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Is the Price of Bitcoin Based on Anything at All?

The cryptocurrency market’s reliance on Tether is a recipe for disaster

Jeff Wise
Jeff Wise
Aug 22, 2018 · 13 min read
Illustration: Jessica Siao

Back in January, the controversial cryptocurrency Tether (USDT), “anchor[ed] to the price of national currencies like the U.S. dollar, the Euro, and the Yen,” as its website puts it, found itself in the midst of an existential crisis. For months, concerns had been circulating in the media and in online forums that something was off. The company that produced the coin, Tether Limited, had promised since its inception that for each unit it created on the blockchain, one actual U.S. dollar would be held in reserve. But in August 2017, a blogger on Hackernoon.com who goes by Bitfinex’ed started raising questions about whether Tether was really sitting on all those greenbacks. If it wasn’t, the coin wouldn’t really be tethered at all.

In response, Tether Limited published a memo from an accounting firm affirming that it was fully backed. But the document fell suspiciously short of an official audit, and doubts only increased. On January 27, 2018, Tether parted ways with the auditor. Then, three days later, Bloomberg’s Matthew Leising reported that Tether Limited and its associated exchange had been subpoenaed by the Commodity Futures Trading Commission in another attempt to determine whether Tether is in fact backed by dollars. (To date, no charges have been filed.)

The fact that a cryptocurrency could shrug off a string of red flags would hardly be newsworthy were it not for the systemic importance of Tether.

For a currency whose stock-in-trade is reliability, the swelling tsunami of doubt was reason enough to send investors stampeding for the exits. But then, something funny happened: nothing. Buoyed along by the unshakable faith of crypto enthusiasts, Tether sailed on as it always had, hewing within a penny of parity with the greenback. Not only that, but on the same day Tether Limited fired its auditor, it went ahead and issued another $600 million worth of coins, raising its market cap by nearly half.

“If everything was on the up and up with Tether,” wrote blogger and Tether skeptic Bitfinex’ed, “there’s no way in hell they would have fired the auditor…because the fallout from firing them would be big. Interestingly, they do fire them and nobody cares.”

The fact that a cryptocurrency could shrug off a string of red flags would hardly be newsworthy (indeed, some would say the entire industry has done precisely that since the beginning) were it not for the systemic importance of Tether. It’s currently the 10th largest cryptocurrency by market cap, but even that fact fails to convey its influence over the sector as a whole. Tether is more than just another cryptocurrency; it’s the main currency by which other cryptos, including bitcoin, are priced. The flood of Tether that poured into crypto markets starting in mid-2017 is believed responsible for much of past year’s remarkable run-up in cryptocurrency markets.

That was the finding of University of Texas finance professors John M. Griffin and Amin Shams, who in mid-June released a paper on the Social Science Research Network asserting that half of the increase in bitcoin value was due to the injection of Tether. The authors state that patterns observed in publicly available trading data “cannot be explained by investor demand.” Instead, they theorized that “Tether is used to support and manipulate cryptocurrency prices.”

The allegation by Griffin and Shams — which no one has managed to refute — leads to a staggering conclusion: that the foundation of the entire cryptocurrency ecosystem, on which billions of dollars now depend, is not what it seems. For all investors know, they have handed Tether a license to simply print money — much like the U.S. Treasury but without the accountability. “If Tether was in fact able to issue tokens not backed by fiat reserves, then effectively they would be printing U.S. dollars in the cryptocurrency ecosystem,” Wang Chu Wei, a researcher at the University of Queensland who has also studied Tether’s impact on the cryptocurrency market, wrote in an email. “If that was the case, Tether Limited’s role/power would be not dissimilar to that of a central bank; i.e., the ability to increase money supply and boost asset prices.”

To appreciate why Tether has such outsized importance, it’s essential to understand how it fits into the overall world of cryptocurrencies. The blockchain’s design makes it easy for traders to move cryptocurrency of any stripe between exchanges without having to disclose their identities. While terrorists and other criminals love this feature, governments and regulators do not, so they enacted rules to improve transparency. That push essentially created two crypto marketplaces: one that follows the law, and one known for a more fast-and-loose approach.

