and balances to prove the amount of fiat currencies held in reserve in traditional banks are not inherent to their blockchain solution. Their Proof of Reserves feature acknowledges the need for undergoing audits. To wit, from page 9, “Conversely, the corresponding total amount of USD held in reserves is proved by publishing the bank balance and undergoing periodic audits by professionals.”
Et voila. Evidence of the USDT in circulation is in the blockchain. The good folks at Tether will subject the system to a periodic audit by professionals. This audit will confirm each USDT is backed one-to-one by US dollars in an account and there are no competing claims to those dollars on deposit. This is a structure with which I am comfortable, and it doesn’t seem that hard to get right.
Furthermore, on their website, under their transparency link[2], they provide up-to-date balances (see “Current Balances”), promise that “Tether is always fully transparent” and provide the assurance that “Our reserve account is regularly audited” just below that promise.
Obviously, the balances displayed in the Transparency section of the website are under Tethers control and can display any balance they want. This page should do nothing to instill confidence. Thus, the need for an audit.
According to Investopedia, “An audit is an objective examination and evaluation of the financial statements of an organization to make sure that the records are a fair and accurate representation of the transactions they claim to represent.” This definition pretty much squares with my experience and, to have any external validity, should be performed by an outside firm with no ties to Tether. For something as simple as validating bank account balances and transactions, quarterly audits are not too much to ask.
Tether’s noose: Proof of Reserves with no Audit
Here is where the Tether team falls flat on their faces. Tether was founded in November 2015 and over the intervening eight full quarters they have yet to provide a single audit. The memorandum [3] they dumped upon what I assume they hoped were credulous rubes in September was by no means an audit. The firm providing the memorandum looked at screenshots and statements provided by Tether and advised anyone reading the document to not rely on the information contained therein! That’s a far cry from an unqualified opinion.
Tether stated that they were posting the memorandum “in good faith” but good faith is grounded upon doing what you say you are going to do.
That the Tether team has missed eight opportunities to provide something as simple, and commonplace, as an audit is one reason, (not the only reason, but one reason), why we absolutely do not trust that USDT are fully reserved. One can’t help to feel like they are hiding something…and rightly so.
Indeed, there has been plenty of digital ink spilled on the topic of Tether. I won’t rehash the arguments here as the core of my argument is simple — if the blockchain solution doesn’t provide proof, then you must resort to tried and true real-world methods of proof.
In Tether’s case, this means regular, unqualified, professional, outside audits.
Some blockchain solutions, like Bitcoin, provide their own proof. Other solutions making digital representations of real-world assets are unavoidably constrained by traditional accountability practices. Failing to deliver on promised audits (and, indeed, firing their auditor) are major red flags. Any experienced and prudent investor would think twice before holding USDT based on this major gap in accountability alone.
But, as I mentioned, there are more reasons to doubt that Tether’s USDT are not fully reserved. Even though half of the accountability around Tether’s “Proof of Reserves” system is missing, statistics and forensic accounting techniques applied to the available data can plug those “Good Faith” gaps with a high degree of confidence.
Which brings me to an excellent report found at www.Tetherreport.com. The diligent author of this report provides convincing statistical evidence that over 40% of Bitcoin’s price appreciation since April corresponds to the creation of USDT. This, in and of itself, doesn’t prove any wrongdoing on the part of Tether. It could simply indicate that whoever really wanted Bitcoin over the last year used USDT to buy them — and was careful about the timing.
But the author doesn’t stop there.
He/she/they also apply a forensic accounting technique to cast credible doubt over the stunning increase in USDT issuance during the last few months. As described in the paper, if USDT transactions into exchange wallets were due to normal customer activities, then the transaction amounts would adhere to specific patterns. Based on the results of the report, it appears those patterns are violated.
Finally, as an example for the executives at Tether, and in the spirit of true research and transparency, the author provides links to the data and the analysis. If it turns out that there are far more USDT issued than U.S. dollars on deposit, the team at Tether will have braided enough rope to hang not only themselves but a lot of other people as well.
At CoinScore, I am fortunate to work with an experienced team bringing market intelligence and analytics to the cryptoasset space. One of the advantages is access to a network of experts who, like us, are dedicated to shedding light on the cryptoasset space — the author of The Tether Report being a perfect example.
[2] https://wallet.tether.to/transparency
[3] https://tether.to/wp-content/uploads/2017/09/Final-Tether-Consulting-Report-9-15-17_Redacted.pdf
