Tether & The Discourse Integrity Crisis
Thoughts on the opaque, unaudited, de facto Crypto Federal Reserve
“Trusted third parties are security holes.”
— Nick Szabo
The events of the past week seem to have forced many to question their faith in the long term economic viability of giving four mysterious guys the power to create a limitless amount of US dollars.
This is an attempt to explain the situation, diagnose what went (& is currently going & will inevitably continue to go) wrong, and spell out an (obvious) prescription for preventing future catastrophes.
Deep breaths, here we go:
What Tether Is
For those late to the party, here’s some background:
Tether is a cryptocurrency that isn’t really a cryptocurrency. Which is to say: the market value of typical cryptocurrencies, like Bitcoin, have been notoriously volatile, which presents risk to anyone holding or — more to the point — trading them. This volatility creates demand for traders to be able to quickly and easily liquidate their assets into fiat currencies like US dollars, which is cumbersome when using exchanges that don’t support US dollar pairings (given the general wild wild west-ness of the space, such exchanges are still numerous).
Enter Tether! Tether is a “cryptocurrency” that serves as a stand-in for US dollars. Like typical cryptocurrencies, it can be traded peer-to-peer on a blockchain network (most tethers use Bitcoin’s omni-layer protocol) freely, without requiring any arbitration from intermediaries. But unlike most other cryptocurrencies, its value is (in theory) not volatile. The idea is that its price stays consistently pegged to that of the US dollar, which is to say, one tether (USDT), should always be worth exactly one USD. This is achieved (they say) by maintaining private, regularly audited reserves of actual US dollars, equal in value to the USDT in circulation, and offering (they say) easy redemption of tethers to US dollars.
What We know
Okay, so that’s the idea. Here’s what we know, with absolute certainty, has happened so far:
- The fine print in their Terms of Services, as of November, indicated that they offer no guarantee of US dollar redemption. Since then, they updated the terms indicate that they offer redemption to “verified customers.”
- Few people, if any, have ever been able to successfully redeem their tethers.
- Their supposed US dollar reserves have never been audited by a third party. Last week, after having promised an audit from Friedman LLP for months, Tether announced that they had fired the firm.
- Suspicions of connections between the popular cryptocurrency exchange, Bitfinex (who has historically controlled much of the tether supply), have long existed and have long been denied by the Bitfinex team, until the Paradise Papers revealed that the men running Tether and the men running Bitfinex were in fact the exact same people.
- Word leaked last week that the Bitfinex/Tether team had been subpoenaed by the CFTC in December.
- Before Tether had been subpoenaed, they had created a total of 815 million USDT. In the the 8 weeks since, they have created an additional 1.4 billion.
What We Can Reasonably Conjecture, or, Why This Has Been a Disaster Waiting to Happen From the Start
Creating money out of thin air isn’t sustainable, tethers won’t ever be redeemable, ergo the value of Tether is destined to completely collapse.
Now how bad would this really be? A common assumption you’ll see from die-hard crypto-optimists goes something like this: “Tether’s total market cap is only ~2 Billion dollars — the total cryptocurrency market cap at this minute is [x] hundred billion dollars! Even IF Tether crashes, that means only 2 Billion disappears. Big deal!”
It’s hard to know where to start here, although admittedly, some (but not all) of what follows does get into conjecture territory. I have no special information here; much of this borrows from research/analysis of @bitfinexed (more on him later). Do your own research, come to your own conclusions, etc, etc.
The Obvious
First off, 2 billion dollars disappearing from the market, just in and of itself, necessarily affects far more than those 2 billion dollars of assets. Recall what’s happened when loans have been defaulted in certain recent global economic crises, and the ripple effect this has.
Buoying The Bottom
The function Tether serves isn’t just reflected in its US dollar value; tethers provide a service mitigating against fear of volatility (as described above). When the global markets cap goes down, people want to cash out, and cashing out, for many, means buying tethers. So, if these tethers’ availability is mitigating market crashes, then we would expect that with less tether activity, markets would dip lower before stabilizing.
