Key Excerpts and Commentary from NYAG/Tether Court Transcript

First of all link to the transcript:

Second of all congrats to @lawmaster and The Block for a great scoop. Now let’s get down to business.

Bitfinex is still being hesitant to hand over documents to the NYAG.  They have struggled to get access to documents relating to the transfer from Tether to Bitfinex, and this suggests to me that either the documents don’t exist or there is a very good reason they are not being shared.

Screen Shot 2019-05-21 at 5.03.56 PM

This is directly contrary to what Bitfinex has claimed to the public wherein they have claimed that they have been fully cooperative. Archive link: Shot 2019-05-21 at 5.05.47 PMHowever, I’m sure that there is no reason to think that Bitfinex is hiding something. No reason at all.Screen Shot 2019-05-21 at 5.09.29 PM

Shortly after this we learn very interesting things, Tether’s lawyer admits to Tether investing in Bitcoin:

Screen Shot 2019-05-21 at 5.13.37 PM

Luckily we have a sharp judge here who quickly gets to the meet of the issue and correctly points out that this seems contrary to the nature of a “Stablecoin”.Screen Shot 2019-05-21 at 5.14.31 PM

The Tether lawyer responds by confirming what we all suspected since the ToS change is that other assets includes cryptocurrencies:Screen Shot 2019-05-21 at 5.15.35 PM

The Tether lawyer then continues basically saying they will not produce documents and will instead appeal and challenge every single step of the way:Screen Shot 2019-05-21 at 5.17.11 PM

The Tether lawyer then also says that they do not think there is any amount of dollars they need to keep in reserve:Screen Shot 2019-05-21 at 5.19.17 PM

The Tether lawyer then takes the classic Tether defender tactic of it’s okay because banks do it too:Screen Shot 2019-05-21 at 5.20.19 PM

The judge quickly ascertains the issue with this and points out that this effectively means there is no reserves:Screen Shot 2019-05-21 at 5.21.18 PM

The Tether lawyer responds by saying it’s okay, if they need to they’ll earn money some other way, pay it back, and just delay redemptions:

Screen Shot 2019-05-21 at 5.22.23 PM

A little further down the NYAG reveals that Bitfinex/Tether executives get lump sum payouts from the unsegregated Tether accounts where no reserves have to be kept:

Screen Shot 2019-05-21 at 5.25.12 PM

The NYAG also reveals the juicy tidbit that the largest redemption ever was less than $25 million:

Screen Shot 2019-05-21 at 5.29.07 PM

Why is this particularly juicy? Well let’s take a quick trip over to their treasury address on Omni: here it does not take long to find bigger transactions coming in than that like this: So somethign is seriously amiss here.

Now relevant to this entire document is the issue of disclosure. Tether claims that they are not in the wrong because once they started using other assets they disclosed it.  However, is that true? I will contend it is not. Let us consider Tether’s own website:

In 2015 Tether openly admits to exchanging Bitcoins for Tethers without KYC. Now it is possible, but in my opinion unlikely that they still had sufficient fiat reserves at that point, but I think it is plausible to doubt that and to believe that Bitcoins have often been a part of the backing.

Screen Shot 2019-05-21 at 5.48.34 PM

In conclusion: Tether has paid executives dividends out of non-segregated accounts, does not feel a need to keep cash reserves, is buying bitcoins with reserves, and cannot handle a rush to redeem.  Their largest claimed transaction is also smaller than multiple apparent redemptions on the blockchain.

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Untethered Tether: Old Developments

Note: This post is out of date but is part of my transition away from Medium.

So today we are going to take a look at some of the Tether drama that has occurred over the last week or so, and it gets interesting fast.

Background: There has been a theory for a while now that Tether has been used to fuel the massive price increase in Bitcoin during 2017.

This was exacerbated by the fact that they did, and still do promise regular audits but have never delivered it. After firing the last auditor they claimed, “Given the excruciatingly detailed procedures Friedman was undertaking for the relatively simple balance sheet of Tether, it became clear that an audit would be unattainable in a reasonable time frame.” I do not know about you, but that sounds to me like the auditors were you know trying to do an audit.

