Bitcon, Bubbles, and Massive Fraud

So I honestly hate to wade into this territory, but I’m doing so as a public service to folks who read this little blog of ours.

Bitcoin and other cryptocurrencies are all the rage right now. Hordes of people want them, many think that they’re “going to the moooon!” You can’t swing a bag of fiat currency without hitting a bus driver and his family that are getting their side hustle on trading cryptocurrency. I’m wading into it because I think rational people need to at least try to speak a little sense and the degree of crazy has reached epic proportions.

First and foremost, should anyone put any money into bitcoin or any other cryptocurrency right now? No, absolutely not. Stay away from it, don’t touch it with a ten-foot pole. Run screaming the other way if someone even suggests that it’s a good investment option. But we need to unpack that answer so 1) We can talk about the legitimately cool technology underlying bitcoin, 2) We can cover some basics of bubbles and the psychology that underlies them, and 3) finally and perhaps most importantly I can warn folks about what is a potentially massive fraud underway at one of the biggest bitcoin exchanges operating, a potential $400M+ ticking time bomb that has the potential to blow up the entire space. This post will get long, there’s a lot to cover, so stay with me.

What are Bitcoin, Cryptocurrency, and Distributed Ledger

The distributed ledger technologies that underlie bitcoin and other cryptocurrencies have the potential to be as disruptive as the IP protocol that created the internet. They have the potential to upend banking and currency systems, deliver radical improvements to everything from logistics management to accounting to journalism. So what exactly is this amazing new technological wonder and why are these things so cool?

Bitcoins (and all other cryptocurrencies) operate on the top of a technology called Distributed Ledger (DLT). Distributed ledger technology is FAR broader than just Bitcoin with the potential to be incredibly disruptive. At its heart, DLT is simply a database of transactions. This can be anything from a series of payments and acceptances to a series of orders and goods shipments, to land registries, to hospital records. Anything that can be stored in a normal database could also be stored and accessed in a distributed ledger in some way. There are a few properties that make DLT so interesting for folks.

Distributed (i.e. not centralized)

Most traditional record-keeping systems are a single point of failure system. If hackers break into one computer system they can compromise the entire database or record. Distributed ledgers are multiple points of failure systems. Hackers have to attack the entire system of multiple nodes to corrupt or take down the system

Transparency and Immutability

Essentially, everyone can see all the transactions that take place across all time, and the history of transactions cannot be altered. The history of all transactions is stored across the entire network, and once again to attack that history you have to attack the entire network, a near-impossible task in a large distributed system.

Process Integrity

The instructions for verification and processing of additions and alterations to the system are inherent in how the system itself operates. Users can trust that the system will process transactions exactly as spelled out in the code underlying the DL. There’s no way for a hidden third party to alter or change the record. This enables all sorts of cool potential applications such as contracts that are enforceable without the need for any arbitration outside of the DL itself.

Trustless Exchange

Due to the nature of how this all works, there is no need for a trusted third party to verify transactions and additions to the ledger. Two parties can interact or exchange funds and each can independently verify on the ledger that the transaction took place, was verified, and is now immutable.

How exactly does all this work?

Short answer – it’s complicated. The longer answer is that it works off the back of very difficult cryptographic algorithms that require large amounts of computing power.

Any particular transaction you add to the chain is secured with what’s called a private/public key pair – essentially two VERY long strings of characters that have a unique relationship with each other. If you want to wade into the details you can find them here. Essentially, when you sign a transaction with your private key you prove beyond a shadow of a doubt that you were the one actually generating the transaction. There is no way someone can impersonate you without access to that private key.

When a transaction occurs, you create that verified transaction and then send it off to the network. There it is grouped together with other transactions to be processed by the nodes across the entire network. There are multiple ways you could handle it from this point – first come first serve is the simplest. Bitcoin itself uses a payment system, you pay the nodes to handle your transaction, highest bids go first. When a block of transactions is successfully verified it is then added to the distributed ledger that exists on every node in the system, the system then moves onto the next group of transactions. The added node becomes part of history stored on the ledger.

That verification system is also computing power intensive algorithm, once a node has been added if someone wanted to attempt to change the history of transactions they would have to recompute every node that follows – a process designed to be as close to impossible as you can get. IBM has a great article explaining it in more detail here.

