The Coming Crypto Market Crisis

How the latest crypto boom has morphed into a house of cards

“Controversial” is the latest euphemism to describe any asset or company that most of the financial community, and the media, perceive to be a stone-cold fraud. But until monetary conditions go from crazy loose to somewhat tight, the biggest facades of the latest cheap money boom can’t be exposed or ousted, no matter how obvious it’s become.

Nothing illustrates this more than the neutral but not-so-neutral headlines we’ve seen the financial media run on crypto, from CNBC’s coverage of so-called stablecoin Tether: “The controversial crypto climbing up the ranks!” to Timothy Massad’s Bloomberg op-ed: “Can a Cryptocurrency Break the Buck?”

The rise of crypto doom and gloom has come after a whopping decline in prices. Ever since Chinese regulators started cracking down on crypto and Tesla stopped accepting Bitcoin, citing environmental concerns — not the protection of Musk’s enormous ego, the crypto market has lost roughly half its market cap, now sitting at around $1.4 trillion.

This “dip” has prompted the leading bears of the crypto boom to rise into mainstream circles, claiming Bitcoin’s historic rally has not been fueled by reckless state policies causing a mass dash into inflation assets, but by bad actors committing fraud and manipulating markets. The level of “FUD”, contemporary slang for things that undermine the prevailing crypto hype, has reached all-time highs.

At the center of the controversy lies Tether Ltd. and its popular stablecoin, or “un-stablecoin” as George Gammon calls it, Tether. Its website describes itself as a digital token, built on a variety of blockchain technologies, that maintains a 1-to-1 peg with the U.S. Dollar ($1 = $1USDT). For every 1 $USDT in circulation, Tether has one George Washington to back it up.

Or so they say.

Over the course of the crypto boom, people from multiple disciplines have started to wonder if Tether is what its creators and backers claim it is. Fraud hounds, legal experts, even YouTube detectives have come out against Tether Ltd., alleging its stablecoin is an elaborate swindle, a Ponzi scheme “backed by squirrels and confetti,” as journalist David Gerard called it.

“Tether recklessly and unlawfully covered up massive financial losses to keep their scheme going and protect their bottom lines,” New York State’s Attorney General, Letitia James, said. “Claims that its virtual currency was fully backed by U.S. dollars at all times was a lie.”

CCC cohost, Bennett Tomlin, described Tether’s owners as “a group of dishonest people who are willing to cheat and defraud the public as a whole in an effort to advance their own aims.”

Blogger Matt Ranger doubled down, not only calling Tether “a fraud on the scale of Madoff and Enron” but “the largest Ponzi scheme in history”, one that’s helped fuel the wider crypto-mania. “It’s awesome to live through one of the great bubbles of history,” Ranger wrote. “You get to see in real-time some of the great speculative mania stories, like people paying millions for something conferring no legal claim to anything or the classic yoga instructor selling her house to go all in on speculation.”

Much FUD. Much anger. Why? As it turns out, there’s more than a compelling case to suggest that Tether is a Ponzi scheme, not the beloved stablecoin that’s fueled the bulk of this crypto bull market.

The track records of its founders, and its child company Bitfinex, don’t exactly radiate the confidence and trust you’d want from a currency issuer.

In 1996, before Giancarlo Devasini became Bitfinex’s CFO, he ran Point G Srl: a Milanese company, which Italian police caught pirating substantial amounts of Microsoft software. Stuart Hoegner, General Counsel for both Bitfinex and Tether, used to run compliance at Excapsa, the parent company of notorious online poker room, Ultimate Bet, which gave some players “god mode”: the ability to see other player’s cards. Bitfinex’s Chief Strategy Officer, Phil Potter, had worked for Morgan Stanley in the 1990s, but after boasting about his affluent lifestyle to a New York Times reporter, he lost his job.

At least Bitfinex CEO J.L. van der Velde has a somewhat cleaner past.

Fast forward to today, and they have yet to cleanse their sins. After seeing some of the stuff they’ve pulled since the start of crypto-mania in 2012, it seems their 20th-century antics have just been a warmup. Here are the highlights.

In 2012, Potter, Devasini, and Van der Velde incorporate Bitfinex, a crypto exchange, in Hong Kong, registering Tether Holdings Limited a year later.