The first type, “banked” exchanges, have relationships with traditional finance sources. One example is Coinbase, an outfit located in San Francisco that lets U.S. residents buy bitcoin and other popular digital tokens with credit cards and redeem them for government-backed currencies such as the U.S. dollar and the euro. To meet federal “know your customer” regulations, Coinbase demands that clients verify their identity by uploading government-issued ID.

“If you want to convert from bitcoin back to U.S. dollars, you have to touch the traditional financial system,” says Tyler Moore.

Unbanked exchanges ask fewer questions about who their users are, so most banks refuse to work with them. Binance, a Malta-based exchange, lets customers trade 380 currencies, but only for other crypto. If you want to cash out, you have to transfer your coin to something that a banked exchange is willing to work with — bitcoin, Ethereum’s ether, and Litecoin are three of the most popular — and sell it there.

“If you want to convert from bitcoin back to U.S. dollars, you have to touch the traditional financial system,” says Tyler Moore, a professor of cybersecurity at the University of Tulsa who has studied cryptocurrency fraud. That sets up a tension between the desire for hard assets, which require oversight and accounting, and the unfettered freedom found on unregulated, unbanked exchanges. “These exchanges are black boxes,” Moore adds. “It’s safe to say that these markets are not fully understood.” Allegations of wash trading, spoofing, and other forms of illegal market manipulation abound.

Tether was established in 2014 as a link between the wild world of cryptocurrency and the more buttoned-up world of fiat money. It was designed such that, like fiat currency, its value would be stable, but like crypto, Tether could whizz unfettered through the murkier corners of the global economic system. If you’re trading on some sketchy exchange in Kazakhstan and want to park your profits in something stable for a while, you can purchase Tether. You can then turn that Tether seamlessly into a different crypto asset, slide it over to a banked exchange, and cash it out there.

What you don’t want to do with Tether is hold onto it as an investment. Unlike every other cryptocurrency, Tether has no hope of suddenly exploding in value. It’s engineered explicitly not to provide any kind of a return. For instance, if you bought $2,500 worth of Tether a year ago, you’d have $2,500 today; if you put the same money into Bitcoin, you’d have ridden it up to $18,000 — and hopefully sold at the height before tumbling back down to the current price, which would still be more than double what you started with.

The quantity of Tether started to grow in early 2016, and by the end of that May, the market cap had risen to $2 million; by July, it stood at $7 million.

For that reason, it’s not clear why Tether Limited, Bitfinex, or their investors would want to mint Tether in the first place. Unlike users on the secondary markets who can easily zip between Tether and other crypto, someone who wants to create new Tether is supposed to do so by laying down a block of cash that will serve as the new coins’ reserve. This reserve then sits in a bank account earning nothing, not even savings account interest. Sure, they can use the Tether they’ve been granted in return to invest in other cryptocurrency, but you don’t need Tether for that.

For Sarit Markovich, a professor in the Strategy Department of the Kellogg School of Management at Northwestern who studies cryptocurrency, the motive for minting Tether is unclear. “I don’t understand the business model,” she says.

Nevertheless, Tether has grown wildly. For the first year or so after its debut in 2014, it was a fairly small-scale venture that operated largely under the radar, with less than $1 million worth of coins in circulation. The quantity of Tether started to grow in early 2016, and by the end of that May, the market cap had risen to $2 million; by July, it stood at $7 million. After a six-month pause, it started climbing again in early 2017, hitting $25 million on February 1 and double that in April.

Then came trouble. That month, Wells Fargo ended its relationship with Tether, and the company issued a statement on April 22 declaring that “all incoming international wires to Tether have been blocked…As such, we do not expect the supply of tethers to increase substantially until these constraints have been lifted.” Despite this change in its business plan, the value of coins in circulation continued to expand exponentially, from $50 million in April to $440 million in September. Today it stands at more than $3 billion.

No one outside Tether knows whether this growth is attributable to investors pumping cash into the currency or if the company has simply summoned money out of thin air. Cybersecurity analyst Tony Arcieri believes it’s the latter, writing that “Tether is being used to effectively counterfeit hundreds of millions of dollars of perceived value.”