During the recent crash, the Tether printer was noticeably silent (perhaps they didn’t want more bad press, who knows), and what followed was the biggest cryptocurrency crash since the Mt. Gox hack in 2013.
Inflating the top
Some have argued that there’s evidence that Bitfinex still owns most of the Tether in circulation, and that they’re using it to artificially inflate market prices via spoofing, wash trading, painting the tape, etc. If so, then no more Tether means prices will deflate accordingly.
Keeping the Peg
It would appear that Federal Reserve — esque manipulation of the circulation supply of Tether’s is their actual mechanism for maintaining the dollar peg. For example, in the four day span from 1/16 to 1/19, while markets were plummeting, 500 million USDTs were created. If this is indeed what’s going on, then we would expect the inverse to be true as well; as Tether decreases in value, Tethers should get burned. And indeed, just last Wednesday, as the value of USDT briefly dipped, they — for the first time in history — burned tethers (30 million of them, it turns out).
Creating a Misleading USD Market Cap
What exactly is meant by a currency’s market cap? This measurement — arrived at by taking the average current trading value of a coin across different exchanges and simply multiplying it by the amount of said coin in circulation — is a bit suspect to begin with (though admittedly, I’m not sure I have a better suggestion). But there’s a deeper question of how the value of this trading activity is being measured to being with. Tether often has the third highest trade volume of any coin. Furthermore, as of writing, according to Coin Market Cap, the highest trade volume of Bitcoin at a given source is BTC/USD at Bitfinex. But this is Bitfinex, so are these really US dollars, or are they Tethers? You might be amazed at how hard it is to find a concrete answer, and the fact that the market has evolved to treat USD and USDT as functionally the same at this point should at least provoke questions about how much of this house of cards rests on the stability of this supposed stable-coin.
What a Collapse Might Look Like
Probably less like the market cap dipping by 2 billion, and more like this: Tether indefinitely stops adding and removing the currency from the supply (either because they don’t want eyes on them, or because they’re in jail at this point, whatever).
More bad news from Tether-land hurts faith in USDT, creating a Tether sellers market, so the USDT decreases in value to well below a dollar. Crypto holders momentarily see their coin values, and the global market cap, spike in value, briefly get excited, until they realized the spike isn’t relative to dollars but to depreciated USDT.
Or alternatively, the market keeps on dipping for unrelated reasons, people still (somehow) have enough faith in USDT to want to cash out into it, creating a Tether buyers market, so Tether actually temporarily increases in value to greater than one dollar, making the global market cap appear to suddenly drop.
Either way, given that the whole function of a stable-coin is to remain stable, once the stability goes, Tether effectively becomes worthless. Traders realize how far their holdings really are from being liquidated to actual dollars, lose faith in the market cap measurement itself, a panic sell into banked exchanges like Gemini and Coinbase ensues, we get network congestion and high transaction fees, exchanges themselves can’t handle the bandwidth, more panic selling, etc, etc, etc, down goes the market.
The “Real Problem”
Here’s the thing though: we could spend all day on the gory details — combing through the Bitfinex dirt, waxing theoretical about economic speculation, drawing analogies to hot-potato credit default swaps and Tulip-mania / Wiley Coyote lessons of the past — but that avoids the more important question about the state of our public discourse: how is it possible that so many people let things get so bad?
Mathematician Eric Weinstein has said some interesting things about the decline, in the Trump era, of what he refers to as “semi-reliable communal sense making.” Random example: consider your current opinion of Michael Wolff’s “Fire and Fury.” Is it the most damaging takedown of an American Presidential administration in recent memory, or a total hoax? Whatever your view is, one thing is clear: gaging the sentiment of public discourse offers you little to no help in answering that question. By and large, regardless of particular facts, opinions will land precisely where individual biases would lead one to assume they would. This forces us poor citizens into the position of having to all become amatuer investigative journalists, which few have the bandwidth for, given that most of us have to worry about things like work and raising kids and eating and stuff.
