A friend of mine, who works in finance, asked me to explain what Tether was.
Short version: Tether is the internal accounting system for the largest fraud since Madoff.
Read on for the long version.
So you want to build a cryptocurrency exchange
The dominant use case for cryptocurrency is speculation. Speculators want to put value into the system, somehow have it become greater, and then take more value out of the system than they put in.
The cryptocurrency community includes many exchanges, each a group of affiliated companies, but it is sometimes clearer to view it as an single entity. It would have a series of ledgers, some mechanism for exchanging between the ledgers (taking a cut for each ledger hop and sometimes for bookkeeping within a ledger), and onramps and offramps to traditional currencies (which the community calls “fiat”). From the point of view of the ecosystem, it doesn’t matter which company has those ramps, because value flows unimpeded within the ecosystem.
The ecosystem is not a single entity with unified control. Cryptocurrency is not Liberty Reserve. It has, however, recapitulated Liberty Reserve’s architecture of a network of peer “exchangers” with a shared ledger between them to enable hawala-like transfers of value. In cryptocurrency’s case, those shared ledgers are blockchains rather than a single traditional database kept by an organizing entity.
Most exchanges do not have fiat onramps and offramps, but the ecosystem has to have them. Because the cryptocurrency community largely does not sell products or services other than speculation, there is no extrinsic sort of funding like you see in other businesses (e.g. no material revenue from customers). Every dollar that goes out to buy the clichéd Lambo is a dollar that went in from a speculator.
Having fiat onramps and offramps is extremely lucrative for an individual exchange, because retail traders largely use exchanges which give consumer Internet quality money movement capabilities. Professionals follow their volume. (To, ahem, rip their eyeballs out.)
Conceptually speaking, all that you need to have a cryptocurrency onramp/offramp is a banking relationship and some glue code. This is quite complicated for Bitcoin exchanges, because of anti-money-laundering (AML) and Know Your Customer (KYC) regulations.
The cryptocurrency ecosystem’s purported raison d’être is building permissionless money, and (descriptively) large sums of money flow between pseudonymous identities without any Compliance Department having asked any questions about them. Financial institutions, which are extremely heavily regulated by a global consensus that AML/KYC are core responsibilities for their industry, are extremely reluctant to bank cryptocurrency exchanges, even ones which (by the standards of the industry) are aboveboard.
But some cryptocurrency exchanges have an attitude towards compliance which is best described as “Bond villain.”
Enter Bitfinex
Bitfinex, founded in 2012, became the largest international cryptocurrency exchange after Mt. Gox imploded in 2013/2014. It has the sort of complicated backstory you’d expect of a Bond villain cryptocurrency exchange.
The most relevant fact in the backstory: in 2016, Bitfinex suffered what Matt Levine describes (facetiously but not inaccurately) as the inevitable fate of Bitcoin exchanges: they lost $70 million of Bitcoin (~120k bitcoins) to hackers.
Bitfinex was insolvent as a result of this hack. The cryptocurrency community has an interesting understanding of the word “insolvent”; here it means “Their balance sheet shows greater liabilities to depositors than they have physical assets they could immediately satisfy the depositors with.” They owed more bitcoins (per their database) than they actually controlled on the blockchain.
Bitfinex conducted a “bail-in” to forestall the collapse of their firm.
In the ordinary course, a financial institution keeps a ledger of how much money it owes which depositors. The liability to the depositor increases as the depositor deposits more money (or earns interest) and decreases as they withdraw money (or pay fees, etc). Financial institutions routinely have customers which have balances in several currencies (or denominated in other things of value, like e.g. shares of Apple); conceptually, they work in the same fashion.
Bitfinex unilaterally decided that, since they could not satisfy all liabilities for Bitcoins anymore, they would apply a 36% “haircut” to all balances (bitcoin-denominated and otherwise) on the platform. In exchange for the haircut, they invented a new unit of account, the BFX token, which tracked dollar-denominated losses to the haircut. (At least one counterparty, Coinbase, has been reported as having not been haircut. Presumably their lawyer said the word “conversion” and that was the end of that discussion.)
BFX tokens were tradeable on Bitfinex (of course), and after initially falling substantially below par, Bitfinex offered the option of redeeming them for equity in Bitfinex (which they arbitrarily decided was worth $1 per share). Eventually, they repurchased them at $1 per token.
But Bitfinex developed a problem with dollars.
Banking a Bitcoin exchange
(You can verify representations made in this section from Bitfinex’s lawsuit filed against Wells Fargo.)
