Perhaps the most substantial news within the crypto asset industry in 2019 has been the announcement from the New York Attorney General’s (NYAG) office alleging that popular exchange Bitfinex lost $850 million and then subsequently used funds from their sister stable coin company, Tether, to cover the shortfall. This news is substantial for two reasons; firstly, Tether is one of the most actively traded crypto assets and serves an important role as the quote currency on exchanges without access to fiat liquidity. Currently, the outstanding tether is not fully backed by US dollars but only partially. Given this fact, there is a significant amount of risk of tether losing its parity to the US dollar or even experiencing a ‘bank run’. Secondly, Bitfinex is exposed to considerable legal risk due to the NYAG’s investigation. Whilst the investigation is still in the early stages, such serious charges present existential risks to the exchange. This article will help the reader understand the role that both Bitfinex and Tether have historically played within crypto asset markets and then assess what impact the NYAG’s allegations will have on the companies and the wider crypto asset market.
Bitfinex is a crypto asset exchange founded in 2012, owned and operated by iFinex Inc and headquartered in Hong Kong but registered in the British Virgin Islands. The exchange was founded by Jean-Louis van der velde (Chief Executive Officer), Giancarlo Devasini (Chief Financial Officer) and Raphael Nicolle. Over the last few years, Bitfinex has become a leading crypto asset exchange. For example, the exchange offers over 100 different trading pairs including those with several fiat currencies as a base (USD, EUR, GBP, & JPY). As of April 28, 2019, the exchange’s self-reported 24-hour volume was $125,231,371 their 7-day volume $1,361,694,758, and their 30-day volume $6,610,518,589. Similar to its main competitors, the exchange offers a number of additional exchange products such as margin trading and algorithmic trading orders.
The below charts plot the trading volume for its BTC/USD pair over time compared to its major competitors measured in both BTC and USD.
One can see that following the collapse of Mt. Gox (counted within the Others category below), Bitfinex has grown to occupy a rather large proportion of trading volume for the BTC/USD trading pair. The crypto asset market now is much more than just Bitcoin, but nevertheless, this data point alone helps show how large a player Bitfinex has generally been within the market.
Bitfinex and Tether
It can be argued that Tether has played an even more important role in crypto asset markets than Bitfinex due to its role as the de facto stable coin within the industry. Tether was founded by a group including Brock Pierce, Craig Sellars, and Reeve Collins in 2014 as one of the first ‘stable coins’ – a crypto asset designed to maintain a peg to a popular fiat currency such as the US dollar by maintaining a 1:1 backing with dollars deposited by customers. The crypto asset was created through the use of the Omni Layer Protocol. Tether’s relationship with Bitfinex is complicated but there is substantial evidence suggesting that the organizations share co-founders – namely Phillip Potter and Giancarlo Devansini. Documents released in the Paradise Papers supports this thesis.
The below chart plots the growth of Tether’s monetary base over time in order to better help explicate the sheer economic scale of Tether.
By most measures, Tether is one of the most valuable (considering per unit price and total circulating supply) crypto assets and the current leader within the stable coin sector. Total reported exchange volume figures can help quantify the extent to which tether is used by investors and traders – by most counts its exchange volume trails on that of Bitcoin.
The metric of the utmost importance to judge the success of a stable coin is its ability to maintain stability over time. The chart below plots OHLC data for the USDT/USD pair on Bitfinex from late 2018:
To put the above chart into even more context, it is helpful to compare Tether’s stability to that of its main competitors. Looking at the data it’s clear that the difference in stability (as measured by price return standard deviation) is minimal between the currently popular stable coins – though this hasn’t always been the case if one chooses to include some of the historically less successful stable coins such as bitUSD within the analysis.
What this analysis should make clear is the dominant role Tether has carved out within the crypto asset space as the obvious choice for traders and investors looking for stability or for other users who are unable to easily access US dollars. It has only been in the last year that credible competitors to Tether have emerged aiming to supplant Tether by focusing on regulatory-compliance (USDC, GUSD, PAX, TUSD), audibility (USDC, GUSD, PAX, TUSD, DAI), and technological advancements (DAI). The reason why those features may be attractive to users should become obvious by the end of the next section.