During this time, former Disney child actor Brock Pierce has developed Realcoin — a dollar-backed stablecoin. But, in November 2014, he rebrands it to “Tether”, coincidentally, just as Tether Ltd. and Bitfinex executives hide how they perform leading roles at both companies. (Yes, they somehow appeared in the Paradise Papers leak.)

For Bitfinex, the first two years prove to be a dumpster fire. The CTFC fines them $75,000 for illegal trades and for failing to obey Commodity Exchange Act guidelines. They also get hackedtwice, losing over 120,000 BTC, forcing the exchange to haircut customer accounts by 36% to survive.

In March 2017, things go from bad to worse, with Wells Fargo cutting off Bitfinex and Tether’s access to bank transfers. In response, Bitfinex executives file a lawsuit, but this has unintended consequences, causing skepticism of Tether and Bitfinex to rise into mainstream circles.

After witnessing strange activity in the crypto markets, similar to when Mt. Gox lost access to its banking, Bitfinex’ed, the first prominent Tether cynic, becomes increasingly active on Twitter. Since Tether is minting millions of its stablecoin while Bitfinex’s assets have been seized, he alleges fraud.

As suspicions arise that Tether’s tethers aren’t backed by anything, executives start to panic. To regain public trust, they must now show evidence of Tether’s 1-to-1 backing. The company announces they are hiring auditor Friedman LLP to conduct a financial audit.

The day before this happens, however, Tether opens an account at Noble Bank of which Brock Pierce is a cofounder. Bitfinex, already a Noble Bank client, transfers a whopping $382 million into Tether’s brand-new account.

The next day, Friedman LLP completes an attestation, and low and behold, it shows that Tether has $443 million in its bank account, equalling the number of tethers in circulation. But Friedman’s report only provides a snapshot of Tether’s account balance and fails to show the names and locations of the banks involved. A full financial audit is the only way for Tether to prove its 1-to-1 backing, but that never happens. Friedman LLP even fires Tether as a client, with no public announcement.

Over the next few years, Tether’s executives fail multiple times to get an audit that proves tethers are 100% backed by U.S. dollars. In November 2018, they provide yet another attestation with their latest custodian, Deltec, a shadow bank based in the Bahamas. In December 2018, a Bloomberg journalist claims to have seen an audited bank statement, but again, this turns out to be another useless attestation.

In February 2019, Tether says its finally come clean about its reserves, but they make things worse. The company not only fails to provide an audit but they admit to using a fractional reserve system, not cash-based reserves.

On its website, Tether changes the definition of its 1-to-1 backing, from this:

“Every tether is always backed 1-to-1, by traditional currency held in our reserves. So 1 USD₮ is always equivalent to 1 USD.”

…to this…

“Every tether is always 100% backed by our reserves, which include traditional currency and cash equivalents and, from time to time, may include other assets and receivables from loans made by Tether to third parties, which may include affiliated entities (collectively, “reserves”). Every tether is also 1-to-1 pegged to the dollar, so 1 USD₮ is always valued by Tether at 1 USD.”

Shortly after, on April 24, 2019, the NYAG reveals it has been investigating iFinex, the parent company of Bitfinex and Tether, and accuses the company of commingling $850 million of client and corporate funds.

As Bitfinex had failed to find a reputable bank to work with, they chose to deposit $850 million in client funds with Crypto Capital Corp, yet another shadow bank, this time, in Panama.

When Crypto Capital had its funds seized by legal authorities, Bitfinex lost access to its client's funds. But instead of accepting defeat, Bitfinex took $700 million out of Tether’s reserves to meet customer demands and remain solvent.

During NYAG’s investigation, in an affidavit, General Counsel Stuart Hoegner admits Tether is only 74% backed.

Roughly two years later, on February 23, 2021,Tether and Bitfinex settle with NYAG. The two companies must pay $18.5 million and are banned from trading in New York State. As further punishment, they must now provide quarterly statements demonstrating they have not violated the settlement.

Next month, Tether releases its first post-settlement attestation, claiming it has $35 billion in “assets” to back up the 35 billion tethers in circulation. But this is still not an audit and fails to show what assets make up the $35 billion.

Now, it’s June 2021. Tether still has yet to complete or release anything that proves tethers have solid 1-to-1 backing, you know, the supposed “sound money” benefit of stablecoins.