Now as for the price pumping.I was introduced to this theory by Bitfinex’ed and was recently supported by a paper published by a couple of professors that suggested again that Tether’s printing was used to increase demand, and was not created “naturally.” Now there have been some criticisms of this paper, including the fact that their method can only show correlation and not causation, and that it was not peer-reviewed, but it did increase public pressure on Bitfinex and Tether to start clearing the air.

Transparency report: So the law firm of Freeh, Sporkin and Sullivan, LLP has released a report meant to show that Tether actually does have the funds to back the Tether’s currently in circulation. Now this report is interesting for several reasons and I am going to try to highlight them for you, and then I’m going to take you down the rabbit hole. So the report can be read here. It basically attests that on June 1st that the accounts (yes there’s two banks now) had enough to cover the number of Tethers in circulation. However, there are several interesting phrases in here, and one that sends us down the rabbit hole.

Well obviously not great news, but probably not unexpected.

It is obviously not an audit, this one should surprise exactly zero of us.

Here is where they admit that this in no way proves that the Tether was always backed.

Good to know that Tether might still be used for money laundering.

WAIT WHAT?! That’s right, a partner for this law firm is an advisor to this bank. Time to go figure out which bank this is now right? I am not a lawyer, but that feels bad, like it could be a conflict of interest (especially if Tether is one of the only clients for this bank….), and casts doubts over this entire report.

Banking: The question we now had to try to figure out was what bank was Eugene Sullivan advising. Several of us set out to Google and dig and try to find something. I even spent several hours digging through the Panama/Paradise Papers in the hopes that I would find a connection and this continued until @eastmother tweeted at me and said this.

When you check the cached version of this page you can see that Eugene Sullivan was an advisor to Noble Bank in Puerto Rico!

This is valuable for a couple of reasons, first and foremost they deleted this and tried to hide it. Which seems odd. Secondly, it helps confirm the research from BitMex that suggested that Noble Bank in Puerto Rico was the most likely steward of Tether’s funds. BitMex also seems to suggest that Tether may be a significant percentage of the total deposits at this bank, suggesting to me excessive scrutiny into Tether likely does not work well for Noble.

Now, Noble Bank is an interesting entity because it is a full reserve bank. This means that they do not fractional reserve like the majority of banks, and they actually keep the cash on hand that they claim. So if your account says $1,000,000 then they have that $1,000,000 in their vault. These kinds of banks often do not offer interest rates, because they cannot afford to. They are not lending the money out and so cannot earn the money from loan interest. Several people have tried to contact Noble and have not been able to get an answer as to what interest rates may be offered. This leads us directly into the next part of the problem.

Business Model/Profit Model: So now we need to try and figure out how Tether could be making money. In their whitepaper they say that the way that they make money is by interest on their bank accounts and by charging a ten basis points fee on transfers to customers (of whom Bitfinex is their sole customer). So if we assume that a significant portion of their assets are being held at Noble Bank, which being a full reserve is likely unable to offer interest, then the only interest they could possibly be getting is from their second bank and from the ten basis points fee. This leads us to two issues. One the ten basis point fee by itself is almost definitely not enough for them to be profitable. So the question then becomes who is their second bank and could they be offering enough interest for Tether to be profitable. If we assume that the larger amount from the two accounts is held at Noble, then the only part earning interest is about $600 million.

Even at about 2% per year that works out to about $1 million dollars a month. It feels as though that would likely be insufficient for Tether considering the size of the operation, but I could be mistaken. However, it is important to remember that Tether is still a business that needs a way to be bringing in money, and so paying attention to this mechanism could be important.

