Preamble: last week, I posted about ICOs (Initial Coin Offerings), and how they might be used to ‘print’ cryptocurrency. I’m very concerned by this. Because rather than being decentralised, the new wave of crypto-offerings appears to be placing ‘institutional’ power into the hands of the exchanges. The exchanges are the key point of weakness in the crypto-space. And because they are unregulated, they are essentially a law unto themselves. But that was mostly speculative theory. Today, I want to talk about Tether, and Bitfinex, and what might well turn out to be an example of this kind of activity.

Here are some terms that I’m going to use today:

• Tether: a cryptocurrency
• Bitfinex: the cryptocurrency/Bitcoin exchange with the largest flow-through of Bitcoin trading volumes.
• Margin trading: a method of buying or selling Bitcoins where the Exchange lends you the money/bitcoins to do it.
• Wash trading: a type of market manipulation, where you buy and sell from yourself in order to move the price (and/or create the illusion of market activity.

Market Manipulation is mostly illegal

Here’s something that you should know: public markets are relatively easy to manipulate. There are all kinds of things that a trader can do to move a price artificially.

This kind of activity has resulted in regulation.

Here is a quote directly from the SEC’s website:

Manipulation is intentional conduct designed to deceive investors by controlling or artificially affecting the market for a security. Manipulation can involve a number of techniques to affect the supply of, or demand for, a stock. They include: spreading false or misleading information about a company; improperly limiting the number of publicly-available shares; or rigging quotes, prices or trades to create a false or deceptive picture of the demand for a security. Those who engage in manipulation are subject to various civil and criminal sanctions.

In an unregulated market space, however, there is no problem with “rigging quotes, prices or trades to create a false or deceptive picture of the demand for a security.”

So in regulated markets, activities like ‘wash trading’ are going to land you in trouble. In an unregulated market, go right ahead.

A Wash-Trading Guide To Manipulating The Price Of Bitcoin

Here’s how wash trading would work:

• Let’s say that the current market price for Bitcoin is $1,000.
• I buy a Bitcoin from someone on the market for $1,000.
• At this point, I am now ready to wash a trade.
• I start by placing a ‘sell’ bid into the market for $1,500.
• I then accept my own ‘sell’ bid, and buy the Bitcoin from myself.
• The trade settles at $1,500 – and the new market price for Bitcoin is $1,500.

To be clear, no money changed hands. But the market price has now changed. And there’s not too much risk to me with that sell bid (because if someone else accepts, then I’m in the money – if not, I get to do my wash trade).

But other market participants might watch this kind of price change and get excited. Which is what I want – because if I pull more people into the trade, I’ll actually be able to sell to someone at $1,500 – at which point, I’ll be $500 richer.

Now if you’re just a small player, with not much money, people are going to view your trade as an anomaly.

But if you’re a big player, with lots of capital to play with, then other potential investors might be persuaded that there is ‘real’ market movement.

The key points:

1. You can artificially create the illusion of market demand by buying and selling with yourself; and
2. The more capital you do this with, the more believable your illusion will appear.

How do you raise the capital to wash-trade?

Two normal ways:

• You use your own money; or
• You borrow it (ie. you trade on margin).

But there is a third way as well in the cryptocurrency space:

• If you can persuade an exchange to list it, you print your own cryptocurrency.

So let’s talk about Tether – a cryptocurrency seems to have attracted some suspicion on this last point.

What is Tether?

Curiously, Tether is a cryptocurrency that is apparently backed by fiat money.

Coincidence?

I think not.

Most cryptocurrency fans are fans precisely because cryptocurrency is not fiat money. Meaning it cannot be inflated by a government or central bank.

But here is Tether:

And here is how they recommend you use it:

“An alternative to traditional currency deposit and withdrawal methods” at an exchange?

That is: you can use Tether as though it were real money. Provided that the exchange in question accepts it as an alternative.

And to be clear, the exchange would have absolutely no obligation to confirm that Tether is, in fact, “backed one-to-one by traditional currency”. If it’s happy to accept Tether at face value, then Tether will trade at face value.

