All the other kids with their pumped up BTCs

What’s driving the Bitcoin bull run right now? Is it the prospect of Facebook’s Libra Coin offering a new on-ramp to retail investors? Is it institutions looking to hedge against volatility or inflation or autocracy or who knows what in the real world? Whatever it is, the rhetoric has certainly shifted back into bull market territory as a flood of new money pours into crypto. 

But what if this new money coming in wasn’t… real money? 

Seatbelts, everybody, cause we’re gonna talk about Tether again. Remember how last week I suggested that Facebook was framing Libra as a cryptocurrency in order to set up all of Bitcoin’s wild problems as a straw man? Well, we’re going to talk about some of those problems!  Note before we begin that I’m not a lawyer, and I engage in some speculation in this post about what is and isn’t fraud; so take it all with a grain of salt. 


If you ask people where money comes from, most people will say “the government prints it.” That’s correct sometimes, but not for most money. It’s true that around 5 to 10% of money, like the paper bills we’re familiar with, are indeed printed by the government: they’re IOUs that you can cash in when it comes time to pay your taxes. But most money comes from somewhere else: it comes from commercial banks, who create money by lending it into existence. If you understand what that sentence means you can skip ahead, but if you’re not sure, then please read on. (Or, better, read this helpful primer from the Bank of England.)

Money creation in the modern economy | Michael McLeay, Amar Radia & Ryland Thomas, The Bank of England

Let’s say you want to borrow money to buy a car. The bank agrees to lend you $10,000, to be repaid in a year. The minute your loan is approved, $10,000 appears in your bank account. Where’d it come from? The bank didn’t take a stack of hundreds out of the vault and hand it to you. Nor, unlike what many people believe, is it lending you existing money out of some big nebulous pool of customer deposits. 

The bank creates the money out of thin air. It does it in a funny way: by creating two matching and offsetting IOUs, One is your account: an IOU from the bank to you, which just looks to you like a credit of $10,000 in your account; the other is a mirror image IOU from you to the bank, to be repaid in a year, which looks like an outstanding loan balance. 

Then you go spend that money on your car, and worry about your loan later. 

Ignoring interest payments for now, take a minute to appreciate what happened. At the minute you accepted the loan, you became neither richer nor poorer: your loan is offset by an IOU of the same amount. The bank became neither richer nor poorer, for the mirror image reason. But $10,000 entered the world that didn’t exist before. Money was created, and you spent it on something tangible. Toyota took your money, paid workers and built factories with it, and stuff. That money is out in the world doing real things.

Now what happens in a year when your loan comes due? As you repay your loan, the reverse process happens. $10,000 disappears from your bank account, and the corresponding $10,000 IOU disappears as well. When loans are repaid, money is destroyed. That’s what makes this setup not a perpetual motion machine. Loans = money creation; repayment = money destruction. 

So how can the bank do this? Why do we trust in banks’ ability to create money out of thin air? The short answer is that the money they create gets to be real because the IOUs they create are real. When you (or Toyota, or anyone down the line) spends that $10,000, you’re passing around an IOU from the bank. We treat it as equivalent to paper cash because banks are good for the money. We know they’re good for the money; not just because of their deposits and other collateral, but really because of the legal system. Both you and the bank have to make good on your IOUs. And you have to suffer actual consequences if you don’t; or at the very least, credibly face that possibility.

Now for a hypothetical: if you take out a 0% loan, and never pay it back, and then suffer no consequences, is it still a loan? 

The answer is: it depends! It depends on your intentions. If your intentions were genuine and you actually put the loan to work on the project that you said you would, and then the project doesn’t work out, and your bank decides to be nice and forgives the loan, then that’s probably okay. But if you and the bank never intended for the loan to be paid back in the first place, or your plan was “I’ll pay it back if my investment goes up, and not pay it back if my investment goes down, with the advance understanding that my lender is not going to ask for their money back in the latter case”, then that’s not a legitimate loan. 