Asset Class Bubbles and What Drives Them

So the technology underlying bitcoin is awesome. It’s tech that has a HUGE potential to be disruptive. Everyone should be watching the space very carefully over the next few years. However, I’m going to argue that investing in the current bitcoin/cryptocurrency hype is not something you want to be engaged in. The current hype is driving a speculative bubble that will inevitably come crashing down. There WILL be great investment opportunities in companies doing very interesting things with DLT after that crash, but we are not there yet.

Before we start talking about if bitcoin is in a bubble or not, we need a working definition of what exactly a bubble is. Robert Shiller, the guy who wrote the book on bubbles, offers the following.

A situation in which news of price increases spurs investor enthusiasm which spreads by psychological contagion from person to person, in the process amplifying stories that might justify theprice increase and bringing in a larger and larger class of investors, who, despite doubts about the real value of the investment, are drawn to it partly through envy of others’ successes and partly through a gambler’s excitement. – Robert J. Shiller, Nobel Prize in Economics

Essentially, Shiller’s definition of bubbles is all about a feedback loop between investing results, the news media, and investors that continue to drive the price higher without any justification based on fundamentals. That is exactly what we see right now in cryptocurrencies.

An initially fantastic story, that of DL technology and bitcoin founded on the back of a groundbreaking paper by an anonymous author, set us off to the races. Bitcoin is fantastic tech, and it very well could be the future of currency and banking. That is a cool story that the media and investors can grab onto. And that is exactly what has happened.

As word of this story spread you got posts like this guy hodling bitcoin no matter what. That spawned a massive popular wave making everything from bitcoin art to bitcoin t-shirts like this. The media reports on it in stories like this one talking about newly minted 20 something millionaires. Those generate more attention and draw in even more investors. Meanwhile, the actual value becomes divorced from any sort of fundamentals.

The clearest example of this divorcing of fundamentals can be found in the Bitcoin Investment Trust. The BIT is a very simple investment vehicle; it holds a fixed amount of bitcoins per share. Thus it is very easy to calculate the NAV (the value of the assets in the trust) of the trust at any given point in time. You can find it here. Currently, the value of the Bitcoins within the BIT is about $350 per share. The current share price of the BTC is over $650 – almost 90% premium over the value of the fund’s assets. Unfortunately, there is no way to currently short the BIT, otherwise, this is a trade that Grizzly Dad, despite my penchant for index funds, would happily make. This divorcing of reality from fundamentals is one of the classic hallmarks of an asset class bubble. The unfortunate thing about bubbles is that they can run for very long periods of time before eventually crashing back down.

Fraud on a Massive Scale

However, if the only thing we had to worry about was just a massive bubble the situation would be much less grim. Unfortunately, not only is there a massive bubble in Bitcoin and other cryptocurrencies there is also significant and accumulating evidence of massive and dangerous fraudulent schemes across the entire ecosystem. This is a story that has happened before for Bitcoin. In the early days of 2013, the largest Bitcoin exchange, Mt. Gox, was hacked with the resulting fallout covered up by the owners until the entire thing blew up in their faces. They ultimately lost of $450M of their customers capital.

ICOs

One of the biggest pieces of news in the tech world over the last few weeks was China cracking down on both cryptocurrency exchanges and Initial Coin Offerings. With good reason, both of these groups are shady as f***. Let’s start with initial coin offerings. What are they? At best they’re naive crowdfunding of speculative projects, at worst they’re complete frauds.

But over the course of the last two years, they have raised over $2 billion. They now account for more money than traditional VCs at the seed stage of companies. This is not a good thing.

Essentially, in an ICO a company creates a new ‘coin’. They then accept payment, usually in the form of another cryptocurrency, the most popular being Ethereum (Ethereum is actually a larger platform that enables others to create their own coins).