The Brock Pierce Connection:

Now we start to flirt with where this all gets really crazy. Brock Pierce is one of those characters who tends to pop up in weird places and doing weird things in Crypto. He was one of the founder of Tether, though has since (according to him) sold his position in it. He is also the cofounder of Noble Markets which controls Noble International the bank. So one of the founders of Tether, is also a founder of the bank they use, which has an advisor who is also one of the lawyers who issued this memorandum. What we are seeing here is in my opinion serious conflicts of interest that force us to seriously question the nature of all of the relationships in play here. Also in general Brock Pierce has a history of being evasive about his relationship with various entities.

Plus, the more you look into Brock Pierce, the more you recognize how he represents much of the worst of the cryptocurrency space. In March he was interviewed and had this great little nugget to share with the world, ““I don’t care about money, if I need money, I just make a token.” Remember, this is the founder of Tether, and the man currently making sure they have banking. Let’s hope he didn’t need money when he made Tether huh?

The MTGOX Connection: This web of connections gets even weirder when we start looking even further into a very weird part of this story. Namely, these same players are connected to MTGOX. So after the whole MTGOX debacle there were several different players who were looking to be the ones who determined the best way to rehabilitate those were injured in the hack. It turns out that there was a group called Sunlot Holdings who proposed a rehabilitation plan. Both Brock Pierce and John Betts were partners at Sunlot Holdings, and John Betts is now a Founder and CEO of Noble Markets who controls the bank Noble International. Furthermore, Sunlot Holdings was advised by Louis Freeh, one of the cofounders of Freeh, Sporkin and Sullivan LLP the law firm that did the report. None of this is criminal, but it suggests that these players have an entangled and complicated relationship stretching back at least until 2014. The more entangled the relationships the more we have to worry that there is a shared incentive to ensure that Tether survives.

The Whole Web of Connections:

This whole web of connections was recently summarized in this image here. As you can see by how entangled all of these people are it becomes very dangerous to trust the word of FSS as to whether or not Tether is in any form usable.

The Imperial Pacific Connection: While researching Freeh, Sporkin, and Sullivan; specifically the fact that Sullivan was claimed in the report to be an advisor, I, along with others, found that he was connected to a casino called Imperial Pacific. He was part of their advisory board until recently. The reason this is interesting? Imperial Pacific has been dinged for money laundering and human trafficking along with general corruption. Freeh also used to be associated with this very same casino. This starts to paint a disturbing image of who these men are willing to be associated with.

Other FFS Shadiness: This law firm actually has quite a few unsavory connections like this. Eugene Sullivan has previously been dinged for trying to use his former position as a judge to profit. They have also defended Ukranian Oligarchs. There have also been criticisms of Freeh’s tenure as FBI director, including how he had handled the critically important Penn State case.

Phil Potter Leaves: Now as the waters start to get really murky and the pressure on everyone seems to be reaching a fever point, Phil Potter the Chief Strategy Officer of Bitfinex departs. The timing of this is very poor for Bitfinex and Tether as public pressure increases on them. He also claims that he is doing this because Tether is focusing less and less on the US, but to my eye, there banking and the majority of their volume is still in the United States, and so that excuse does not pass muster. Furthermore, we do know that the Fed’s were looking into Bitfinex and Tether and it is possible that he may have flipped to protect himself. Finally the most recent dump started shortly before the news of his departure became public, and as such we do need to wonder whether or not there were people trading on this insider information. Just to be clear I have no strong evidence for either of these claims, but the timing is quite odd.

Weird Connections from Noble: Now we are going to temporarily back to Noble, because there are some weird connections that I cannot fully explain.

I got another tip on Twitter:

that there have been some….interesting websites associated with the same Google Analytics ID as Noble. Including….Blockchain Capital! The venture capital fund that Brock Pierce used to be a part of! Isn’t it fun when little things like that work out? Also a bunch of other “blockchain” focused websites including: Blockchain Alliance, bloq, Chicago Blockchain Center, the Chamber of Digital Commerce, Dunvegan Space Systems (blockchain in space), Silk Road Equity. Now just to note, I do not neccesarily think all of these are connected, because there were also a couple of design sites for something called Neu Entity and so it is possible that is why these are shared. However, it is funny to see Blockchain Capital which is another of Brock’s babies coming up in here.