At the time, Bitfinex (theoretically a Hong Kong entity but whose location, like a Bond villain, changes moment-to-moment to fit the needs of the scene) was banking in Taiwan at Hwaitai Commercial Bank, KGI Bank, First Commercial Bank, and Taishin Bank.
Taiwanese banks do not have direct access to the U.S. financial system; they engage via correspondent banking relationships. These banks corresponded through Wells Fargo. Wells, in the wake of publicity about the Bitfinex hack, told the banks they would no longer clear USD wires to or from Bitfinex.
This meant that customers could no longer move money in or out of the casino, and a casino which can’t get money in or out can’t collect a rake. So Bitfinex a) sued Wells, fruitlessly and b) intensified their use of a company they had purchased (and, until the lawsuit, had prevaricated about being related to): Tether.
How Tether works
Blockchain blockchain blockchain, blah blah blah.
Tether builds a USD/etc-denominated ledger on top of a collection of slow databases (Bitcoin, Ether, Tron, etc). They promised that entries in that ledger correspond to demand deposits held in reserve, meaning that customers can rely that one Tether is worth 1 USD (or one Tether euro is worth 1 EUR, etc).
You buy tethers from someone who has bought them from Tether, generally a cryptocurrency exchange or OTC desk. After buying them, you can use a client (or your exchange’s software) to send them to another address on the blockchain. Similar to Bitcoin, with the promise of less price swings due to the capability for redemptions and the promised reserve.
Tether is a “stablecoin.” Stablecoins are conceptually similar to a money market fund: a place to park money with minimal market risk. A money market fund is backed by short-term commercial paper; this genre of stablecoins were supposed to be backed by… well, that was cagey, but the answer rounded to “money in a bank.”
Why have stablecoins? They give cryptocurrency exchanges and their users a USD-denominated ledger to handle inter-exchange money movement and ease onramps and offramps between value in the cryptocurrency economy and value in the regulated economy, by causing the transaction (seen by a Compliance Department at a regulated financial institution) which moves money in or out of the ecosystem to occur at remoteness to the cryptocurrency exchange.
This is not the messaged purpose of stablecoins. Those are:
- quickly transfering between Bitcoin exchanges
- giving a safe-harbor still in crypto but with less volatility when not actively trading
- allowing you to self-custody USD balances so you’re not exposed to counterparty risk at each exchange you keep a balance at
The community extremely underestimates the degree to which the designed intent and best use case of Tether is facilitating money laundering. Specifically, it allows socially established individuals/firms trading at reputable OTC desks or exchanges to function as the bankers for the rest of the industry.
The cryptocurrency ecosystem largely believes that “If it’s all crypto, then YOLO”, requiring nowhere near compliant levels of KYC or AML for customers who transact only in cryptocurrencies. A representative example, from Tether in 2015:
You can fund your account with bitcoins and convert to Tethers to stabilize your bitcoins and (sic) without having to undertake KYC.
Their customers prefer this, some because they would prefer to not have their identifying documents leaked when their cryptocurrency exchange is inevitably hacked, some because they philosophically disagree with regulation, some because they are evading taxes, and some because their business is international narcotics smuggling.
Since people believed Tether’s representations that a Tether was as good as a dollar, and could be surrendered for a dollar at any time, it quickly became the unit of account for most of the cryptocurrency community. At the point Bitfinex/Tether lost access to high-quality banking, there were about $55 million of Tethers in circulation. Tether claims there are now more than $4 billion.
Tether’s claim about reserves was a lie.
Tether has routinely not had actual control of hundreds of millions of dollars of their purported reserves.
They have lied repeatedly about this fact.
While they promised their customers that Tether was backed by “traditional currency held in our reserves”, their reserves were actually accounting fictions; receivables from money launderers like Crypto Capital Corp, receivables from related parties such as Bitfinex, and cryptocurrencies.
This is a pretty robust accusation, but Tether has admitted to it in court.
Where were the reserves kept in 2017 through today?
Tether has, in the words of Bitfinex CFO Giancarlo Devasini, “banked like criminals.”
After losing useful banking in Taiwan, Tether shuffled their reserves through a series of shell corporations, periodically getting them frozen when banks realized that they were banking a cryptocurrency exchange which was lying to them about their actual business.
Tether eventually found a bank willing to bank it: Noble Bank, in Puerto Rico. Noble’s board was against banking Tether:
[Recent articles came] to the attention of the board, and there is a concern that if not managed correctly, that [our relationship with you could] cause blowback on Noble, and could negatively affect our relationship with BNY Mellon.
