The Mystery Behind Tether, the Crypto World’s Digital Dollar

By Anonymous

A fast-growing digital currency that claims to be backed by U.S. dollars has become a cornerstone of the volatile cryptocurrency market. The problem: There isn’t hard evidence the cash supporting it exists.

Tether, whose main selling point is its tie to the U.S. dollar, has grown dramatically over the past year—its daily trading volume of around $3 billion trails only bitcoin’s $5 billion. Tether has also become a “crypto bank” for cryptocurrency businesses that have trouble maintaining real-world banking relationships, providing liquidity and a place to park assets, according to a new study from blockchain research firm Chainalysis.

Tether has assumed this role because of its link to the dollar. Unlike other cryptocurrencies that fluctuate wildly in value, one tether generally equals one dollar. This makes it a sort of digital-dollar substitute.

That is also why it is important that Tether has dollar reserves backing each of its approximately $2.5 billion worth of coins in circulation.

But Tether has never produced an audit showing it has the purported reserves. The company that controls tether maintains it has the reserves, yet it has never named the banks it uses to hold these funds, nor said where they are based and regulated.

Last year, Tether hired accountants Friedman LLP, based in New York, to audit the reserves. The firm issued a preliminary report last year, but Tether says it released Friedman before a final audit was completed. Friedman declined to comment.

Leonardo Real, Tether’s chief compliance officer, said that since then the company has had difficulty finding a reputable firm willing to take on a cryptocurrency client. He declined to say why Friedman was let go.

“There’s nothing to hide here,” said Mr. Real. “It’s not three managers just cranking out money randomly in a dark basement somewhere.”

In June, Tether hired law firm Freeh Sporkin & Sullivan LLP, co-founded by former Federal Bureau of Investigation Director Louis J. Freeh, which issued a report stating that it believed tether had full dollar backing. But the report, critics noted, wasn’t an audit and the law firm wouldn’t identify the banks it contacted to verify the reserves. Eugene R. Sullivan, a senior partner in the law firm, declined to comment, saying the report speaks for itself.

Mr. Real said Tether plans to release more evidence of its reserves.

The opaque way in which tether are created also causes concern among investors and market participants.

Unlike other cryptocurrencies, there isn’t a set amount of tether in circulation. In theory, demand drives new issuance. Cryptocurrency exchange Bitfinex places orders for new tokens with Tether and wires dollars or euros to the company’s bank account, according to both companies. Tether sends the newly created tokens to Bitfinex, which distributes them to investors.

Investors have little visibility into the process. Bitfinex shares ownership and management with Tether, and it is the only entity through which Tether issues tokens.

“It’s sort of the central bank of crypto trading,” said David Gerard, a programmer and author of “Attack of the 50 Foot Blockchain.” Yet “they don’t conduct themselves like you’d expect a responsible, sensible financial institution to do.”

Kasper Rasmussen, the director of communications at Bitfinex, said Tether isn’t a bank nor it is trying to be one, but that it does adhere to “applicable laws and regulations.”

In the decade since bitcoin’s introduction, cryptocurrencies have grown significantly, with assets in circulation worth about $216 billion. But the trading market is fractured and volatile.

Exchanges don’t share trading data, there are no circuit breakers or other trading halts, and options for hedging or other sophisticated bets are limited. Moreover, many of those exchanges have trouble maintaining bank accounts, since regulated banks are wary about having any exposure to the sector.

Tether Ltd. marketed its cryptocurrency as a way to mediate the sector’s volatility—offering the safety of the dollar along with the speed and anonymity of a digital currency.

The pitch worked. Tether’s market value has risen steadily over the past 18 months, to $2.4 billion from about $10 million at the beginning of 2017. That has made it a crucial link in the wider cryptocurrency market.

Tether-based trading volume grew more than 15-fold between October 2017 and March 2018, Chainalysis found. U.S. dollar-based trading volume, meanwhile, tripled in that same period.

As a result, tether has become a key source of liquidity. At times this summer, tether has represented as much as 80% of bitcoin trading volume, according to research site CryptoCompare. When the year began, it accounted for about 10% of bitcoin trading volume.

Nearly half of tether’s trading volume is among just a handful of tether-accepting exchanges, including some of the market’s largest.

Some investors say tether has become systemically important within the cryptocurrency market. “There are a couple of forces in this market that if they failed, it would be catastrophic,” said Ding’An Fei, a managing partner at Ledger Capital, a digital asset investment firm in Beijing. “Tether is one of them.”

Chainalysis also found tether trading is increasingly concentrated among smaller, more speculative digital currencies, a sign it is being used as a tool of “pump-and-dump” schemes, in which traders hype an asset, causing its price to rise, before dumping it for a profit.

Tether trading in newer tokens such as EOS and NEO has risen to about 20% of overall tether volume, according to the report.

The Securities and Exchange Commission recently singled out tether in its rejection of a proposed bitcoin-based ETF, citing studies that raised the possibility that the digital currency is being used to manipulate the bitcoin market.

Tether’s Mr. Real contested such claims. “It’s not anything about tether that enables this volatility,” he said.

Write to Paul Vigna at [email protected] and Steven Russolillo at [email protected]