In fact, it may be worse: it could be a crime. If a bank takes deposits from the general public, there are rules it has to follow around what its IOUs mean. If the bank goes off and makes reckless or illegitimate loans to all its friends that it knows will never be paid back, and blows up the bank’s credibility, then the bank’s other IOU-holders – especially its depositors – will probably sue the bank. They will probably win, too. 

This is why, just to reiterate, the reason why we trust banks to lend money into existence isn’t just economics: it’s the legal system. We trust that the legal system compels banks to make real loans. The IOUs have to be real, and the legal system is what makes them real. 

Now, let’s imagine a slightly different scenario: suppose you’re in charge at Tether. (Hahahaha.) 

Just to recap: I’ve written about Tether several times before back when I was writing Snippets at Social Capital, and more recently a few months ago when the news dropped that they were being investigated by the NY Attorney General’s Office. I’m not going to rehash everything here because that would take too long, aside from a few essentials:

-Tether is a so-called “Stablecoin”, often demarcated $USDT, that is supposed to hold a peg to the US Dollar. If you buy one $USDT, you hold an IOU from Tether that is redeemable for one dollar. Tether is acting like a bank in this regard. It takes deposits and gives you back IOUs. The value of a Tether hinges on these IOUs remaining sound. 

-Many cryptocurrency exchanges that do not have legitimate banking partners use Tether as a way to offer their customers trading in US dollars. 

-Tethers were initially advertised as being backed 1 to 1 by hard currency deposits, but have since slid into “backed by currency or other crypto assets (e.g. Bitcoin). Much of the thrust of the NYAG’s office lawsuit is to whether customers were misled about what was backing their IOUs. It’s easy to see why: if your Tethers are backed by Bitcoins rather than real money, then you’re getting the upside of dollars and the downside of BTC, which is obviously not great. 

As I was saying: imagine you’re in charge at Tether. You’re kind of like a bank. You sort of take “deposits” in from customers, and then in exchange give them back IOUs called Tether Tokens. But you’re not a bank. You don’t have FDIC insurance; you don’t have a long, built-up history of successfully lending, holding and recouping money. In order for anyone to trust your IOUs, you need to hold one real dollar in reserve for every Tether that you print. But that shouldn’t be a problem, since your customers are giving you a dollar for every Tether that you print. Just hold on to them. 

The thing is, that’s not a very interesting business. You’re not creating any new wealth, or any new product, or anything; you’re just taking in customers’ analog dollars and giving them back synthetic digital dollars, holding them at a 1 to 1 ratio. You provide a useful service, particularly to exchanges who don’t have legitimate banking partners and need your synthetic digital dollars in order to let their customers transact with real money. But if you do it by the book it’s kinda boring. 

What would be more interesting is if you could collateralize your Tethers with something other than dollars. You could collateralize a hundred dollars worth of Tethers with 75 dollars, for instance, which is called Fractional Reserve Banking and is a common business model – but isn’t what you promised your customers. Or, you could do something even bolder, which would be to collateralize your Tethers with something else entirely, like Bitcoin itself. That’d be great for you, but not so great for them – it means Tether holders are holding something with the upside of a dollar but the downside of Bitcoin. Not exactly what they signed up for. 

But what would be really nice is if you could get into the Money Creation business. Surely, if you could temporarily lend some IOUs into existence, people out in the crypto market would be able to put that money to work somewhere. Then once their projects pay off, they could pay you back, just like banks do in real life. You’re already in the IOU creation business; you do it every day when people deposit currency with you. Sounds like a grand idea!

Now if you’ve been watching Tether print hundreds of millions of dollars’ worth of tokens over the last few months, it may strike you that this looks an awful lot like what’s going on. (Unless you think that depositors are actually entrusting an organization who’s currently under criminal investigation with hundreds of millions of dollars of their own money, just so that they can use the shadier crypto exchanges instead of the more legitimate ones. In which case, I admire your positive outlook!) A few internet sleuths, @Bitfinexed in particular, have been pointing out this pattern for a long time. 