Tether replied to the allegation in an email to Medium: “We can confirm that Tether is fully backed by USD reserves,” a spokesperson wrote. On June 20, it released a report it had commissioned from the Washington, D.C.–based law firm of Freeh, Sporkin & Sullivan (FSS) attesting that “Tether’s unencumbered assets exceed the balance of fully-backed USD Tethers in circulation as of June 1st, 2018.” The report included important caveats, however, stating that “FSS makes no representation regarding the sufficiency of the information provided to FSS,” and “FSS is not an accounting firm and did not perform the above review and confirmations using Generally Accepted Accounting Principles.”

Let’s assume, though, that Tether really does have $2.7 billion sitting in a safe somewhere. Where did it all come from?

This kind of language raises questions. The white paper that heralded Tether’s creation explicitly calls for regular audits. Without them, anyone buying Tether is effectively operating on faith. Think about it: You can barely rent an apartment without going through a credit check and proving you can cover the cost. You’d think the market would demand some concrete assurances about the issuance of $2.7 billion worth of currency.

Let’s assume, though, that Tether really does have $2.7 billion sitting in a safe somewhere. Where did it all come from? The most innocent answer is that some deep-pocketed investors decided they wanted to invest in cryptocurrency, but rather than simply buy some with dollars, they instead opted to buy Tether first and then use that to purchase the crypto.

Just why anyone would do that remains unclear, especially since, as UC Berkeley computer science researcher Nicholas Weaver has pointed out on Lawfareblog.com, “[O]ne has to believe that they did this even though these unregulated exchanges have a history of getting hacked, with customers losing their investments.”

A less innocent answer is that the investors couldn’t go to a banked exchange because their funds came from illegal activity, so they used Tether to turn their ill-gotten gains into untraceable crypto loot. In other words, money laundering.

Perhaps the most troubling answer for crypto investors is that Tether minted currency out of thin air, used it to buy other cryptocurrency, sold that cryptocurrency, and used the proceeds to create its reserves. That is, assuming the reserves actually exist at all.

In a sense, though, it doesn’t matter whether the money is in the bank or not. Tether’s terms of service state, “We do not guarantee any right of redemption or exchange of tethers by us for money.” Even if the money is in the vault, Tether holders have no claim to it.

So, what is Tether worth? In the early days after its introduction, the answer was obvious: The coin was worth a dollar, because the two were interchangeable at will. Since that’s no longer the case, one might expect Tether’s value to float, much as the Argentine peso did after it was decoupled from the U.S. dollar in 2001. It hasn’t. Even when several hundred million new tokens hit the market, as happens fairly often these days, Tether’s price stays locked to the dollar.

The seemingly bulletproof stability of Tether is critical for cryptocurrency markets, because as the volume of Tether swelled, so did the proportion of the overall trading volume that took place in it. Tether’s ubiquity means it plays a crucial role in determining the published price of bitcoin. That price is a volume-weighted average of bitcoin’s price on all the markets on which it’s traded. Since three times as much bitcoin trading takes place in Tether than in U.S. dollars, this means that the published price is based three times as much on Tether trades as on dollar trades.

Most of the smaller cryptos don’t trade in U.S. dollars at all, yet their prices are also reported in dollars.

The obscurity and complexity of cryptocurrency valuation should be a red flag for investors, experts say.

None of this would matter if Tether really were equivalent to U.S. dollars. But it is functionally a completely different currency. Dollars and Tether trade on different exchanges and are not visibly interconnected. There’s simply no functional reason why they should be treated as being equivalent. It’s true that dollars and tethers are directly traded in tiny amounts on a single exchange, Kraken, but a recent Bloomberg investigation found that this market showed signs of rampant manipulation.

So what, then, does CoinMarketCap mean when it lists the price of Tether as close to $1? Buckle in, because things are about to become confusing.

