Tether — A Potential Disaster Waiting to Happen
The white elephant in the crypto world which only the brave acknowledge
Turning a blind eye won’t make the problem go away. There is a high profile cryptocurrency that is questionable at best and at worst has fraud written all over it. If that cryptocurrency fails it will have major implications for the entire cryptocurrency market. However, the currency’s failure will be most severely felt in the stable coin market. The coin we are talking about here is Tether (USDT).
Tether has the fourth highest market capitalization of any cryptocurrency, with a market cap of just over $10bn. Bitcoin (BTC) stands at $218bn, Ethereum (ETH) at $48bn and XRP at $13bn. Tether is a stable coin pegged to the US dollar. It is the most valuable stable coin by far. The next biggest stable coin is Dai (DAI) with a market cap. of $417m, followed by TrueUSD (TUSD) at $283m and then Paxos (PAX) with a market cap of $245m.
Why are stable coins important?
The importance of stable coins isn’t going to be a flash in the pan. June recorded the highest transaction volume ever, up 14 percent against May with the value of stable coin transactions at $54bn.
So why do we need stable coins at all? The problem with cryptocurrencies is that they are volatile. This volatility makes the use of cryptocurrency unsuitable for a medium of exchange. That is where the stable coin comes in. They are pegged to the USD on a 1:1 basis in most cases and are usually backed by the fiat equivalent held in a bank account. Some stable coins use an algorithm which pegs the coin to the USD. Tether however, is collateralized with reserves held in USD. Both Paxos and TrueUSD are also backed by reserves of fiat and likewise pegged to the USD. There is a third type of stable coin, this is based on the value of other cryptocurrencies and is called a crypto collateralized stable coin, the largest coin here is Dai with a market cap of $417m and growing fast.
Stable coins provide a major source of liquidity in cryptocurrency markets. What does that mean? They are used by traders and investors to buy other cryptocurrencies on exchanges that don’t accept fiat currencies and as a place to store funds when other crypto assets are experiencing major volatility.
The problem is most exchanges don’t have relationships with banks. So investors purchase stable coins with dollars on an exchange which does have such a relationship. They then transfer the stable coin to the exchange where they wish to trade. Many exchanges use stable coins as trading pairs rather than dollars.
Collateral backed stable coins
We are going to focus on collateral backed stable coins. This is by far the biggest category in terms of percentage of the total market cap of all stable coins and also represents the highest risk to the user. In order for a stable coin to maintain its value its reserves should equal 100% of the value of the coins in issue or circulation. In fact that isn’t exactly true. Let say that Tether believes that they can earn 2% in the money markets utilizing their reserves then they could in effect only have circa 98% coverage i.e. fiat reserves against the total value of Tether in issue. However a user requires confidence in the underlying collateral to readily trade in the coin and for the coin to maintain its 1:1 peg. That confidence can only be achieved in two ways, the funds are stored in reputable Grade A rated banks and there are regular independent audits of these funds. There is a third requirement which is not essential but would provide additional security to the market, that the operating company which oversees the stable coin is regulated. That would mean the organization would have to report their reserves monthly (possibly even in real time) and provide other relevant statistics to the regulator.
Gemini (GUSD) (market cap $10m) and Paxos are the only stable coins that are regulated in this way. Tether does not tick any of the boxes. Let us look more closely at this.
Gemini (GUSD) (market cap $10m) and Paxos are the only stable coins that are regulated in this way. Tether does not tick any of the boxes. Let us look more closely at this.
Tether provides no audited accounts
Tether is not regulated
Tether does not publish up to date information on its reserves.
This in itself is worrying. Let us dig a little deeper and also look at the history of Tether.
USDT was established in 2015. According to the Wall Street Journal 80% of all BTC trading is made with the help of USDT.
Tether started with good intentions. Here are a few assertions and promises extracted directly from Tether’s original white paper issued in 2015:
‘The goal of any cryptocurrency is to completely eliminate the requirement for trust.’
‘Tether employs a simple but effective approach for conducting proof of reserves which significantly reduces our counterparty risk as the custodian of the reserve assets.’
‘Reserves are held on a one to one ratio.’
‘Tethers one to one backing implementation is easier for non technical users to understand…’
‘At any time the balance of fiat currency held in our reserves will be equal to (or greater than) the number of tethers in circulation.’
In addition to the above Tether also commits to the following:
‘Publicly reporting Proof of Reserves and other audit results.’
