Last week in Snippets, we teed up the story of Tether: one of the greatest scams we’ve ever seen. We walked through the idea of “stablecoins” and why people have wanted them to exist since the early days of cryptocurrency. And we teased, but did not answer, a remarkable question: could last year’s incredible bull run for Bitcoin and the rest of crypto have been almost entirely driven by one very subtle, sophisticated and systemically entrenched actor? It sure looks like the answer is yes, and today we’re going to see how.
First, a note: we owe a huge debt of gratitude to the handful of people who spotted and exposed this as it happened in real time. One in particular is an anonymous Twitter persona, Bitfinexed, who’s absolutely worth following and from whom I learned the most about this whole mess. To explain this story, I’m going to borrow one of Bitfinexed’s metaphors and extend it a bunch — so both for the metaphor idea and for the early and insistent alarm writing even when it wasn’t popular, thanks to Bitfinexed, whoever and wherever you are. Ok, everybody ready? Seatbelts.
Imagine that you’re in the practice of speculating on the price of Pokemon cards: you believe that the generally rising interest in Pokemon, plus your skill as a trader, will allow you to make money buying and selling cards. One particular card, Charizard, is particularly interesting to speculators because they have a fixed supply: only 21,000 of them can ever be created, so that makes them potentially interesting as a speculative asset. But there are lots of other Pokemon, too, each with their own interesting properties and effects.
Now imagine there are two kinds of markets for Pokemon cards: first, there’s eBay, where cards are bought and sold for real US Dollars, in the real world. Second, there are Pokemon trading conventions, where enthusiasts come together to play and trade cards with one another. In these conventions, no outside money is allowed (i.e. there’s no banking): traders can trade any cards they want between each other as they’d like, and they can respond to news that’s happening in the outside world as they’d like, but no US Dollars may enter or leave the building. Both kinds of markets have something to say about the desirability of Pokemon cards relative to one another, but only the first kind (eBay) can really say anything conclusive about the value of Pokemon cards relative to real US Dollars. Which, of course, is what you actually care about.
(So far, to make sure everyone’s on the same page in our analogy: eBay = Crypto exchanges that have real banking and can cash you out in real dollars; e.g. Coinbase/GDAX, Kraken, Gemini; whereas Pokemon conventions = exchanges that do not have USD banking and can only trade cryptocurrencies amongst one another: e.g. Binance, Bithumb, and others, allegedly. Oh, and Charizard is Bitcoin. Other Pokemon are all the other coins.)
Now imagine someone shows up at the card convention with a new card called “PokeUSD”. He claims, “The value of this card is tethered, 1:1, to the US Dollar. These cards are backed by real money: any time you want, you can leave the convention and redeem them for $1, on eBay or anywhere else you like.” (For a background on “stablecoins” and how people are trying to create and use them, refer back to last week.) If enough people at the convention believe this guy, then very quickly we’ll see trading pairs get established between all kinds of different cards and PokeUSD. Initially they might trade at a discount (the PokeUSD-denominated price would be higher than the US dollar quote on eBay), but in time the 1 to 1 conversion rate seems to hold up, so the prices inside the convention eventually converge to the same as they are outside. Before too long, traders at the convention start simply referring to PokeUSD as “Dollars”. Newcomers arrive at the convention, and don’t know (or care) about the difference between a PokeUSD versus a Real USD; the numbers look the same to them.
(Back to our analogy: PokeUSD are Tether tokens; sometimes abbreviated as “USDT”. Trading card conventions that have adopted PokeUSD, trade in PokeUSD, and call them “dollars” are unbanked crypto exchanges that denominated in USDT, or as we’ll call them, “Tether exchanges”.)
Now, what happens when our friend from before shows up with a giant box full of PokeUSD? And then another, and another? Well, if you were skeptical, you’d ask, “Are we sure these are really fully backed and redeemable for actual cash? How do we know this guy’s not just… printing them?” But — here’s the thing — everyone at the convention is heavily invested into Pokemon cards. They see this influx of new “money”, which we’ve gotten into the habit of just calling “dollars”, and say Alllllllllright!!! and high five each other: all these new “Dollars” are pushing up the prices of their Charizards and their Mewtwos and all their other Pokemon. (As an aside: there’s a great line from a recent season of the show Bojack Horseman, “When you’re wearing rose coloured glasses, red flags just look like flags.” That’s exactly what’s happening here.)
