Tether, a Pathbreaking yet Flawed Element of Crypto Market Infrastructure
Tether, the most widely known stablecoin in the cryptocurrency markets, remains the subject of considerable concern and skepticism and while these questions may well remain unresolved, Tether’s lasting legacy is likely to be associated with its role as the initial stablecoin project to develop a large market presence, in effect serving as an important proof of concept in a space that has attracted considerable attention.
Amongst the stablecoins in today’s cryptocurrency ecosystem, none are as widely known as Tether, a cryptocurrency based on the Bitcoin blockchain, via the Omni Layer, that is fully-backed in a one-to-one ratio with the United States Dollar (USD). Tether is prominent both as the earliest instance of a stablecoin–defined as a cryptocurrency maintaining a stable price relative to an underlying asset to which it is pegged–that managed to gain significant mainstream awareness and user volume, and as a meaningful source of liquidity within the cryptocurrency space. Tether’s mid-2018 market cap of $2+ Billion, with an equally elevated daily transaction volume, suggests the scale of its success and its entrenched overall position as a core element of the financial and transactional infrastructure of the larger cryptocurrency ecosystem. Despite these successes, however, much of Tether’s existence has been clouded by questions, many of which remain unresolved. As an indication both of Tether’s important role and the gravity of these questions, it even has been argued that any potential difficulties or even collapse Tether might experience either because of structural or regulatory issues could have repercussions across the entire cryptocurrency space.
Tether’s existence can also be seen as a metaphor for the entire crypto industry in the sense that many early crypto founders and developers, arguing that the crypto community was establishing entirely new vehicles and institutions that effectively fell outside of existing legal structures, largely ignored existing laws and regulations. With the passage of time and the growth of the industry, which has unsurprisingly attracted the interest of a variety of regulatory bodies across the globe, there is growing acceptance that the crypto community cannot unilaterally declare itself exempt from existing legal and regulatory regimes by virtue of being innovative or decentralized.
This evolving perspective has been interwoven with Tether’s own existence. Specifically, Tether’s early operations occurred largely outside of existing regulatory structures and banking laws, and that history has continued to be relevant. As such, Tether’s story must also be read as inseparable from the question of the growing intersection of the crypto world with mainstream world throughout the last five years. Even as Tether finds itself struggling to maintain banking relationships with mainstream banks during 2018, as will be discussed below, its attempts to fulfill the regulatory requirements necessary before fully legalizing its operations appear hamstrung by past actions and approaches that, in some cases, appear to date virtually to Tether’s founding. But regardless of whether Tether succeeds in normalizing its regulatory and banking situations and addressing the popular concerns that surround it, it is likely that Tether’s ultimate legacy will, in time, be seen as dependent upon other important aspects of its unique history as an early stablecoin.
Background on Tether
Tether Limited (“Tether”) is a Hong Kong-based company that is wholly owned by Tether Holdings Limited, a British Virgin Islands (BVI) business company. Although details on Tether’s leadership team were somewhat opaque for an extended period dating from 2014, in late 2017 it became clear that the leadership is effectively identical to that of the Hong-Kong based cryptocurrency exchange Bitfinex. Key leaders including Tether CEO JL van der Velde, Tether CFO Giancarlo Devasini, Tether CSO Philip Potter, Tether General Counsel Stuart Hoegner, and Tether Chief Compliance Officer Matthew Tremblay all occupy the identical leaderships positions with Bitfinex.
Tether began trading under its current name in February 2015, although its history begins in mid-2014 with the unveiling of Realcoin, planned to be developed upon the Omni protocol (then called Mastercoin). In November 2014 the project announced its intention to rebrand itself as “Tether,” a move intended to signal the project’s distance from both altcoins as well as unique blockchain protocols, while referencing its role as cryptocurrency with its price pegged to that of another asset. In early 2015, Tether began to trade its initial USDT product, initially in modest volumes.