‘We publish the bank account balance on our website’s Transparency page.’
‘Professional auditors will regularly verify, sign and publish our underlying bank balance and financial transfer statement.’
And in conclusion:
‘Tether has a simple and reliable Proof of Reserves implementation and undergoes regular professional audits. Our underlying banking relationships, compliance and legal structures provide a secure foundation for us to be the custodian of reserve assets and issuer of tethers.’
Let’s see what happens in reality:
The first place to look is the face of the company, the website — www.tether.to
It appears upon first glance that Tether have been true to their word and do have an area on their homepage which states:
The value of our reserves is published daily. The value of our reserves matches or exceeds the value of all tethers in circulation.
Every Tether is always 100% backed by our reserves, which include traditional currency and cash equivalents and, from from time to time, may include other assets and receivables from loans made by Tether to third parties, which may include affiliated entities.
So on the face of it Tether is abiding by its commitment in its White Paper. But there is something new that has been introduced which did not appear in the white paper…
‘…may include other assets and receivables from loans made by Tether to third parties, which may include affiliated entities.’
So now Tether has introduced new rules to the game. This is a massive concern. We will come back to this point shortly.
As we continue to search through Tethers home page we see a tab which says:
Proof of funds
Great we think, and like curious investors interested in ensuring our holdings of tethers are secure we press the tab to see how much of the currency in issue is actually backed with money in the bank, because in reality that is all that matters, the rest is smoke and mirrors.
And there is a report from a firm of lawyers, a decent looking firm it seems so that is a positive. But the positive soon turns into a huge negative. The report is dated 1 June 2018, some two years ago! So much for daily reporting of proof of funds. The only good thing about this report is that it did confirm that the tethers in issue two years ago were fully backed at that time. But that was a long time ago. In the crypto market two years is the equivalent of twenty. Anything could have happened between then and now and as you will see below much has happened, none of it good!
Change of banks
Tether’s White Paper disclosed two Taiwanese banks as its main bankers, The outlook on both of these banks according to Moodys was ‘negative’. But that isn’t relevant now despite Tether’s reassurance in its white paper, ‘Our underlying banking relationships, compliance and legal structures provide a secure foundation for us to be the custodian of reserve assets and issuer of tethers.’ Their banking relationships were terminated with these two banks in early 2017 because of the intervention from Wells Fargo who cut off correspondent banking services for the Taiwanese banks due to their relationship with Tether. Tether was out on its ear needing a new home. They found a home in the Bahamas. A new relationship was announced with a financial institution (not a bank) called Deltec Bank & Trust Limited, definitely not an A rated bank. Tether published a letter from Deltec, the very same day as Tether announced its new relationship. This letter confirmed the reserves held with them. Dated November 1st 2018, it does pose the question what happened in the intervening time between losing their banking relationship with the Taiwanese banks and the new arrangement with Bahamas, some eighteen months? Whatever happened it was obviously not disclosed to the holders of tethers and no doubt involved some shenanigans that Tether did not want to inform the market about.
The report from the law firm did confirm the reserves between much of this period of uncertainty. It would be interesting however to see where these funds were parked for the eighteen months when it appeared Tether had no formal banking arrangements in place. It is also very suspicious why Tether decided on appointing a firm of lawyers to review the reserves rather than a reputable firm of accountants who are more accustomed to carrying out such reviews. This is a big question mark.
Enter the New York Attorney General
On April 25th 2019 the Attorney General of New York announced its investigation into Tether, Bitfinex and their parent company iFinex.
‘Our investigation has determined that the operators of the ‘Bitfinex’ trading platform, who also control ‘tether’ virtual currency, have engaged in a cover-up to hide the apparent loss of $850 million dollars of co-mingled client corporate funds, New York state has led the way in requiring virtual currency businesses to operate according to the law…’
Five days later Tether made its own announcement; ‘USDT is only 74% backed by fiat equivalents as of 30 April 2019.’ This was a bomb shell, but the market quickly shrugged this news off and continues to do so.
So what does this all mean as far as the holders of tether are concerned? It means that the AG believes that $850m of Bitfinex money was lost (Bitfinex claims that the money is not lost, only frozen. This is irrelevant to the AG’s argument however, as we will see.). In order to prevent the insolvency of Bitfinex it borrowed $850m from Tether to make up the difference and entered into a loan agreement, none of which was disclosed. So this basically opened multiple cans of worms.