As more and more PokeUSD show up at conventions everywhere, the dollar-denominated prices of Pokemon go up, and up, and up. Some people successfully cash out their PokeUSD and their cards for real dollars, but most people reinvest their gains into more cards; much larger numbers of newcomers join the party, bringing real dollars of their own from the outside world and investing them into cards themselves. So, yes, there is a lot of new money coming into the Pokemon card ecosystem — CNBC is giving them 24/7 coverage and Floyd Mayweather has announced his own new line of Pokemon cards, so there’s that — but beneath the surface it’s all being primed by these PokeUSDs that reliably flow into conventions everywhere, often at exactly the right time to soothe mini-corrections and stoke new rallies. Some community members object to the hyper-inflation of the Pokemon community and become self-described “Charizard maximalists”, insisting that the value of all other Pokemon will eventually crash to zero. But their own Charizard holdings are massively boosted by the overall euphoria for Pokemon, so their objections are mostly drowned out. The PokeUSDs still cash out at 1 to 1 as promised, so no one asks too many questions. (The reality, as we will later find out, is that PokeUSD are indeed backed by something — they’re getting cashed out from a big pile of Charizards, whose value has skyrocketed because of all the printed PokeUSD!)
Eventually, some skeptical sleuths notice some funny stuff going on at one of the biggest and most popular exchange conventions, PokeDEx. (Sorry, sorry, I couldn’t help myself.) There seems to be a lot of really odd price movement on PokeDEx: lots of vanishing orders, strangely paced trading volume, and other cues that should ring a bell from the other week. Further investigation confirms what we’ve been seeing: there is indeed a LOT of wash trading, spoofing, and other illegitimate activity on PokeDEx that seems to be highly correlated with new arrivals of fresh PokeUSD. Eventually, right as the euphoria for Pokemon cards is nearing its peak, the shoe drops: PokeUSD and PokeDEx are owned by the same people.
It all starts to make sense. And the whole house of cards starts to reveal itself: the price of Charizard, the price of every other Pokemon, everything about the past year’s bull run — is a product of all that printed PokeUSD, which for so long was just synonymous with “dollar”. But it’s not. Not for long, anyway.
(Back to our cheat sheet once more: PokeDEx is Bitfinex; the “big reveal” that Tether and Bitfinex are one and the same happened in November of 2017 with the Paradise Papers leak.)
Careful analysis of price and volume movement in 2017 backs this up: although there certainly was a large influx of retail money coming in last year that contributed to the crypto surge, that money was mostly lagging: it was playing catch-up to the real price booster, which was Tether printing. We were watching a pump happen, but instead of regular wash trades driving public FOMO, it was this a new kind of scam that was centered around something we didn’t have good pattern recognition for: the “Tethers = Dollars” sleight of hand.
So, coming back into the real world, the first thing we need to say is that the story isn’t over: we’re still figuring out what’s going on. But we can still appreciate the sheer complexity, brazenness, and implications of what happened: Tether and Bitfinexed gamed the entire cryptocurrency world. They gamed everyone. Even if you had nothing to do with Bitfinex or any of the Tether-denominated exchanges, you were still playing in a world where the price of Bitcoin and every other cryptocurrency was being manipulated by a single entity that held a dominant position. They could print Tethers with impunity, distribute them out first through Bitfinex and then launder them through other exchanges (who needed Tethers in order to be able to show USD denominated prices on their own exchange). Printing Tethers made prices rise; rising prices not only brought in new investor cash (as a pump and dump scheme would), it also increased the value of their own crypto holdings that were “backing up” each newly issued batch of Tethers in case anyone ever tried to get their US Dollars out. And they might have even gotten away with it, too, were it not for one crucial lynchpin on which the entire scheme rested: how did they keep the 1 USD to 1 Tether Peg going for so long? We’ll get to that question, as well as what has happened in recently, next week.
In this week’s recommended reading links, we have something slightly different: not links to articles or books, but to Twitter threads that are worth your while.
First, this tweet from James O’Malley, showing the “Five Star Rating for your personal life” dystopia in real life — of course, in China. The “Social Credit System’ being trialed around China right now is particularly Black Mirror-ish (seeing as it was actually a Black Mirror Episode, and one of the more memorable ones too). It’s also an interesting counterweight to much of what’s going on in the United States and elsewhere around the world: ubiquitous internet connectivity enforcing pro-social behavior in some countries (with darkly totalitarian overtones) versus ubiquitous internet connectivity fostering rabid anti-social behavior in the west, as we grapple with a crisis of “the whole world is becoming online trolls” without any real levers to pull.