How Tether Works
As described in its whitepaper, Tether’s basic premise is exceedingly simple. Users send fiat currency to Tether (the off-chain incorporated entity), and Tether issues a digital token representing that currency, primarily the United States Dollar (USD), but with a few EUR Tethers also in existence, on the bitcoin blockchain using the Omni Layer. The Omni Layer is a colored coins protocol that attaches data to individual Bitcoins that ‘color’ them as representing both their underlying Bitcoin value (typically a tiny fraction of a Bitcoin) and as something else, in this case, Tether. Omni (then Mastercoin) preceded the Ethereum ERC-20 contract standard as an option for tokens built on top of underlying protocols. The newly created Tether token, whether USDT or its Euro counterpart, can be exchanged on a permissionless basis between users, or between accounts held by one user, such as accounts on different crypto exchanges. Tether has particular utility for exchanges, who are able to easily settle outstanding fiat-like balances, while providing a vehicle for cryptocurrency market participants to avoid the oft-noted volatility of the crypto sector.
Tether retains all fiat currencies in designated bank accounts, with each Tether 100% backed by fiat currencies held in reserve. Tether charges no fees on transactions between Tether wallets or blockchain wallets, and the greater of 10 basis points or $20 on deposits and withdrawals to fiat bank accounts. While Tethers are redeemable for the underlying fiat, its legal terms of service state that it is not legally obliged to do so in every instance. While Tether performs KYC and AML verifications upon purchases or redemptions, once created Tethers can be transacted anonymously and Tether makes no claim to be able to block or prevent individual transactions.
The Omni Layer, an open-sourced platform built upon the Bitcoin blockchain allowing for the creation and trading of decentralized digital assets, is a critical element of Tether’s functioning being. All issued, redeemed, and existing tethers, including transactional history, are publicly auditable via the tools provided at Omniexplorer.info, where one can see, for instance, the largest Tether holders. A smaller number of Tethers also exist as ERC-20 tokens upon the Ethereum blockchain, a more recent step promising more rapid transactions.
Issues of Uncertainty Related to Tether
Despite the simplicity of Tether’s design and operations, a number of questions have emerged surrounding Tether’s structure, its fiat reserve holdings, and its legal structures.
The nature of the questions and controversies that have dogged much of Tether’s existence broadly appear to fall within two groups. One group is perhaps best characterized as self-inflicted wounds that might have been avoided through more careful management and messaging of its affairs. The other group of controversies relate to Tether’s operations and structures and is largely linked to the uncertain legal status of various projects within the cryptocurrency community. Adding to the challenge of interpreting the various points of contention related to Tether is that the two issues of communications and legal status often blend together to create an intertwined, convoluted state of affairs.
One of the most basic questions relating to Tether surrounds the question of who controls the project. As noted, since December 2017 it has been explicitly acknowledged that the Tether and Bitfinex management teams are virtually identical. Prior to this, numerous questions about the identities of the Tether leadership, and whether and to what degree they overlapped with Bitfinex’s own leadership, have existed. Some date back to Realcoin’s late 2014 rebranding as Tether. This uncertainty has been intimated to represent evidence of various nefarious, or at least worrying, activities. That said, little more than assertions of impropriety have been advanced. The reality is likely less worrying than some would suggest, if only because the relations between Tether and Bitfinex have never really been as obscure as has been suggested. For instance, in early 2017 Tether founder Craig Sellars acknowledged on Linkedin that he simultaneously occupied CTO roles at both Tether and Bitfinex during 2015 and 2016. Nor was that the only suggestion that overlaps existed between the two groups. Overall, while transparency and disclosure may have been suboptimal, it is difficult to consider this a critical issue that casts an immense shadow upon Tether’s existence.
Nevertheless, this question of control has persisted, in part because at the heart of the matter of who controls Tether is concern for potential abuse when an exchange controls and issues a vehicle for liquidity. Specifically, whether Tether was merely a liquidity vehicle premised upon investors sending funds to create Tether, or whether Tether could be employed as a speculative tool has been the source of considerable concern. In a situation where Tethers were created first, without fiat backing and in order to make directional trades, as has been hinted at by more than one observer, Tether’s place in the cryptocurrency marketplace would be considerably different. The potential for Bitfinex to have issued itself unbacked Tethers that were invested in crypto markets then re-sold after prices rose, in part as a result of the influx of buying pressure generated precisely by converting the Tethers into BTC, for instance, would be concerning. Whether this has occurred is impossible to ascertain with certainty, but a full audit of Tether’s banking and financial situation would undoubtedly do much to dispel these concerns.