Bitfinex and Tether have, since early, been involved in a number of controversies which are worth noting before unpacking. Below we summarize the most significant:
In May 2015, 1,500 bitcoin were stolen from a Bitfinex hot wallet
In June 2016, the U.S. Commodity Futures Trading Commission (CTFC) ordered Bitfinex to pay a $75, 000 fine for offering illegal retail commodity transactions and failing to register as a futures commission merchant
In August 2016, 199, 657 bitcoin (worth at the time $65m) was stolen from Bitfinex. The loss was shared proportionally amongst all Bitfinex’s users and users received BFX tokens proportional to their personal losses which Bitfinex pledged to exchange at a later date for the adequate repayment by Bitfinex.
In August 2017, Bitfinex announced it would no longer permit U.S.- based individual investors to access the trading platform.
In November 2017, 31 million USDT is hacked from the Tether treasury wallet. Tether subsequently hard forks to prevent the spending of those funds.
In December 2017, the CFTC sends subpoenas to Bitfinex and Tether.
In June 2018, a memorandum prepared by law firm Freeh Sporkin & Sullivan, LLP claims that the value of Tether’s reserves equaled the value of circulating USDT.
In October 2018, Tether and Bitfinex’s relationship with Puerto Rico-based Noble Bank comes to an end.
In March 2019, Tether changed its disclosure, to include that “[elvery 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’). “
Aside from the aforementioned controversies, Tether and Bitfinex have constantly been plagued with accusations of Tether’s insolvency and claims of market manipulation – most notable from the pseudonymous writer Bitfinex’ed. The claims of Bitfinex’ed have been followed up by analyses conducted by Bloomberg and academics from the University of Texas at Austin, both drawing suspicion to Tether and postulating its use as a possible means to manipulate the Bitcoin market.
Now that sufficient context has been given to both Tether and Bitfinex, we can now turn our focus to the NYAG investigation and summarize its main findings. On April 25, 2019, Attorney General Letitia James announced that her office had obtained a court order enjoining iFinex Inc., operator of Bitfinex and Tether Limited – the issuer behind ‘Tether’, from further violations of New York law related to their ongoing activities believed to have defrauded New York investors. The key violation was the accusation that the operators of Bitfinex had engaged in a cover-up to hide the loss of $850 million dollars of client funds. The court order requires the iFinex to ‘cease further dissipation of the U.S. dollar assets which back [Tether] while the Office’s investigation continues”. The court was issued under a provision of New York’s Martin Act – a New York’s anti-fraud law which grants expansive law enforcement powers allowing officials to conduct investigations of securities fraud and bring civil and/or criminal actions against violators of the Act. The key findings of NYAG’s investigation are as follows:
The Tether entities are owned and operated by the same group of executives and employees who operate Bitfinex. Moreover, Tether is majority owned by an entity named DigFinex Inc. which is the majority owner of iFinex. This fact was widely thought to be the case but can be thoroughly confirmed with the NYAG investigation. (1)
Despite Bitfinex’s August 2017 ban of U.S.-based individuals from accessing its trading platform, the Office of the Attorney General (OAG) has reason to believe that Bitfinex sill allows New York-based investors to access their trading platform. (2)
On November 27, 2018, the OAG served subpoenas on both Bitfinex and Tether seeking documents and information – as previously reported but not yet confirmed. (3)
In 2014, Bitfinex began a relationship with a (believed to be) Panamanian entity called Crypto Capital Corp. to act as one of their ‘payment processors.”. By 2018 Bitfinex had deposited over one billion dollars of client funds with Crypto Capital. Importantly, no contract or written agreement was ever entered into between Crypto Capital and Bitfinex or Tether. (4)
By mid-2018, Bitfinex began encountering difficulty honoring its clients’ requests to withdraw their money from its platform because Crypto Capital – which at this point held almost all of Bitfinex’s funds – refused to process customer withdrawal request and refused to return any funds to Bitfinex. Despite this, Bitfinex published two notices on October 7 & 15, 2018 to investors ensuring them that the company was not insolvent and that all cryptocurrency and fiat withdrawals are processing as usual. (5)
An individual at Crypto Capital told a senior Bitfinex executive (“Merlin”) that the reason that Bitfinex’s funds (which now totalled $851 million) could not be returned was that they had been seized by governmental authorities in Portugal, Poland, and the United States. Respondents from Bitfinex do not believe Crypto Capital’s representations that the funds have been seized. As such the $851 million of customer funds remains inaccessible to Bitfinex to date. (6)