But then amazingly enough, just this week somebody named Will Harborne, who runs Ethfinex (a subsidy of Bitfinex, which is Tether’s sister exchange / owner / symbiotic parent) came out the other day and came very close to admitting that this is exactly what’s going on. Seriously, this interview is like a living embodiment of the “he just… tweeted it out” Twitter meme. The money line was Harborne saying how Tether prints tokens before money actually gets received: “Tether essentially just ‘pre-creates’ the blockchain tokens based on rough projected demand.” So, having fully admitted that Tethers are printed in advance of customers explicitly ordering them, we’re also supposed to believe that at no point are they ever lent out as IOUs to those same insider customers, or even advanced one second of cash payment. Mmhmm.

Now, what could all that that newly created money be going towards?

  As many of you know, whenever you have some security or marketable asset whose price trades on public perception, there’s a really straightforward scam you can run called a Pump-and-Dump. Get a few people with deep pockets together, and then start trading shares of some Penny Stock back and forth among each other. (Or, better yet, something like Bitcoin whose price is purely a matter of public perception, rather than a guesstimate of intrinsic value.) 

If you represent a significant enough percentage of the trading volume of that stock, you can “pump” the stock by selling it back and forth at higher and higher prices. If retail customers see the price rising, get FOMO, and then start buying the stock themselves, then you can dump the higher-priced stock on them and pocket the difference. Congratulations, you’ve just run your first basic stock market scam. 

One inconvenient thing about pump and dumps is that you have to put up actual cash to make it work. But you’re a bank! You can lend a bunch of Tethers into existence as symmetric IOUs with a friend of yours. Then your friend can go spend those Tethers to pump the price of Bitcoin up. When he makes money, he can pay back your IOU out of the profits from the pump. Awesome! 

Of course, you’d have to be a real cynic to think that this current Bitcoin rally was being driven entirely by Tethers being lent into existence in order to pump the price, rather than genuine investor interest. Unless, oh, you saw something like this:

Not a lot of USD volume there to support a real rally – but don’t worry, there’s plenty of Tethers being printed to make up the difference. The only problem is that they aren’t deposits. They’re loans. 

As Tether CEO, take a minute to admire this incredible business you’ve built. You have two sets of customers, which you’ve probably named something like the “Fish” and the “Whales”.

On one side, you have the Fish: retail customers who bought Tethers with their US dollars, possibly without even realizing they’ve done so, if it’s through an exchange. To them, it probably just says “US Dollar Balance”, and they happily trust that one dollar on the screen means one actual real dollar somewhere that’s theirs. 

On the other side, you have the Whales: a close group of friends for whom you’re happy to print Tethers for today in exchange for payment tomorrow – again, not a sale, but a loan. The Whales, with their freshly conjured Tethers, can go put them to work – pumping up the price of Bitcoin, for instance. 

One more time: all those Tethers being printed for the Whales are not deposits. They’re loans. 

By now I hope you appreciate the problem here, which is this is big time fraud! What’s fraudulent, funny enough, isn’t the market manipulation. While there are laws that protect the integrity of well-established markets like the NYSE, you cannot expect any such integrity if you’re playing in the Wild West of crypto. Sorry.

The fraudulent part concerns the nature of your IOUs and how you’ve marketed them to your customers. It’s why we spent all this time talking about banking and money creation at the beginning. Banks get to do this because they are very rigorous about what an IOU from them means, and because they’re operating within the well-understood confines of the modern legal system. Tether? Not so much. 

The easiest way to illustrate the con is to look at how Tether could do this totally above board if they chose. You could mint two different coins: one called Tether, which is rigorously backed in a bank account somewhere (which also is what Facebook’s Libra Coin will be, and I actually believe that they will do this), and another called let’s say Pleather that is a credit offering you lend into existence as a mutual IOU. If you explicitly separate them and advertise each of them honestly, you’re in the clear.

But you’d immediately see the problem: no one wants Pleathers. They are worthless IOUs backed by nothing. You can’t use them to pump the price of Bitcoin; you can’t use them for anything. The market for Tethers, though, is quite real – all these unbanked crypto institutions out in the world are critically dependent on Tether to provide fiat liquidity to their clients. If you’re willing to equivocate the two, you have a fully liquid market to pump Bitcoin with your Tethers, make a healthy profit, and then cash in your Tether cost base as you “pay back” your loan. 