Another major point of contention surrounding Tether relates to the question of its reserves. While Tether claims all existing Tethers are fully-backed by Tether’s fiat reserves, and lists on its website figures claiming to illustrate as much, Tether has not been forthcoming about its actual banking partners, nor fully audited its reserves. Further, while Tether lists an initial auditor’s report on its website, the report clearly falls short of being a definitive audit or substantially putting to rest any and all concerns about the nature of Tether’s holdings. Moreover, this issue of reserves has been linked to questions about whether Bitfinex may have used Tethers as funding for proprietary trading, with speculation that the inability to complete an audit may be related to this issue, given that any such trading could have served to generate the profits that had already been posited to exist as backing for Tether’s fiat reserves.
Further, Tether’s apparent inability to acquire mainstream banking partners, or simply banking partners eager to identify themselves as being associated with Tether, is related to the legal implications of core aspects of Tether operations. Given that Tether effectively allows USD to be sent anonymously between users in a virtually permissionless system, Tether likely runs afoul of specific banking and money transmission regulations in a manner that would trouble bank compliance departments and leave many banks unwilling to provide banking services for Tether. It has been compellingly argued that this, rather than actual concern that Tether does not hold the reserves it claims to, is behind Tether’s lack of transparency.
An important aspect of the banking issue is that Tether, and Bitfinex, did have mainstream banking partners initially, but in March 2017, when Wells Fargo refused to continue to provide services to Tether and Bitfinex, via four Taiwanese banks the two used, Tether and Bitfinex effectively found themselves unable to operate within the global banking system. This early 2017 period corresponds to one of the increased periods of attention and scrutiny towards companies operating within the crypto sector and the ways they interacted with, and faced compliance requirements from, broader legal and regulatory regimes. It is not surprising that banks might have begun to express unwillingness to work with certain companies in the crypto space during this period. What the immediate impacts of this action were for Tether are not entirely clear, but this period also corresponds to the date when Tether’s daily trading volume, which had been modest for more than two years subsequent to Tether’s initial launch, began to expand rapidly in Spring 2017. While this is in no way evidence confirming that Tether could have been, as suggested above, used for directional trades or even to meet short-term liquidity demands, the coincidental nature of the timing is unfortunate in providing circumstantial evidence to critics and doubters of Tether’s operations.
Compounding this concern with how banks might view Tether’s capacity to be used anonymously for illicit activities is the question of the extent of Tether’s centralization. Tether claims to be a decentralized cryptocurrency, by virtue of existing with the Omni Layer upon the Bitcoin blockchain. However, evidence for Tether’s de-facto centralized nature can be seen in the Tether’s response to a November 2017 hack of its own treasury wallet where 31 million USD Tether’s were transferred to an unauthorized Bitcoin wallet. Tether’s announcement shortly thereafter of a forked client of the OmniCore Protocol in order to freeze the stolen funds has been interpreted as evidence that Tether is in fact a centralized project, which has specific additional legal implications. In particular, as a centralized project that permits anonymous transfers of USD between users, the project faces real risk of regulatory action including closure. The Bitmex blog cited above provides a number of compelling examples of earlier examples of centralized, permissionless vehicles for the anonymous transfer of USD that were shut down by authorities. Examples include Costa Rica-based Liberty Reserve in 2013, GoldAge (2006), e-Bullion (2008), DigiCash (1998), and several others.