On February 21, 2019 counsel for Bitfinex and Tether explained that they were in the process of contemplating a move wherein Bitfinex would take a line of credit of $600 to $700 million on the reserve funds backing tether to help make up for the apparent loss of $851 million to Crypto Capital. The OAG raised serious concern over the viability of such a plan. (7)
On March 29, 2019, OAG received a letter from the counsel for Bitfinex and Tether which disclosed that the line of credit transaction had already closed on March 27, 2019. Moreover, the description of the terms of the transaction differed massively from what had already been described to the OAG. (8)
It was revealed that during November 2018, Tether transferred $625 million held in its account at Deltec (their bank at the time) to Bitfinex’s account at Deltec. Simultaneously, a ledger entry at Crypto Capital credited Tether’s account in the amount of $625 million and debited Bitfinex’s account by the same amount. (9)
In December 2018, Bitfinex undertook negotiations with Tether on an agreement wherein Tether extended a secured, revolving line of credit of up to $900 million on a term of three years and a 6.5% interest rate on outstanding loans. The line of credit was secured by 60,000,000 iFinex Inc. shares owned by DigFinex. This transaction closed on March 19, 2019. In total, $700 million has been accessed under the loan facility as of April 25, 2019. (10)
On March 27, 2019, Bitfinex and Tether began a transaction debiting $625 million which had previously been credited to Tether’s account at Crypto Capital and then consequently crediting Bitfinex’s account for the same amount. This was done because the previous transaction (9) had been converted into a line of credit (10). (11)
Up until this point, the OAG believes that none of this information had been disclosed to investors in Tether or Bitfinex’s clients. (12)
The purpose of the OAG’s ongoing investigation is to determine the extent to which New York investors are exposed to ongoing fraud by Bitfinex and Tether. (13)
Documents required from Tether and Bitfinex following the court order include among others: (i) All documents and information requested in the November 2019 Subpoenas and in the OAG’s letter to Tether and Bitfinex in February 2019; (ii) All documents concerning Bitfinex and Tether clients and business partners who reside or do business within New York; (iii) All documents concerning any transactions to extend the line of credit made between Tether and Bitfinex. (14)
Finally, it is important to note that the OAG does not seek to interfere with the operation of Bitfinex and Tether’s “legitimate business” nor limit their ability to further access or extend the line of credit in order to preserve the “status quo and protect the interests of New York tether holders and Bitfinex clients”. (15)
Perhaps the key takeaway from this investigation is that, as of today, the estimated 2, 846,831, 191 USDT are in-fact only backed by 2,146,831,191 US dollars (75%) at the most, with the rest backed by a loan secured by 60 million iFinex shares. Secondly, attention is drawn to the controversial bank, Crypto Capital, the ostensible reason why Bitfinex is unable to claim back its customers’ funds. This is the same Crypto Capital who received the blame for QuadrigaCX’s withdrawal problems; moreover, Crypto Capital has been linked to a total of four exchanges which have had issues with fund withdrawals historically – Bitfinex, QuadrigaCX, CEX.io, and Coinapult. Finally, it is important to note that the scope of the OAG’s investigation is limited to the extent to which Bitfinex and Tether defrauded residents and citizens of New York – the magnitude of which may be argued to be much smaller than the full extent of their overall alleged fraud.
Understandably so, the news of the NYAG investigation shook the crypto asset news cycle and impacted the markets. Interestingly enough, we have not seen a massive market downturn nor a catastrophic impact on USDT’s dollar parity. The data points which truly tell the story of the Bitfinex-Tether drama have been: the pricing of crypto assets on Bitfinex compared to its competitors, exchange on-chain in-/out-flows data, inter-stable coin pricing, and on-chain data for the minting of competitor stable coins.
The charts below compare pricing on Bitfinex for the BTC/USD trading pair with that of Coinbase and Kraken. One can see that, once the news broke, Bitfinex’s trading pair has been consistently trading at a premium to that of its competitors as investors try to get their funds out of the exchange.
As of yesterday, the premium was as much as 3% when compared to the averages of Kraken and Coinbase Pro. This point becomes even more obvious when we begin to look at the Bitfinex’s on-chain inflows and outflows and how they have changed since the news broke. Below we plot the exchange net outflows for both ETH and BTC on Bitfinex1.