BNY Mellon is a large, NYC-based custodial bank. One of their functions is holding assets for banks from outside the U.S. inside the U.S.’ financial system. They don’t bank money launderers. Noble’s board was worried that BNY Mellon might fire Noble as a customer over the Tether relationship (and, broadly, the sort of controls environment and risk appetite that the relationship would be evidence of). If that happened, it would kill Noble.
Tether got Noble over the hump leading a $2 million Series A investment in Noble. (As an aside: there is a reason that professionals say “the e in email stands for evidence.”)
(“Was Noble a bank?” That gets into a fascinatingly deep tangent; suffice it to say that they were a regulated financial entity operating with high-quality access to the US financial system, which is close-enough-to-a-bank for Tether’s purposes.)
Tether then deposited minimally hundreds of millions of dollars into Noble, which intrepid analysts noticed when the Puerto Rican financial regulator reported that balances at International Financial Entities increased by almost 5X virtually overnight.
Tether warned customers to not talk about the banking details they were exposed to when onramping or offramping USD, because they were worried about their business coming to the attention of BNY Mellon.
This instigated a predictable series of responses, ultimately killing Noble and forcing Tether to find another banking partner.
Tether moved their reserves to Deltec Bank, and ramped up their usage of Crypto Capital Corp.
Crypto Capital Corp
Crypto Capital Corp is not a bank. Crypto Capital Corp is not kinda-sorta-bank-like if you squint at it. Crypto Capital Corp is not even a Bond villain.
Crypto Capital Corp is a money launderer.
Tether was their largest client. Other clients included Quadriga, the largest Canadian Bitcoin exchange, and Kraken. One of these two has collapsed due to the founder looting it. The other is trying to put this chapter behind them.
Several governments, including Poland, believe the Colombian drug cartels were also clients.
This implies that Tether (and, by extension, the cryptocurrency ecosystem) played the part of the nail salon and Colombian drug cartels that of Jesse Pinkman in Breaking Bad’s famous discussion of how money laundering works. (Though in this situation the nail salon is also money laundering, but they’re the kinder, gentler, acceptable-at-the-best-parties sort of money launderers.)
CCC’s modus operandi was identifying banks with poor compliance controls and opening shell entities which it represented were engaged in real estate transactions, shuffling money in and out until the bank closed the account, then doing it again.
Tether purported in a recent court filing to be shocked, shocked that their money launderer might have lied to them about the ownership structure of the shell corporations they directed customers towards; Crypto Capital was only supported to lie to the banks.
[…] Crypto Capital never disclosed that several of the bank accounts to which Bitfinex’s customers transferred fiat funds were actually held and controlled by Spiral and Reggie Fowler, and not by Crypto Capital or any of its related entities.]
What did this look like for customers?
Bitfinex makes a pedantic distinction that only authorized customers (like Bitfinex) can deposit money with Tether and only those authorized customers can redeem it, a distinction they adopt or discard whenever the plot requires it. Bitfinex is Tether. This distinction is shell games within shell games.
When a customer would want to deposit money with Bitfinex, they would contact Crypto Capital Corp, who would give them the name, account number, and bank of a shell corporation (with names like “Global Trade Solutions A.G.”), with instructions to wire the shell corporation money with a lie designed to not rouse suspicion from their banks. (The lie in their support documentation was: “Treasury transfer back to my own account”).
It bears repeating at this point: Bitfinex knew that these were the instructions it should pass to customers, and explicitly instructed customers to not reveal the wire instructions they were given, for fear of drawing official attention to the crimes they were committing.
[Do not share these instructions] except with your financial institution. Divulging this information could damage not just yourself and Bitfinex, but the entire digital token ecosystem. Accordingly, you are cautioned that there may be severe negative effects associated with this information becoming public.
CCC would then increment Bitfinex’s balance with CCC, and provide Bitfinex with confirmation that they had received the wire. Bitfinex would then credit the customer with a Tether-denominated receivable on their books or with actual on-the-blockchain Tether.
When a customer wanted actual money in return for Tethers, they’d run the process in reverse. The customer would send Tether to Bitfinex. Bitfinex would make a “transfer” (accounting entry) on CCC’s books, using their online system, decrementing the amount CCC owed Bitfinex and incrementing the amount they owed Tether. CCC would then launder a wire to the customer, lying to their banks, and tell Bitfinex they had done it, then decrement the amount they owed Tether.
Did Crypto Capital Corp actually have the money?!
No, they did not.
CCC’s principal architect, Reginald Fowler, was skimming 10% of all deposits in the system for his personal uses.