As the Bitmex blog further suggests, Tether’s options for addressing both popular and regulatory concerns also appear limited. Needing to alter its operations so that specific transactions can be blocked when accounts not passing KYC/AML checks attempt to transfer Tethers, a necessary step if Tether is to avoid running afoul of regulators, Tether could be forced to move off of public blockchains, instead running its operations on private ledgers. The implications for attitudes towards Tether within the crypto community are clearly negative. If Tether moves ahead without addressing this issue, however, it risks eventually being shut down by authorities. Given that Tether’s daily volume has often been greater than $3 billion during 2018, the potential for Tether to become a focal point for concerned regulators is clear. At the same time, concern about a potential regulatory action, and the implications for any banking partners Tether might have, is likely behind the refusal or reluctance of banks to publicly work with Tether. The result is the creation of a sort of Catch-22 where an audit is impossible given the lack of publicly acknowledged top-tier banking partners, whilst the lack of an audit renders it virtually impossible to quell the concerns about Tether’s current structure and backing, its internal controls, whether it might have been used to fund proprietary trading, or to acquire additional banking partners that would help improve its image.
While the questions surrounding Tether are numerous, substantial, and not ones that can or should be easily dismissed, the common thread in each of the above questions is confusion or uncertainty as those interested in this matter are simply unable to ascertain where the truth lies and the ways Tether likely is, and perhaps is not, in a legal and regulatory compliant position.
Tether and the Question of the ‘Ideal’ Stablecoin
While an important aspect of Tether’s place in the crypto ecosystem has been and continues to be Tether’s role as the first stablecoin able to attract meaningful volume, another near-constant aspect of Tether’s identity has been the nearly continuous criticism it has been subject to on the part of rival stablecoin projects. For the most part such criticisms concern either Tether’s “too centralized” nature or the problematic nature of its centralized reserves (in the case of projects that accept that Tether holds the reserves it claims.) These stablecoins that criticize Tether are themselves also advocating for how their own approaches lie somewhere between the anti-Tether and the Tether-plus, depending upon the particular manner in which they explain their own modifications and adjustments to Tether’s own approach. Ironically, few acknowledge Tether’s own role in opening up the stablecoin space to meaningful audiences, and attracting enough volume to make clear that an actual market for a workable stablecoin exists. Nor do such criticisms of Tether’s real and perceived shortcomings acknowledge Tether’s own successful ability to survive an extended period with meaningful trading volumes, which will likely not be the case for some of the newer and more elaborate stablecoin projects emerging into the market. While undoubtedly the case that Tether could likely have better managed numerous aspects of its project more effectively, the disregard with which it is too frequently referred to does not do justice to its innovations.
Conclusion: Tether as a Bridge to an Expanded Cryptocurrency Community
The numerous questions and controversies surrounding Tether can be considered in a number of ways. Whether they are viewed as overblown, unwarranted, disconcerting, the result of overenthusiastic regulators stirring up trouble, or simply as reflective of often uncertain regulatory status of the entire crypto space, what is clear is that Tether’s average daily volume of more than $1 billion since the start of 2017 suggests the important role Tether has played as a stablecoin and liquidity vehicle facilitating the expansion of the crypto markets to their current size.
Unfortunately, much of Tether’s existence has also been plagued by a series of fundamentally significant questions, ranging from concerns over Tether reserves, where those funds are held, why they apparently cannot be audited, and whether Tether’s corporate structure and functioning is legal. These questions remain unaddressed and cannot, and should not be dismissed. That said, it could also be argued that these questions will likely not define Tether’s legacy.
Rather, Tether’s ultimate impacts are more likely to be regarded as twofold. One will be in regard to its invaluable role as a stablecoin and source of intra-exchange liquidity at an early stage in the crypto markets, when virtually no comparable products or tools existed. The second concerns how Tether inspired a second generation of crypto stablecoins, products often seeking to do nothing more than emulate Tether’s own role and function, while painstakingly ensuring they were doing so in an explicitly legal fashion. The emergence of these competing stablecoins throughout late 2018 and early 2019 will highlight Tether’s own impact as an early pioneer in the space. How Tether fares during this period, and perhaps whether it even survives, will arguably be of lesser significance than the legacy of the role it fulfilled during a critical period in the crypto markets.