There are legitimate teams out there trying to do cool stuff, such as Filecoin. But even at their best customers are simply purchasing the equivalent of loyalty tokens that can be used on the to-be-created-platforms. However, the vast majority of ICO’s are little better than Ponzi or pump and dump schemes. You have great examples of ringing celebrity endorsements such as these gems:

Take a look at a few of the upcoming ICOs over at Coinschedule. Just doing a cursory check of a few of the offerings turns up such gems as internetofcoins.org. They raised $3M in June. To do what? Who knows. Who’s running it? This guy. Who apparently has only worked for the Internet of Coins for the last 10 years. Oh and he went to Hogwarts for undergrad. And this was just the first one I clicked on. They’re almost all like this. Complete frauds all the way through.

An entire ecosystem has developed around creating, pumping, and hustling these ICOs. With players whose sole job is to market these schemes across the various cryptocurrency new groups and message boards. There is a much more in-depth look at all the problems with both Bitcoin and ICOs over here. But the gem below stands out.

And even if one of them is successful, it’s not as if the holders of these coins are equity holders in the company. At best they have purchased tokens that can be redeemed on the platform – little better than this.

Bitfinex, Tether, printing dollars, and massive price manipulation

If Initial Coin Offerings were the worst part of the cryptocurrency world it would still be terrible. Unfortunately, there seems to be an even bigger story brewing. A potentially massive fraud that could crash the entire market. Enter Bitfinex and Tether. For a much more in-depth treatment of this, I recommend heading over here. It’s scary stuff.

Bitfinex

Bitfinex is largest Bitcoin exchange currently operating by volume. There’s only one problem. Bitfinex has been having lots of financial difficulties and were cut off from the US banking system earlier this year in April.

Thier access to the USD banking system has yet to be restored. This is but the culmination of a host of shady things that their management has said or done in the past. Such as trading on their own exchange

Buying on the way up and selling on the way down – definitely not trading. Or playing cat and mouse tricks with banks (which is probably what got them banned in the first place).

“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 (Source)

Bitfinex still has yet to re-establish banking ties with any legitimate institution and is basically shady as all hell. But they also own a wonderful little company called Tether.

Tether

Tether is simple in concept. It’s a cryptocurrency that is marketed as pegged to the dollar. For every tether issued there is supposed to be $1 USD in a bank somewhere backing it up. At least that is what their marketing materials say. Tether is owned by Bitfinex. It was originally built by this guy and sold to Bitfinex in 2015. So the largest bitcoin exchange owns an instrument that everyone believes to be backed 1:1 by USD, what’s wrong with that?

A few things, but nothing truly horrible as long as that instrument is truly backed and redeemable for USD, but there’s every reason to suspect that is not the case. From Tether’s own legal terms and conditions:

So at best, every holder of tether basically has this:

That’s the best case scenario. The worst case scenario is that Bitfinex has basically just decided to use Tether as a way to print USD and inject them into the cryptocurrency ecosystem. And it looks like that’s exactly what they’re doing.

Tether was cut off from the US banking system at the same time as Bitfinex. So no real way for new USD to come into their coffers. At this time Tether even stated the number of Tethers issued should not increase.

However, since April what has happened to the number of tethers?

Almost $400M of new Tethers have been issued since USD banking was cut off for both Bitfinex and Tether. These tethers have also been issued at very interesting times. You can find the full schedule here. And here is that schedule plotted vs. price movements in Bitcoin itself, blue lines are big blocks of new tethers:

And then, starting immediately after the news of the Chinese crackdown on cryptocurrencies, we saw another issuance of a total of $120M tethers over the course of a couple weeks.

No one is buying new tethers.

1. Any small players can’t get money in because their USD banking has been cut off for many months.
2. Tether and Bitfinex claim it’s large institutional clients with “special” relationships with them. This is baloney. Even if a very large institutional investor was clamoring to get exposure to BTC or any other crypto there are many better ways to do such a thing (Get GS to write you a contract, Coinbase/GDAX with the backing of massive top VC funds, etc.). No $25M+ buyer is sending money to tether.to
3. Anyone that believes that such “Large Institutions” exist is a fool. Telling a bunch of chumps that “Big Unknown Players” are investing is technique number one when running a massive financial scam.

It appears increasingly likely that Bitfinex is simply minting new USD to use on the various cryptocurrency exchanges. $400M of fake USD assets utilized by a crooked exchange could wreak havoc on these marketplaces. And it is, the price of Bitcoin since tether started minting money in March?

+500% to the most recent market peak