Welcome to the Tether circus.

Let’s face it. Considering that the most popular stablecoin is probably a fraud doesn’t look good. But even so, does it matter? Surely it’s just one of many leading cryptocurrencies in the space. How could Tether’s collapse disrupt the latest crypto boom or, worse, damage crypto’s long-term rep?

Unfortunately, Tether has become the crypto market’s primary source of liquidity. The crypto ecosystem’s backbone is now the dodgiest stablecoin on the market. As Coinlib shows, most of Bitcoin and other coin’s daily inflows come from Tether, with USDT facilitating 50 to 60% of Bitcoin transactions since 2019. Its total circulation has surged from $5 billion in February 2020 to $56 billion in May 2020 to almost $63 billion in the last few weeks — and shows no signs of stopping.

Since Tether’s money printer has effectively fueled crypto-mania, a loss of confidence in its stablecoin will likely create the largest crypto crash in history. We’ll witness the Bitcoin equivalent of a bank run, a crypto-style rerun of the 2008 subprime collapse.

Why then, with all this FUD out in public, has everyone yet to panic? Why have large chunks of the financial community, who know it's likely a Ponzi, snubbed both its critics and skeptics? After all, markets have shrugged off past Tether shenanigans. When the NYAG concluded Tether “had no access to banking”, Bitcoin dropped 25% then recovered. Just two months ago, Tether’s questionable “Pie Charts” release cut crypto’s market cap in half. Tether survived. What gives?

This, folks, is the “golden age” of fraud, and it’s going to take a lot more than speculation and in-depth detective work to prove Tether’s alleged deception.

If Tether’s critics are right, only when tight money ushers in deflation will we see crypto’s biggest FUD producer meet its fate. Since it’s the only economic environment where everyone wants to tell the truth and face up to reality, tight money is a crony capitalist’s worst enemy.

In the 2000s, several warnings from whistleblower Harry Markopolos, plus multiple S.E.C investigations, failed to bring down Bernie Madoff’s $69 billion Ponzi scheme. In the end, economic gravity exposed the scam. It’s been a recurring theme throughout history with the other famous Ponzis: the 18th-century South Sea Bubble, the 21st-century subprime boom, and the latest high-profile swindle: Wirecard, which collapsed in June last year, just after the German economy started to slump.

Authors’ definition of deflation scares = the market prices in short-term deflation, which quickly reverses.

Right now, with major indicators of economic growth starting to peak and reverse course, we’re starting to see early signs of deflation emerge. Stock markets remain euphoric as ever, but we’ve seen the NFIB small business optimism, NAHB homebuilder confidence, and U.S. building permits top out, plus rising unemployment claims and lackluster retail sales.

Not all indicators have turned, of course, but it’s been enough to provoke some markets into signaling deflation. The U.S. Dollar has started to strengthen after months of weakening. Bonds have continued to rally following a steep rise in yields. Several commodities, such as cocoa and palladium, have entered bearish territory. Plus, stocks in some cyclical industries have taken a dive.

Since these are classic early signs of an economic peak and a deflationary transition, once the broader stock and commodity markets start to fall, we’ll know the phoniest reflation trade in history has ended.

For crypto markets, this spells disaster, with deflation creating significant drawdowns. Crypto traders will remember the 38% intraday plunge in Bitcoin on 11th March 2020, which destroyed newfound hopes of cryptocurrencies becoming the defacto safe-haven, replacing gold (which also plunged but only by 7% on the day).

(It’s ironic that Bitcoin performs best in a Peter Schiff-style economy: where the economy is expanding and inflation is muted) Source: Author’s calculations — Jan 2011 onwards

Source: Author’s calculations — Jan 2011 onwards

In the next economic downturn, as the above charts illustrate, we know cryptocurrencies will take a dive. How far, however, depends on a range of factors, from the Fed’s response to the amount of leverage in the system. But the most important factor is Tether. What will the next downturn do to its balance sheet? Is it 74%-backed, 100%-backed, or backed by thin air? Who knows. For obvious reasons, Tether Ltd. will never release a full audit.