“The price of USDT itself, like any other coin or token on the site, is a weighted average of all the available markets by volume,” says Luke Wagman, chief content officer at CoinMarketCap. Since virtually all Tether trading occurs in markets where it is traded against bitcoin and other cryptocurrencies, the only way to arrive at a dollar price for Tether is by dividing its price in crypto by the price of that crypto in dollars. But the dollar price of most cryptos is itself in turn derived from trades with other cryptos, primarily Tether.

If you’re confused, well, of course you are. We’re in a hall of mirrors. The price of crypto is derived largely from trades in Tether, the price of which is derived from trades in crypto, the price of which is derived largely from trades in Tether.

The obscurity and complexity of cryptocurrency valuation should be a red flag for investors, experts say. “When we don’t know how price discovery is happening, that’s a recipe for abuse,” says Rosa M. Abrantes-Metz, a professor at NYU’s Leonard N. Stern School of Business who studies market behavior.

The valuation of Tether would be entirely a self-referential process, with the price of Tether being defined as arithmetically equal to itself, were it not for the existence of U.S. dollar (and other fiat) bitcoin markets. A change in the price of bitcoin in these markets, without a concomitant one in Tether markets, will shift the price of Tether away from a dollar. So, essentially, when someone says that a Tether is worth a dollar, what they’re saying is that the price of bitcoin in Tether on unbanked exchanges is the same as the price of bitcoin in dollars on banked exchanges. But there’s no obvious mechanism for keeping the two values at parity.

“Tether doesn’t have a built-in (blockchain-coded) stability mechanism as far as I can tell,” an academic who studies wrote me in an email. (The source asked for anonymity in order to prevent “a mob chasing me.”)

“I find this parity something extremely puzzling, because there is no reason for their prices to stay matched,” agrees NYU’s Abrantes-Metz. “If things trade freely, the only way to keep parity is for someone to actively intervene in the markets.” But who, or how, is unknown.

Until that day comes, many welcome the apparent liquidity that large amounts of Tether in the market provide, as well as the support it lends to the price of bitcoin and other cryptos.

“It seems to be a belief-based equilibrium,” the anonymous academic adds. “You are supposed to always be able to find a someone who will buy a Tether from you for $1. If you believe that is true, you will think it’s worth $1, and therefore you are willing to accept $1. This kind of equilibrium falls apart if people stop believing that the conversion will occur.”

David Weisberger, CEO of the cryptocurrency data provider CoinRoutes, agrees that the key to Tether-dollar parity is the widespread belief that others believe in it. “It’s a self-fulfilling prophecy,” he says. “I know it sounds stupid, and it sort of is. Until it doesn’t work, people will continue to use it, and as long as they continue to use it, it will keep working. While we have no opinion on Tether’s backing, if it isn’t fully backed and that fact becomes known, however, it would be like musical chairs: Whoever’s holding it when the music stops is screwed.”

Until that day comes, many welcome the apparent liquidity that large amounts of Tether in the market provide, as well as the support it lends to the price of bitcoin and other cryptos.

Skeptics take it for granted that sooner or later Tether will collapse, either because the authorities will crack down and shutter Bitfinex or because the market participants will finally lose faith. In the latter case, says Markovich from the Kellogg School of Management, “I think it’s going to take time, because it’s about people losing trust. So you’re going to have the first ones losing trust, at some point it’s going to build up, and then you’re going to have a collapse.”

How bad could the bloodshed get? One possible indication is that before Tether tokens began flooding the market at the start of 2017, bitcoin was priced at less than $1,000. “If there’s a panic in the market, we’re going to go to the same price we had before,” Markovich says, “and we’re going to see it across all cryptos.”

If bitcoin returns to pre-boom levels, then, five-sixths of its current value — about $90 billion — would be wiped out.

Or it could get even worse. A large and growing body of economists and cryptocurrency experts are convinced that the crypto market has evolved in such a way that it’s no longer possible to give it any kind of valuation at all. As Brazilian computer scientist Jorge Stolfi wrote in a letter to the U.S. Securities and Exchange Commission, “The price of bitcoins is totally fictitious.”

Update: An earlier version of this article incorrectly described Bittrex as an unbanked exchange. The company partnered with Signature Bank in New York on May 31, 2018.

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