In this previous post on Tether, I wrote about stablecoins & how they’re important cogs in the cryptocurrency ecosystem. We also spoke about how Tether is supposed to keep a 1:1 peg with the USD$ and how as per a [really comprehensive] Bloomberg report - that might not be the case.
Bottom-line: What happens if everyone makes a run at Tether, withdrawing all their Tether at once? What happens…if Tether goes bust?
Is Tether a Ponzi scheme?
Before I talk about Tether, I want to give you a quick example of how a bank works - I think it will set the right context to understand how Tether works.
Imagine that you deposit INR 50K in a savings account with a bank. The bank pays you a steady interest on that deposit of 4-6%. You don’t need all the money at once, so majority of that sits with the bank for long periods of time.
The bank uses this behavior to their advantage. They use the depositors’ money & give out loans to individuals/businesses in need of credit & earn interest of around 8-12% on such loans. [more in case of risky/unsecured loans]
The ‘spread’ also known as ‘net interest margin’ - is the difference between the rate of interest banks earn on the loans they give out minus the rate of interest they pay out to depositors
A very lucrative business isn’t it? You’re using money which isn’t yours & earning a profit from it.
However, it isn’t always this rosy. In a market downturn, businesses fail. They aren’t able to honor their loan commitments & fail on their loan repayments. The bank does what it can to recover the money [selling off collaterals etc.] & when it is certain they can’t get the money back, they write off the loan from their books.
In some cases [insert 2008 financial crisis], the situation gets OUT OF CONTROL & so many loans ‘go bad’ that the banks do not have enough money to pay back their depositors - which is what we call a liquidity crunch.
In that scenario, either someone [mostly the country’s Government using taxpayers’ money] bails them out by infusing additional capital into the bank OR the bank is simply allowed to fail. In the latter case, all hell breaks lose. Depositors make a run on the bank trying to get their money back.
People start to panic & start withdrawing their money from other banks putting the entire banking system under pressure. Without enough credit, banks aren’t able to disperse loans to businesses & the entire credit cycle stops. Stock prices start to tumble as liquidity slows down. And, you can watch the movie ‘The Big Short’ to visualize what happens next.
You’re probably thinking - ‘Yeah, I know how a bank works. What’s your point? And, how is this possibly connected to Tether?’
Well, Tether Holdings Ltd., the company which mints & issues stablecoins called ‘Tether’ into circulation is quite similar to a bank - with certain differences.
When you buy a Tether, you’re in effect depositing real money with Tether. You deposit your money with the crypto-exchange which in turn transfers that money to Tether Holdings in exchange for Tethers.
In an ideal world, when you deposit your money with a crypto-exchange & buy a cryptocurrency - that money would be given by the crypto-exchange to a bank to hold it in a fiduciary capacity. But the problem is, banks don’t want to do business with these exchanges.
So what do the exchanges do? They choose stablecoin providers to fill the void. They allow investors to buy cryptos using stablecoins. Investors buy Tether, deposit their money with Tether Holdings Ltd & use that Tether to buy the likes of Bitcoin/Ethereum etc.
Now, Tether Holdings doesn’t pay you any interest for the money that you’ve given them to buy Tether. Plus, it isn’t a bank & is not covered by any banking regulation - so it doesn’t have to disclose what it does with the money that is lying with it. Tether Holdings could literally spend that money on buying a football team & we’d never know.
It is rumored that Tether used that money to buy a lot of risky debt from Chinese real estate players. If the bet played out, the people running Tether would make a sizable profit - but if things went south, the only people to lose would be the crypto-investors who had parked their money with Tether Holdings Ltd., not knowing the underlying risks.
Even banks, which work in an extremely regulated environment can go bust [in extreme situations]. And here is Tether Holdings Ltd., unregulated - holding $69B dollars in real money, claiming that it is maintaining a 1:1 peg [if you’re to believe a report published by an accounting firm in the Bahamas], meanwhile everything you read about the company reeks of suspicion.
So - what if Tether is a big Ponzi scheme?
Before we answer that question - let’s take a look at some of the other facts that had come to light during the New York Attorney General’s investigation.
The Bitfinex Connection
Bitfinex is a cryptocurrency exchange - a place where you can buy & sell cryptos. The company which owns Bitfinex is iFinex Inc.
Guess who owns Tether Holdings Ltd?
Yep, you guessed it right. It’s iFinex
This connection is important because Bitfinex has had it’s share of misfortunes since incorporation. It’s been hacked several times in the past, losing customer money.
And a couple of years back, Bitfinex found itself in a really sticky situation. Here’s what happened.
We’ve established that traditional banks don’t want to be involved with crypto exchanges. Bitfinex found a way around this. It partnered with Crypto Capital Corp. (a payments processor based in Panama) to deal with withdrawals & other transactions on the platform.
However, one fine day - Crypto Capital refused to send money back to Bitfinex. Crypto Capital said that their accounts were seized by regulators in the US, UK & Poland. (Why were the accounts seized? You can read the full story here)
How much money are we talking about here? A WHOOPING $850 million.
Bitfinex was caught in a vice. It had to pay back customers making the withdrawals. And if Bitfinex couldn’t pay back - these customers (your normal crypto investor) would panic, leading to a massive sell off - which would lead to more withdrawal requests & the vicious circle would be complete.
Giancarlo Devasini, the guy who owns Bitfinex & who is also the CFO at Tether Holdings Ltd had a master plan. He thought - ‘Wait a minute….why don’t we use the funds lying with us at Tether to plug the holes at Bitfinex? Who’s going to find out anyway?’
And voila! Close to $800 million was transferred from Tether Holding to Bitfinex & all Tether did was tweak it’s website to read:
“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.”
I tip my hat to Letitia James - who is New York’s Attorney General & her office for uncovering this for the world to see.
What is a Ponzi scheme?
Simply put, it’s an investing scam where investors are promised an exorbitant rate of return with little to no risk. All they have to do is - invest & stay invested
When the early investors are paid a handsome return, the word spreads attracting more people to invest in this scheme.
The people who run the scheme simple use the funds from new investors to pay back to the earlier investors & this goes on until the flow of new money dries up - hence exposing the devil at play.
Evaluating the above, in literal terms - Tether isn’t a Ponzi scheme, since it’s not really paying back any ‘returns’ to the people who invest in Cryptocurrencies. It merely acts as a fiduciary (at least it’s supposed to) holding money on behalf of the investors until they want to withdraw it.
But - just like Anmol Gandhi mentioned on the podcast, 90% of all cryptocurrencies in circulation today might be a scam. Including Tether. No one knows where it’s parking it’s money. There are rumors of it parking substantial amounts of money in Chinese real estate CPs to make large profits. Or funding Bitfinex helping the exchange to stay afloat & cover it’s losses. Or pushing the prices of Bitcoin by using pump & dump schemes
Tether could be one of the biggest scams of this decade. It’s modus operandi being simple: ‘Issue new digital tokens, raise more real money & pay back the people who want their money back’
The only problem here - is that Tether is systematically important for the entire cryptosphere. You’ve got over $70BILLION plus Tethers in circulation. Someday, people are going to want their money back - and what happens the day Tether defaults?
History, will repeat itself.
Where is Tether keeping it's money? [Part II]