On the day following the news breaking, the exchange experience unprecedented net outflows of both ETH and BTC from their wallets which supports the thesis that many Bitfinex customers have been hastily attempting to get their funds out of the exchange. Over $250 million worth of ETH and BTC left the exchange the day following the news of the OAG investigation and we can imagine considerable amounts of other crypto assets followed suit.
Furthermore, we can get a better idea of the news’ effect on Tether by considering what premium the market has placed on BTC/USDT trades when compared to competitor stable coins. We focus on stable coin trading on Binance with the exception of DAI since there is currently no BTC/DAI trading pair on Binance.
As expected, the BTC/USDT trading pair is priced at around a 100-unit premium to that of the other trading pairs. This is a strong signal that traders are trying to move their capital from USDT into BTC. It would follow from this data point, one would assume, that there has been an increase in demand for the competitor stable coins as well. The fundamental metric to ascertain this is the number of new stable coins which have been issued since the April 25th announcement.
The spike in issuances amongst three of the most popular stable coins (PAX, TUSD, USDC) is noticeable and the highest it has been in the last two months. However, interestingly both GUSD and DAI did not experience significant spikes in new stable coin issuances – likely in DAI’s case, due to the slightly more complicated mechanism involved in the issuance process. It is difficult to draw conclusions from only a few days worth of data but everything suggests that the news has led to investors start to withdraw their crypto assets from both Tether and Bitfinex. Moreover, there has been a noticeable increase in interest for the main Tether competitors but it remains to be seen if this change in trend will make any significant difference to Tether’s dominance within the stable coin market.
This report has helped demonstrate how important the OAG’s investigation is and it should now be easy to imagine what negative effects this could have on Bitfinex and Tether. A more interesting question is to consider what effects this report and its findings will have on the wider crypto asset market.
As we have previously mentioned, Tether is one of the industry’s most widely-used crypto assets and there is the potential that the findings of the NYAG’s investigation could damage the market’s belief in USDT’s parity with the dollar – and for good reason. Currently, for each outstanding USDT, only around 75¢ are currently held by Tether with the 25¢ being ‘backed’ by illiquid debt – in turn, collateralized by an illiquid security (the 60,000,000 shares in DigFinex). As a result of this fact, Tether is currently unable to honor all redemptions for outstanding USDT. Given this fact we can expect to the market to begin to price USDT at a steep discount to the dollar; alternatively, if this doesn’t happen exchanges where USDT continues to trade at odds with reality expose themselves to a large amount of risk and the whole industry to contagion risk as a result.
Given the fact that USDT is still priced relatively close to parity with the dollar, it would not be surprising if certain exchanges with viable stable coin alternatives considered de-listing USDT. This remains a possibility but is perhaps relatively unlikely for now. Moreover, aside from the problem of USDT’s backing, Bitfinex still faces the possibility of criminal and/or civil charges from the NYAG during the concluding stages of the investigation. It’s outside of the scope of the research article to speculate on the legal outcomes of the investigation, however.
As we have shown, there has been a cloud of suspicions following Bitfinex and Tether for the last few years, this investigation could act as the impetus behind the market moving towards better regulated and trustworthy stable coins, as well as exchanges being held to higher standards. Such a move would be in the industry’s long-term best interests but the fall out in the short-term for an industry, which is somewhat dependent on Tether and Bitfinex, could be somewhat damaging.
A consistent theme in the stories of trouble exchanges seems to be the Panama-based Crypto Capital which, as previously mentioned, has in the past provided banking for QuadrigaCX, Bitfinex, CEX.io, and Coinapult. The OAG investigation supports the case that the bank is functionally insolvent despite having relationships with several important crypto asset exchanges. The thesis that Bitfinex’s historical withdrawal problems have solely been a function of their failed banking relationships is more appealing and realistic than the claims of wash trading which came to promise over the last two years. Nevertheless, we imagine that such claims will either be refuted or proven true as the investigation continues.
To conclude, this report presents the most comprehensive overview of the Bitfinex-Tether investigation by the NYAG and its aftermath. There are a host of questions to be answered and we expect more to become clear as the market continues to react to the news, and the OAG’s investigation continues to bring to light more information about Tether and Bitfinex’s operations.
1 Data from TokenAnalyst
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