Other Recent Weird Happenings: So one of the last really weird things that has happened, was a weird transaction of Tethers. Namely there have been some “send-all” transactions which are quite uncommon, and sent primarily to wallets that are “back and forth” meaning they receive it from Bitfinex and then send it back and that’s it. These have happened before, but no one knows why.

Claim that Audit is Impossible: This is my favorite claim that Bitfinex makes. They try to claim that it is impossible for them to get an audit. First and foremost it is important to remember that back in 2017 they had someone who agreed to audit them, and they fired them because, “Given the excruciatingly detailed procedures Friedman was undertaking for the relatively simple balance sheet of Tether, it became clear that an audit would be unattainable in a reasonable time frame.” They fired their auditor being thorough….

Best part of this claim is that True USD, which is an incredibly similar stablecoin (with fewer, but not zero problems), gets regular attestations by an actual accounting firm. So apparently their claim that it is impossible, not just for them, but for anyone is false. (Important note, these attestations are only done once a month, and it would technically be possible to game them, but it is still better having an actual accounting firm do it, and having them do it every month.)

Conclusion: In conclusion, Tether and Bitfinex cannot be trusted. Their transparency report has actually helped expose how deep some of their entangled relationships go, and I am now more scared than ever for the cryptocurrency market. Brock Pierce is likely still materially involved in Tether, and is working with them to help maintain banking through his own bank, and even the lawyers have worked extensively with him before. Phil Potter was the first executive to leave, but he will not be the last. I would expect Giancarlo to be next, and when he does leave, I would recommend (not financial advice) to stand clear of the house of cards that is the cryptocurrency market.

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How Does a Stablecoin Make Money?

Note: This is an old post with some minor flaws, I am posting it here in protest of Medium.

This post is prompted by something interesting I have noted in the cryptocurrency space, namely that there has been a significant proliferation of so called “stablecoins.” Besides the proliferation there has also been recent VC investment into some of them, making me wonder, “how does a stable coin make money for a VC?” Let’s look into this and make sure everything adds up.

Update: I published a deep look at the Basis protocol here.

Let’s start with Basecoin, oh wait I mean Basis Protocol. This “stablecoin” has raised well over $100 million dollars from VC investors. I’m worried about these investors, many coming from top firms after looking at the economics of this BitShares 2.0 (Worry anyone else that the founder of that project is the founder of the new $4,000,000,000 darling EOS?). The way it works as best as I understand is using a three-token system. The tokens are as follows:

  1. Base Shares
  2. Base Coins
  3. Base Bonds

The base shares are created in the genesis block and all new base coins go to them as “dividends” (holy shit I hope they spent some of that $100 million on Securities lawyers). The base coins are a separate coin that is issued to holders of the base shares when the price of the base coin exceeds peg, in theory diluting their value and bringing the value back to peg. Base bonds are issued when the value falls below peg. When this happens you can purchase a Base bond for the current value so say $.80 and then redeem it for $1.

Now where this gets even trickier is when it comes time to issue new coins is that it goes first in, first out. So it goes to the oldest bond holder first, and then continues down the line, and if there are in theory no bond holders then the coins are issued to the share holders.

Now what is the issue with this system? Economics mostly. Let’s start with what is the most obvious to me, my incentive if I am a whale and if this is liquidity is to become a large share holder, and then whenever I get a dividend to immediately sell it, purchase bonds, wait for them to redeem, and then dump again. If the market gets too big for me to do this alone, I do what all the whales are already doing in crypto and organize this process with a few other people.

The second problem and the more troubling one, where this needs more investors always coming in (gotta maintain the stability fund they talk about) is better captured by Preston Byrne than I could: “It seems to me on this very cursory review that Basecoin depends on

  • Printing free money and giving it to crypto-investors who are inclined to hold it and thus restrict supply;
  • Providing financial incentives to subsequent investors to introduce money into the scheme and subsidize the price of the scheme if the price of a coin should fall below a certain level (say, $1);
  • Vulnerable to a not-at-all-decentralized reliance on price indicators provided by unsupervised, unregulated third-party trading venues already suspected of serious shenanigans;
  • Granting primary benefits of the scheme to early buyers in an unregulated ICO;
  • Where every participant is betting on the price of their assets rising;
  • Which cannot sustain itself without finding new buyers for $BASE.”