Take that dilemma, scale it down to a fringe online community, and then multiply it by a few orders of magnitude, and you have the current problem in the land of Crypto.
Communicating the blatant risk that is Tether isn’t all that difficult. One needn’t be Friedrich Hayek to see that making dollars out of vapor is ultimately a bad idea. The leading voice — by far — in trying to warn people has been @Bitfinnex-ed, who’s been tirelessly investigating and tweeting about all of this since last summer. He’s done an impressive job. Hell, I’d give him a pulitzer. But why have we come to relying on an anonymous blogger volunteering his free time to inform us about what may prove to be one of the biggest cases of fraud in recent memory? Why so little mainstream coverage until very recently? And more importantly, why so little attention from the outspoken Crypto-evangelicals?
The frustrating thing isn’t just that the people with the knowledge and megaphones aren’t using them: it’s that this group is almost weirdly well-suited to diagnose and explain this particular problem. The crypto-libertarian-anarchist types are the ones constantly trying to warn us of the dangers middle-men in financial transactions, and, more particularly, of granting the federal reserve the power to control currency supply in particular. Creating a payment system that doesn’t necessitate these trust vulnerabilities was, in fact, the whole impetus for creating Bitcoin in the first place (remember those days?) And what’s happened, in effect, is that a group that has done nothing to earn anything but suspicion at best (and, to be blunt, contempt at worst) are being entrusted with keeping the entire exchange market machine running. To say that a blind eye has been turned is putting it gently.
Which is not to suggest that none of the true believers have been making noise about this. But clearly, it’s been too little too late. Perhaps the direct incentives involved may be the core of the problem. Political/cultural biases are one thing; it’s another thing entirely when perpetuating a narrative leads to direct monetary gain. Put another way, the venn diagram of people who know and understand these risks and the people who benefit in the short term from keeping it hush-hush has far too much overlap. The loudest voices are far too partial; the impartial voices get chastised for spreading FUD whenever they say anything less than bullish. The de facto information gatekeepers have thus been able to keep this all at bay.
And that’s just it: keeping this at bay is a really, really terrible idea, no matter how you look at it. Recognize danger and failing to point it out — whether you think you’ll somehow end up on top, or you think that somehow keeping excitement alive will work out better than scaring others of something they ought to be scared of — is shortsighted, irresponsible, and frankly insane. Gravity will take effect. Water will flow down the path of least resistance. You can tell people to brace for a crash landing, or you can keep flying higher and try to hide the fact the plane is out of fuel. Just keep in mind, you’re on the plane too.
Conclusion: Looking forward, Desperately Grasping For Optimism (and finding it, sort of)
Tether is the biggest security hole imaginable. If you care about cryptocurrency, you ought to look forward to its crashing. Let’s hope that the market delivering coin traders a kick to the teeth forces enough people in the space to realize that maintaining a community without appointed leaders requires a strong network of white blood cells, and unless they emerge, we’ll just find ourselves in the same mess again.
Let’s also remember that if you’re like me (and who isn’t?), the reasons you became consumed by cryptocurrency and blockchain technology had next to nothing to do with market prices. Little perspective: strangers across national boundaries can directly transact in a protocol that functions without reliance on external third party interference in the form of bureaucracy and threats of force. Craziest part: it’s actually working. At the risk of sounding fluffy, it’s hard to overstate how unprecedented and dizzying this truly is. Even those closest to the metal are still struggling to grasp the implications, and what the ultimate outcomes of all of this will look like. And while the results might not directly translate into a five-fold increase in your bank account balance, they may — I know, I know, but they just may — be more exciting. Let’s do our best not to lose sight of this. And in the meantime, should the Tether infrastructure indeed keep burning down, let’s just be sure to salt the ashes.