On a lighter note, check out a delightful and interesting Twitter thread by Max Fagin about a massive change (pun intended) coming to the scientific community, and by extension, the whole world, this November. You may know about SI “Base Units” from which all other units of measurement are calculated: the meter, the second, the degree Kelvin, the kilogram, and others. All of these units were initially defined by Earthly parameters: one second, for instance, used to be strictly defined as 1/86400 of the time it takes the Earth to rotate once; we’ve since moved on to more universally-consistent definitions. (A second is now defined as the amount of time it takes an electron in a Cesium-133 atom to oscillate 9,192,631,770 times over.) All of them, that is, except one: the kilogram, which is still defined to this day as the exact weight of a particular object that is stored in a vault in France. But not for long: we’re finally closing the book on that chapter in a few weeks. Max’s Twitter thread is excellent so please give it a read if you’re so inclined.
Old dogs, new tricks?
The stark vulnerability of our voting infrastructure:
(Yes, it’s the same Ryan North from Dinosaur Comics)
Transportation-as-a-service has a dark side:
Other reading from around the Internet:
And just for fun, one of the most entertaining podcast episodes I’ve ever heard:
Every week at Social Capital, both here in Snippets and otherwise, we share news and notes about what’s going on with the team, with portfolio companies, and with every member of the extended family. But this week was a particularly special one: we published our annual letter, which is open to read for the public:
The letter was clearly an anticipated ticket, as traffic from readers immediately crashed our website — so after re-hosting it on AWS, we’re now finally pleased (after take two) to share this letter as the first of many: our thoughts on the markets, on tech, on our performance, and on our mission.
Investor letters are one of the great traditions of the investing world, and one reason why our practice is sometimes called “the last liberal art.” Great letter-writers, like Howard Marks from Oaktree, and Warren Buffett in his yearly letters to Berkshire Hathaway shareholders, aren’t just publishing a report card — although that is part of it! — they’re also taking the time to say whatever they feel that their audience ought to hear. Venture capital is often an exception to this rule: it’s not common for funds to publish their returns. In the interest of transparency, we are publishing ours, both this year and in each annual letter thereafter. (As always, refer to the end of the letter for necessary disclosures.)
The rest of the letter outlines how we see the state of the venture world, as of late 2018: the good, the bad and the ugly. This isn’t the early innings of innovation anymore: we’ve reached a point of undeniable maturity, both for front end software development and business creation and for the back end infrastructure that supports it all. The Googles and Amazons of the world can continually reallocate capital back into their own business, precisely and aggressively. New money, in funds both small and large, pours into the ecosystem every week; pressure on VC returns continues unabated, as the VC index broadly continues to trail the S&P over any measurable time period. Put generally, the big picture world is maturing, and that maturation presents a new set of challenges.
When we look into the gritty details of where and how all of this investor money is being spent, the picture doesn’t get any prettier. Nick Sibley’s line about banking applies: “Giving capital to a bank is like giving a gallon of beer to a drunk. We know what will come of it; we just do not know which wall he will choose.” We’ve reached a point in today’s venture-backed startup ecosystem with ad spend that feels similar, and skyrocketing valuations (propped up by VCs bidding up and marking up each other’s funds) are only worsening this trend. Fighting your way into market is increasingly becoming a Red Queen’s Race: an accelerating treadmill of dumping more money into more expensive ads, increasingly subsidized products, and accelerating table stakes.
So what is the solution? The solution is not to continue the status quo: it’s to return to the roots of venture investing, by deliberately committing to learn and double down on specific areas of the future we care about and where we want to make an impact. It’s also time to change our relationship with the capital we allocate: away from the fee-driven game that has enveloped so much of the industry, and towards establishing ourselves as a holding company with permanent capital of our own. Please read Chamath’s letter to get it straight from the source: you won’t regret it.
As a final note to follow our annual letter, we want to say thank you to everyone who supports Social Capital, in whatever way you do — whether it’s by working with us, hoping to do so in the future, or even just by reading and sharing what we believe and challenging us to get better every day. This includes Snippets readers of course! Thanks so much for your continued readership, and as always, you can invite friends to sign up anytime at socialcapital.com/subscribetosnippets.
Have a great week, and don’t forget to vote!
Alex & the team from Social Capital
Disclosure: Social Capital is a technology holding company that only makes proprietary investments from our own balance sheet of permanent capital. We are not open to new investors and no longer raise funds or otherwise provide investment advice to others. This letter must be read together with the supplement disclosures attached to it which are integral to the information contained in this letter.