This is corroborated by information contained in the Master US Workbook indicating that scheme members set up a “10% Fund” from the client deposits.
Those personal uses included, probably, funding a football league which, and this is a quote, “made a deal with the devil” and promptly collapsed when Fowler did what he has done many times before.
This was likely the primary way he was compensated.
Bitfinex claims to have believed, per their court filings, that CCC subsidized their services through net interest.
[B]esides a nominal fee for each deposit or withdrawal, Crypto Capital charged no fee for these services to [Bitfinex] because it was able to earn substantial interest on the funds it held on [our] behalf in its accounts.
This would make sense for a financial institution, but it doesn’t make sense for a money launderer, because risk-free assets generate very little interest (1% of a billion dollars doesn’t pay for the minimum viable financial institution) and because most ways to do this at scale require negotiating rates.
During the course of that negotiation, the bank is going to ask a question like “Wait, this only makes sense for me if you keep those assets deposited long-term, but you’re a real estate company. Why would you want that? Why would you want that from me? The thing you should want from me is a loan. I can do this on your assets if you bring me some of your loan business, which is clearly going to be an order of magnitude larger than your long-term deposits, because you are a real estate company. What projects are you working on right now that you expect to borrow about $10 billion for?”
Crypto Capital didn’t and couldn’t select banking partners on the basis of interest rates. They selected for extremely inattentive (or corruptable) compliance departments.
Because Bitfinex and other customers did not want to know the internal operations of their money launderer, they didn’t notice that CCC was routinely siphoning off their funds.
This could have gone on for quite a while. Think of a distinction the cryptocurrency community uses a lot: hot wallets (where an exchange keeps cryptocurrency for day-to-day use, connected to the Internet) and cold wallets (airgapped storage which isn’t connected to the Internet). They do this because they’re worried about getting the hot wallet taken by adversarial action (hackers). Bitfinex was using CCC, and not Deltec, to move money around because frequent wires draw adversarial attention; CCC is the hot wallet.
In an environment where more money is flowing into the hot wallet than flowing out, if you don’t audit the cold wallet, you wouldn’t notice adversarial action against the cold wallet. In separating the two for your security, you’ve played yourself. (Sound unlikely? It happened at Mt. Gox; the cold wallet had a leak in it. The Wizsec broke the fraud and has a 40 minute presentation; here are my notes. It’s glorious.)
A function of Tether is to encourage far more actual money to flow into the ecosystem than flows out (“Why withdrawal all the way to a bank account when you can just withdrawal to Tether? It’s easier to invest back in, a much faster round-trip, and why would you trust banks.”), and so to the extent Tether’s balance was going up, the fact that it was being repeatedly siphoned off would not be noticed unless you were either a) the thieves or b) asking to get more money than inflows would cover.
That liquidity crisis happened in 2018, after regulators froze some CCC’s shell corporation bank accounts. By August 2018, CCC couldn’t pay outflows out of inflows and had exhausted their cash on hand. They explained that this was because they had some temporary liquidity problems caused by regulators.
That was a lie; CCC had liquidity problems, alright, but a major part of it was that the money they had embezzled was illiquid.
Word of this liquidity crisis got out. Quoting chat logs by a senior Bitfinex representative, who has not learned Stringer Bell’s dictum on the wisdom of keeping notes on a criminal )%#)(ing conspiracy:
We are seeing massive withdrawals and we are not able to face them anymore unless we can transfer money out of [CCC].
By October 2018, rumors were circulating that Tether was insolvent. It faced a bank run. The rumors were, bluntly, accurate; their reserves were a receivable from a money launderer who had stolen a portion of the money and gotten more of it frozen.
Some people in the cryptocurrency community expect that, after Bitfinex has convinced the regulators that Crypto Capital Corp was their money launderer and that Crypto Capital Corp owned Fictitious Real Estate Firm, LLC that regulators will give FREF, LLC’s money back to Bitfinex.
Hahahahahahahahaha. Let’s review precedent here to see whether that is a reasonable belief.
Mt. Gox created a U.S. subsidiary, Mutum Sigillum, LLC, directly to receive funds from U.S. customers and effect value transfers to/from the mothership. It did not complete a required money services business registration. Its accounts were seized. Mt. Gox’s bankruptcy administrator got in touch with the U.S. government and, because they were feeling merciful, the government offered a deal. The government would give back half of the $5 million back in return for Gox surrendering any claim to the rest. The administrator wisely took the deal.
You are welcome to your estimate of how likely it is that regulators will show mercy on Bitfinex. My estimate: the frozen money is gone.