Now the question that is blowing my mind is why the investment in this from VC firms? And then I figured it out. The reason this stablecoin has gotten so much investment is because of the structure of the shares. When they buy their shares they are trying to basically buy money printing machines they will continue to issue them dividends, as they accumulate the follies of every retail investor who purchases the coin to use to trade in the crypto world. They’re trying to profit of a couple really nice facts.

  1. Many cryptocurrencies banks have no strong fiat on-ramp and thus depend on stablecoins like Basis protocol for people to trade, creating built in buy pressure.
  2. The initial purchase of shares will allow for the stability fund to maintain the peg long enough for them to cash out their investment.
  3. Plus, if the price of cryptocurrencies continue to rise and more people are purchasing then they can continue to print money for longer.

Not exactly a great product for all of us.

Update: I wrote an in depth look at MakerDAO, Dai, and MKR here.

So let’s look briefly at another stablecoin. This time MakerDAO.

MakerDAO which issues DAI confuses me because I cannot figure out the advantage to using it. Basically you put up about a whole bunch more money than you want in Ether. They then issue the Dai. So say you wanted $1,000 worth of Dai, you need to overcollaterize and put up let’s say $1,500. Now why would you do this instead of trading into the much more stable USD? Good question. I cannot for the life of me figure it out.

Best part is though how vulnerable this system is. Let’s say that tomorrow there is a another horrible event on Ethereum. Think like the DAO hack, but larger, and they are unable to achieve consensus to roll the chain back. The value of Ethereum plummets and then you are not overcollaterized, you are undercollaterized and the value plummets.

There is also a bunch of the same algorithmic BS that Basis Protocol and BitShares try to use to maintain their value thrown in for good measure.

Oh and the best part if they do end up undercollaterized? They dilute the pooled Ethereum so you can no longer claim back the same amount of Ethereum you put in. How’s that for a fun little twist?

So well I’m confused about this, at least it’s clear how they make money. To pay back their “Stability fee” you need to use their MKR token.

Worst of all? It hasn’t maintained it’s peg.

Finally, we need to discuss the elephant in the room. The one who’s imminent collapse will also be the black swan event that destroys MakerDao and wipes out a ton of value in the crypto ecosystem. Tether. I am not going to go back over ground that has been thoroughly covered, so just read everything Bitfinex’ed said. But more than that, it is supposedly backed, with no audits, and no convertibility yet trades with no counterparty or insolvency risk even when bank accounts get seized.

Plus, it’s linked to Bitfinex, which has also been linked to the delightful market makers over at Cumberland mining as Spoofy McSpoofface detailed already. Namely bad.

Though if you want me to answer how does Tether make money, again I’m not exactly sure, best guess I have is they don’t and it’s all used for money laundering. (Remember Kraken let’s you trade fiat into Tether with no fees, but won’t let you trade using Tether).

Update: I wrote a piece discussing recent developments in Tether here.

Update: Okay so Tether makes money in two ways, 1. a ten basis points charge on Tether purchases, and 2. Interest on the money held. However, it is still an open question as to whether or not they are actually earning interest due to the complexity of their current banking situation.

That’s the secret behind all of these stablecoins. They hide behind their algorithms and everything else, but they all rely on market-making bots in order to maintain their pegs. Some even outright admit it, like Basis with their “Stability Fund” or this one which is just beautiful:

If you still are in doubt, ask George Soros about what happens when someone tries to peg something. In his case he got rich. For many people in this case they will get caught holding a bag. If you are going to trade crypto, then trade responsibly and do it with real fiat on ramps not magic pegged currencies. And as always nothing I say is legal or financial advice, I’m just an angry guy on the internet.

Update: Added clarifying comment about nature of Cumberland mining.

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