Source: Tether

Instead, all we have to go on are two bizarre pie charts they released back in March 2021. Not only does this fail to prove Tether has a full 1-to-1 backing, but it also deepens the mystery. Their balance sheet has become a fusion of the wildest financial instruments available. Commercial paper, short-term debt instruments issued by corporations, makes up half of Tether’s assets, but there’s no way to tell what company that debt belongs to. It could be Apple or Microsoft. If so, great. But it could also be a dodgy crypto company issuing worthless paper.

Even 3.6% of Tether’s reserves consist of “reverse repo notes”, which shows they have entered the shadow banking layer, doing business with Wall Street’s underworld — something that most crypto fans will regard as heresy.

These are the kind of questionable financial assets now backing the most systemically important stablecoin in the crypto ecosystem. Tether, a company that’s supposedly spearheading the crypto movement, has gone full “Wall Street casino”. The major source of crypto market liquidity, the primary lever providing essential crypto plumbing, is backed by the same financial instruments of Wall Street’s premier gambling den, the very paradigm Satoshi Nakamoto sought to eliminate and topple.

You’d think the prominent voices in crypto might come out against this. But you’d be wrong. The top Bitcoin bulls, the Peter McMormacks and Anthony Pomplianos of the crypto world, plus other notable personalities, have embraced and endorsed Tether, despite how it goes against every founding principle of Satoshi Nakamoto’s Bitcoin whitepaper.

CSO Samson Mow and cofounder Adam Back of Blockstream, one of the four seed investors backing Tether, have declared multiple times on Twitter that its reserves are fully backed, despite the NYAG proving otherwise. To them, it’s FUD.

Chief FUD debunker, Dan Held, is Director of Growth Marketing at Kraken, one of the most popular cryptocurrency exchanges. Tether happens to be its second-highest liquidity source. No conflicts of interest here.

Anthony Pompliano, the most popular Bitcoin influencer by far, has “strong connections with BlockFi and Blockstream,” writes crypto analyst Mr. Whale. “His investments make him susceptible to large losses if Tether fails”.

Ever since Tether loaned prominent Bitcoiner Peter McCormack money to fight a lawsuit, he’s had a vested interest in keeping the stablecoin alive. Upon settling, he’s even invited Tether’s lawyers onto his podcast What Bitcoin Did while failing to mention his conflict of interest. “His podcast episode”, says Mr. Whale, “was basically just a paid promotion to heal their reputation.”

Even Microstrategy CEO Michael Saylor, king of cyber hornets, has committed sound money blasphemy.

Credit: Doomberg — Source: Bloomberg

Saylor, as the elusive finance blogger Doomberg illustrates, has put his software business on the line, issuing $1.7 billion in unsecured bonds to acquire — you guessed it! — more Bitcoin. “In a liquidation scenario”, Doomberg writes, “the software business barely covers the new secured obligations”.

“Pull the plug quickly, if that's even possible,” crypto bear Peter Schiff taunted Saylor, “before [your balance sheet] gets fried to a crisp!”

No doubt, it’s sad that the leading figures in the crypto space seem to have abandoned Satoshi Nakamoto’s vision of a payment system based on sound money. By supporting Tether, a currency that ex-Wall Street and corporate mischiefs have built, backed by dodgy assets that go against everything “sound money” stands for, they have abandoned their principles, succumbing to denial and greed.

This shows how much the status quo of ultra-cheap money has eaten away at our society. It’s even corrupted the crypto movement, the very revolution that set out to defeat crony capitalism.

If the crypto movement has any legitimacy left, it must show cheap money who’s boss, by eliminating bad ideas and punishing bad actors. Unlike the megabanks, Tether won’t get a second chance. It’s not backed by the casino bailout machine at the Federal Reserve. With the evidence suggesting that its critics will be proven right, when deflationary forces arrive we may witness Tether’s collapse, creating the next crypto crisis.

In the aftermath, it will seem unlikely that another bubble will form. But while the monetary elites maintain the cheap money status quo, the demand for crypto will remain strong. No matter how much damage the coming collapse has on crypto’s reputation, tight money and deflation will force out a huge monetary response from the financial power structure, paving the way for cheap money to fuel the next crypto boom.

We’ll witness the rise of a new coin or token, one that will become the chief wheel-greaser of the next crypto-mania. Though, hopefully, it’s not based on dodgy foundations and dealings but a paradigm that puts the crypto movement back on its original path toward sound(er) money.