As an aside, if you read the legal fine print, you might come across this phrase:

“There is no contractual right or other right or legal claim against us to redeem or exchange your Tethers for money. We do not guarantee any right of redemption or exchange of Tethers by us for money. There is no guarantee against losses when you buy, trade, sell, or redeem Tethers.”

Now perhaps that is legal speak. But to me, it says “Just because we back Tether with traditional currency, that doesn’t mean that we’ll allow you to redeem Tethers for cash. We may fulfil that obligation. But that’ll be at our option.”

And at worst, it implies that the ‘backing’ of tethers is possibly just a marketing ploy.

What is the market capitalisation of Tether?

Well here is a fun graph for you:Things to notice:

1. The price has not really deviated from the $1 for every Tether.
2. But the market capitalisation has been growing at a massive clip this year.

How is this possible?

Well, at the beginning of 2017, there were about 850,000 Tethers in circulation.

Today, there are about 380,000,000 Tethers. And every ‘jump’ that you see in the market capitalisation translates into a new round of Tethers hitting the market.

How does this correlate to Bitcoin’s trading price?

Well here is Bitcoin’s year-to-date price chart:

And here’s Tether’s market cap:

And here’s a combined chart from Twitter:

How should we be reading the fact that the price rallies in Bitcoin seem to be preceded by new influxes of Tether?

Are they unrelated?

Here is Bitfinex’s explanation for the sudden growth in Tether’s market cap:

“There are Institutional Tether customers that have their own bank accounts in Taiwan that are able to make an internal transfer to their Tether accounts, hence the new Tethers created.”

But the question I have in response is: “Why would an institution buy Tethers in order to buy Bitcoins, instead of simply buying Bitcoins directly?”

Oh, and for the record, Bitfinex is the exchange that honours Tethers as ‘USD-equivalent’.

Now let’s talk about margin-trading at Bitfinex

For my money, the biggest risk of a new altcoin is when it can be used to leverage a trade. In other words:

1. The exchange allows you to borrow money from them for cryptocurrency trading;
2. In order to do this, it requires collateral;
3. If the exchange accepts your altcoin as collateral, then you multiply the amount of ‘capital’ you have.

For example:

1. If the exchange requires a 10% collateral deposit for margin-trading, it means that every $10 trade requires me to place $1 in the margin account of the exchange as collateral.
2. That is: $1 of margin collateral gives me $10 worth of capital to trade with.
3. And if the exchange accepts my Tethers as collateral for all crypto-trading, then I can take $1 of Tether and use it to buy $10 worth of Bitcoin.

Question: which exchange accepts Tether as collateral?

Answer: Bitfinex.

Question: which exchange has the largest volume of Bitcoin trading in 2017?

Answer: Bitfinex.

And here’s the most curious thing: Bitfinex does not have access to any formal banking facilities. It used to, but was cut off (as I wrote about back in May). A quote from their chief strategy officer:

“We’ve had banking hiccups in the past, we’ve just always been able to route around it or deal with it, open up new accounts, or what have you… shift to a new corporate entity, lots of cat and mouse tricks.”
-Phil Potter, Chief Strategy Officer of Bitfinex

So to summarise:

• An exchange with no official banking facilities has the largest volume of Bitcoin trading volumes flowing through it;
• It is accepts Tethers in lieu of US dollars; and
• It facilitates margin-trading.

To cap this all off, what if I wrote that Tether and Bitfinex are owned and controlled by the same parent company?

Because they are.

To conclude…

There are two possible conclusions:

1. Bitfinex created Tether as a workaround solution after they were cut off from formal banking channels for refusing to comply with KYC requirements. This may all look suspicious – but they are really just crusaders against regulation. And now they’re the dominant Bitcoin exchange, on the back of fiat-backed cryptocurrency. Or
2. Someone (or a group of someones) is manipulating the Bitcoin market.

For more:

• Are fraudelent Tethers being used for margin trading on Bitfinex?

PS: a shout-out to Josh for pointing me in the direction of Tether, and to Rachel for doing a bunch of background research. Thanks!

Rolling Alpha posts opinions on finance, economics, and sometimes things that are only loosely related. Follow me on Twitter @RollingAlpha, and on Facebook at www.facebook.com/rollingalpha. Also, check out the RA podcast on iTunes: The Story of Money.