Worse, they may not even pay back these loans, who knows. The cost of creating a Tether is zero! And I’m sure they absolutely won’t pay them back should the crypto market go down. Like our bank who lends to their friends while asking for repayment only if the investment goes up. These are not real loans! Repaying the Tethers is good housekeeping to keep the grift looking legitimate, but it isn’t necessary for the mechanics of their pump scheme.

The specifically fraudulent part of what Tether is doing is continuing to market Tethers to its retail clients and also lending out Pleathers to its friends, all while stamping them with the same interchangeable IOU collateral: their deposits. As a retail Tether buyer, you have marketed me a product that you claim is “fully backed”; if you then start lending them into existence backed by nothing, while insisting to me that Tethers are fungible and interchangeable. You’ve certainly sold me a misleading and dishonest financial product. Claiming “oh they’re crypto; it’s the cryptography that grants them integrity” or something is a great red herring, because, yeah sure I trust that Tether’s cryptography is fine. But that’s not at all what matters; the nature of the IOU is what matters.

But it gets more serious: if you’re printing Tethers explicitly to lend them to your buddies, with prior knowledge that the purpose of these lent-into-existence Tethers is to pump the market and then unload the pump on retail bagholders, then that’s probably worse than run-of-the-mill breaking securities law; I’m guessing that counts as conspiracy to defraud investors.

This is well into our “0% loan we both agree is never going to get paid back” territory we talked about before, except instead of lending dollars, you’re lending fake synthetic internet dollars that continue to be redeemable for other honest customers’ deposits – oh, and the project you’re investing the loan into is “pump Bitcoin’s price through the roof, dump it on those very same retail customers, keep the change if it goes up, and abandon them if it goes down.” I’m not a lawyer, but if I were the NYAG’s office this would be exactly the kind of line I’d pursue. 

Part of the reason why I’m fairly confident that this is true is because if Tether / Bitfinex were acting above board in the way they say they are, it’d be so easy for them to prove it. They’d just need to show, you know, some actual deposits! Anything! If you’re actually operating a boring stablecoin like you say you are, it shouldn’t be hard to show it. 

So why doesn’t anybody say anything about this? Well, because the outcome of all of this is that the price of Bitcoin gets pumped – and everybody in the ecosystem wants that to happen! I don’t know any juicy insider information about who is pro- or anti- Tether in the ecosystem or anything like that, but it you don’t have to be particularly insightful to observe that in a whole industry that’s paper rich on crypto, you’re going to have a hard time being opposed to crypto pumps on principle. You get rich! 

Furthermore, it’s not like there’s an easy anchor for what Bitcoin “ought to be worth”, aside from zero if that’s your point of view. Bitcoin’s not like a share of stock, even a penny stock, where there’s an intrinsic value that at some point has to anchor the price. The only thing “weighing it down”, for our purposes, is Bitcoin holders looking to sell. So long as Tether and their Whale Friends are pumping the price up, then yeah, they can find buyers. But the minute they stop, there are a lot of bag holders with some pretty heavy bags who are going to try to cash in, and find that nobody’s home when they knock on the door. 

As a general warning, it’s tempting for us to rush into the crypto ecosystem and build all of these kinds of “institutions” that exist out in the real world, especially banks and all of the different jobs they do. But remember: banks are able to do what they do because the legal system legitimizes their IOUs. Crypto does not have a legal system. Perhaps it will one day! But in the meantime, just know that the farther you stray away from buying plain old vanilla Bitcoin, the more you’re leaving the land of cryptographic protection and entering the land of legal protection, for which their may not be any. 

Anyway, as I write this, the bulls are running. Have fun, be safe. Don’t do anything stupid, but do go participate. It’s a remarkable moment. 


Note: I published this around noon, eastern time, on Wednesday the 26th. A few hours later, this happened:

Totally normal market behaviour! Looks completely real to me! Nothing to see here!

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