Firstly it meant that Tether is no longer covered 1:1 by fiat, if it ever was, there is at least an $800m shortfall, although Tether announced in July 2019 the receipt of $100m from Bitfinex but there have been no further announcements. Perhaps that is the reason why the definition of 100% backed has been changed so drastically on Tethers home page.
Secondly we have to look at another possible reason why the definition of 100% backed was changed…
It is always tempting when a lot of money is sitting around earning minimal interest to utilize some of it for your own purposes, especially when there is no one to answer to. Tether is basically a two man band. The money market isn’t offering anything too attractive so why not lend the money to some ‘affiliates’ and use this money to develop some other businesses with good intentions of course, we hope, of repaying these loans. The history books are unfortunately littered with financial good intentions and these always end in investors nursing heavy losses. Now we are not stating that this is definitely what is happening here at Tether but that it is a compelling reason why this definition has been changed so recently. Otherwise why not just leave the definition as it was?
And that brings us to our third point, why did Tether choose a lawyer over an accountant? The answer is simple, an accountant would want to report on the cash, the cash equivalents and the loans and more relevantly, whether the money lent to the affiliates was recoverable. This is unlikely to be an attractive proposition to Tether.
What are our allegations here exactly?
We have a few points which we think are relevant to investors/holders of tether.
Tether is failing on its reserve reporting obligations to the point that the last independent report is over two years old.
In 2019 Tether acknowledged that the tethers in issues were only backed 74% by cash
Client Funds are being held in poorly rated institutions which are more susceptible to failure than a mainstream A graded bank.
Client funds are likely being diverted to affiliates which may not be recoverable.
Tether is misleading investors/holders of its coins into believing the currency is 100% backed by cash when in fact that is not the case.
Misappropriation of client funds. There has been inadequate disclosure of how clients funds have been used. Tether owes a responsibility to its users to disclose in a timely manner how client funds are being utilized.
To be fair to Tether
This got too big too fast!
Let’s be real. Tether had a great idea but there was a fundamental problem which still has not been satisfactorily resolved. Banking. All mainstream banks refuse to do business with cryptocurrency based businesses. They were put in the same category as marijuana businesses. So Tether was clever, they hustled, they found a couple of banks in Taiwan. Not exactly a mainstream jurisdiction but it would do for the time being they no doubt thought. But then their worst fears were realized. The bank accounts were closed. They quickly found another solution. However that disaster was shortly followed by another, they were hit with a sidewinder…
Their sister company suffered a huge loss which wiped out all their liquid funds. And of course they had to support their sister exchange. If Bitfinex collapsed after the $850m was frozen, stolen or lost, then that would impact both businesses, so naturally the owners did what all of us would probably do, it lent money from one pocket to another forgetting that this was client money they were playing with.
It is obvious that Tether are terrified of coming clean and by a quick glance at their website it is obvious they are continuing to mislead investors, exchanges and regulators.
What could Tether do to rectify this?
Tether must recognize that the longer they continue to hide the reality of the situation the more chance of this problem growing from what is currently a medium sized snow ball into a snowball big enough to crush a village. There are a few simple steps it could make quickly. It starts with a painful one — bite the bullet. But this is the time to do it whilst it rides high.
Appoint a reputable firm of accountants (top 10) to review its resources monthly at least, and post these onto their website.
Put a plan in place to make up any deficiencies and follow that plan diligently.
Make a commitment to comply with a set of transparency guidelines it publishes.
Appoint a high profile compliance officer who will be responsible for the above.
This can’t be brushed under the carpet any longer.
What happens next — how does this get resolved?
If Tether continues with its negligent and misleading behavior then there are a few things that should happen. Exchanges that trade in tethers owe an obligation to their clients to ensure proper compliance and standards are met. Exchanges should demand that changes are made. If the exchanges don’t act a regulator is sure too at some point and then it will be too late for everyone. There is already a proposal for a law called the Crypto-Currency Act. This proposes regulating cryptocurrencies. It would be in Tether’s best interests to put their house in order before the Federal government does.
It may turn out that Tether does have sufficient reserves, and we truly hope it does, but this isn’t the issue any more. This is a $10bn business being run like a corner candy store with total faith being placed in a couple of people no one knows from Adam and who are acting suspiciously at best.
What about the other stable coins?
And this is where the main threat to Tether is. Investors decide to use a stable coin that has independently verifiable reserves and is regulated. Surely that is the safest bet? That is where Gemini and Paxos come in.
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