Will the Tether fraud bring down bitcoin?

Yesterday, I talked about the bank run in the film It’s a Wonderful Life, and showed how the same thing happened to Metro Bank last Saturday.

Both events, the fictional one and the real one, were started from rumours. And both were able to happen because of the way the banking system works.

As I showed yesterday, banks only have to hold a tiny fraction of people’s deposits in reserve. The rest of the money they loan out and collect interest on.

The idea behind bitcoin was that it was to be an alternative to this system, doing away with banks, making money printing impossible and cutting out middlemen.

But last month it was revealed one of crypto’s major players had been taking a leaf out of the traditional banking handbook.

The importance of stablecoins

Tether is what’s known as a stablecoin. Unlike most cryptocurrencies, stablecoins are designed to keep a stable price.

Most of them, Tether included, are pegged to the US dollar.

Stablecoins are an incredibly important development in crypto because they mean people can use crypto like an actual currency.

Convert $3,000 of bitcoin into a stablecoin and a year later your stablecoin stash will still be worth exactly $3,000.

This means people can do things like get paid in stablecoins and not worry that they’ll lose all their money if crypto prices drop.

It also means people can buy products and services with stablecoins and not end up like “bitcoin pizza guy”… the guy who once bought two Papa John’s Pizzas for 10,000 bitcoin (worth $80,000,000 at today’s prices) back in 2010.

Stablecoins are also fundamental for using crypto exchanges.

By using stablecoins you don’t have to trade back into fiat to take a profit or to cut a loss. You can simply trade into a stablecoin, instantly and at virtually zero cost.

You can even deposit your money on to an exchange and change it directly into a stablecoin so you’re ready to execute a trade whenever you feel like it.

And finally, stablecoins offer a lifeline for countries with hyperinflation.

It’s all very well and good sending bitcoin to Venezuelans, but given that bitcoin can and does double in price in weeks and drop just as fast, it’s not a great store of value. You’re much better off with something pegged to a stable currency like the US dollar – for the time being at least.

So it’s fair to say stablecoins are an extremely important development in crypto.

There are many different types of stablecoins, but the first and simplest model was the asset-backed one. One token is backed by $1 held in reserve in a vault.

This is the model Tether is based on. One Tether represents $1 held in a vault by Tether’s creator iFinex.

Here’s what I wrote about Tether, six months ago, in my October issue of Crypto Wire:

Tether is the most well-known stablecoin – and the most controversial.

One Tether (USDT) represents $1 held by Tether Limited.

There are currently 2.7 billion USDT in existence, so in theory Tether Limited holds $2.7 billion in a vault somewhere.

Whether Tether actually does or not is very much up for debate. There is no way of verifying it.

In fact, Tether is potentially the biggest threat to crypto’s future. If Tether turns out to be a scam, it’s going to take the whole market down with it.

However, due to Tether’s lack of transparency and credibility, other more reputable stablecoins were formed.

For example, on 26 September, Circle announced its own stablecoin, USD Coin. In launching it, Circle’s CEO, Jeremy Allaire even referred to how little trust there is in Tether:

Market infrastructure like stablecoins will become the base layer that supports every financial application. It has to be legitimate, trustworthy, built on open standards. We are solving a lot of these fundamental problems that exist. That’s a huge difference from something like Tether, and we think the market will very quickly gravitate to that.

As you can see, even back then people didn’t trust Tether.

The ugly truth about Tether

Fast-forward to this April and the office of the New York Attorney General announces it is investigating Tether’s owner iFinex for fraud.

From the Wall Street Journal:

A cryptocurrency exchange that claims real dollars back its popular digital coin Tether raided those reserves to cover up $850 million that went missing, the New York Attorney General’s office said Thursday.

Now, the reason this is such a big deal is Tether is responsible for most of the daily trading volume in crypto.

The Tether cryptocurrency itself has a market cap of $2.8 billion. So in theory iFinex holds $2.8 billion in a vault somewhere.

If it turned out that it didn’t – as many have long suspected – Tether’s price would no longer remain stable and it could drag the entire crypto market down with it.

So as you can imagine, when this news came out, crypto markets crashed… for about 24 hours. Within a couple of days, crypto was back up as if nothing had happened.

Since then two other developments have happened.

Firstly, iFinex admitted it doesn’t actually back Tether on a 1:1 ratio. In fact, it is only 74% backed.

From Bloomberg:

The companies behind the digital exchange Bitfinex and the cryptocurrency Tether said the so-called stablecoin is backed by cash and short-term securities equal to 74 percent of the outstanding coins rather than completely pegged to the U.S. dollar.

So iFinex had been taking a leaf out of the traditional banker’s handbook and operating a fractional reserve model – without letting anyone know.

You’d expect this to ruin whatever was left of Tether’s reputation and send the crypto market into a death spiral.

But then we got the second development in this strange story.

Tether’s owner conveniently makes $1 billion in private token sale

A couple of weeks after the above news surfaced, iFinex declared it had just made $1 billion in a private token sale and now had more than enough money to fix its faux pas.

How convenient.

From CoinDesk on Monday:

Cryptocurrency exchange Bitfinex has raised $1 billion through its native token in a private sale, according to its chief technology officer.

Paolo Ardoino‏ tweeted Monday that Bitfinex has achieved the target in just 10 days, with participation from “giant” firms from both within the cryptocurrency industry and outside. The funds were collected in the form of USDT, the stablecoin operated by the closely-linked firm Tether, according to the tweet.

Some of the investors, which were not named, invested over $100 million worth of tokens each, Ardoino‏ said, adding that others also contributed investments of over $1 million each.

And since iFinex’s announcement on Monday the crypto market is up 19% (at time of writing).

So is this really all sorted now as iFinex would like us to believe… or is this just the beginning?

It’s hard to say, but personally, I wouldn’t be putting any of my money into Tether right now, or using the Bitfinex exchange.

Whether or not this will turn out to be a thorn in crypto’s side akin to the curse of Mt. Gox, or simply stumbling block, is still up for debate. As usual only time will tell.

And remember, if you want to stay up to date on the latest crypto developments and, and get my take on the potential of specific cryptos including IOTA, BAT, VeChain and Ethereum, click here.

By following that link, you can get a trial to Eoin Treacy’s Frontier Tech investor service, my Crypto Wire service, and a free copy of my publisher Nick O’Connor’s tech investment book, The Exponentialist. All three things are included in one simple trial.

If that sounds like something you might be interested in, click here now to find out more.

Until next time,

Harry Hamburg
Editor, Exponential investor

Category: Cryptocurrency

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