Did Unbacked Tether Creation Manipulate Bitcoin Prices?

NYTimes: Bitcoin’s Price Was Artificially Inflated Last Year, Researchers Say

In particular, Mr. Griffin and Mr. Shams examined the flow of Tether, a token that is supposed to be tied to the value of the dollar and that is issued exclusively by Bitfinex in large batches. They found that half of the increase in Bitcoin’s price in 2017 could be traced to the hours immediately after Tether flowed to a handful of other exchanges, generally when the price was declining.

Other large virtual currencies that can be purchased with Tether, such as Ether and Zcash, rose even more quickly than Bitcoin in those periods. The prices rose much more quickly on exchanges that accepted Tether than they did on those that did not, and the pattern ceased when Bitfinex stopped issuing new Tether this year, the authors found.

Sarah Meiklejohn, a professor at the University College London who pioneered this sort of pattern spotting, said the analysis in the new paper “seems sound” after reviewing it this week.

What is really interesting is how Tether may have morphed into credit money when manipulating Bitcoin.

Every Tether coin is backed by $1. Theoretically, Tether supply and demand will rise and fall with the movement of real dollars in and out of Tether. It isn't being traded. The highest weekly trading volume in Tether was $97,800 in the week of December 25, 2017. Volume this week is $58,500 currently, of which is $50,000 today as Bitcoin threatened to drop below $6,000 and the highest since February (which takes us back to the brief drop below $6,000 for Bitcoin). Tether is being created and redeemed.

The paper is here: Is Bitcoin Really Un-Tethered?

Abstract

This paper investigates whether Tether, a digital currency pegged to U.S. dollars, influences Bitcoin and other cryptocurrency prices during the recent boom. Using algorithms to analyze the blockchain data, we find that purchases with Tether are timed following market downturns and result in sizable increases in Bitcoin prices. Less than 1% of hours with such heavy Tether transactions are associated with 50% of the meteoric rise in Bitcoin and 64% of other top cryptocurrencies. The flow clusters below round prices, induces asymmetric autocorrelations in Bitcoin, and suggests incomplete Tether backing before month-ends. These patterns cannot be explained by investor demand proxies but are most consistent with the supply-based hypothesis where Tether is used to provide price support and manipulate cryptocurrency prices.

Here's the part that makes it sound like Tether could be operating as a credit money:

Alternatively, if Tether is ’pushed’ on market participants, Bitfinex supplies Tether regardless of the demand from investors with fiat currency to purchase Bitcoin and other cryptocurrencies. The acquired Bitcoins can then gradually be converted into dollars. In this setting, the Tether creators have several potential motives. First, if the Tether founders, like most early cryptocurrency adopters and exchanges, are long on Bitcoin, they have a large incentive to create an artificial demand for Bitcoin and other cryptocurrencies by ’printing’ Tether. Similar to the inflationary effect of printing additional money, this can push cryptocurrency prices up. Second, the coordinated supply of Tether creates an opportunity to manipulate cryptocurrencies. When prices are falling, the Tether creators can convert their Tether into Bitcoin in a way that pushes Bitcoin up and then sell some Bitcoin back into dollars to replenish Tether reserves as Bitcoin price rises. Finally, if cryptocurrency prices crash, Tether creators essentially have a put option to default on redeeming Tether, or to potentially experience a ’hack’ where Tether or related dollars disappear. Both the ’pushed’ and ’pulled’ alternatives have different testable implications for flows and cryptocurrency returns that we can take to the powerful blockchain data.

Printing a fiat cryptocurrency is straight up money printing. Creating unbacked Tether coins is effectively fractional reserve lending and credit money. If the exchange or people operating through the exchange were able to create unbacked Tether, it would be deeply ironic. Using U.S. dollars and modern banking practices to prop up a cryptocurrency explicitly designed (in part) to get around the risks created by modern banking and its accompanying monetary system. Moreover, it relied on the perceived stability and credibility of the U.S. dollar. Furthermore, the collapse in Bitcoin would the same as the collapse in stocks, bonds, housing and other assets artificially propped up by credit money.

Figure 1 describes how Tether moves among major market participants on the Tether blockchain. The size of the nodes is proportional to the sum of coin inflow and outflow to each node, the thickness of the lines is proportional to the size of flows, and all flow movements are clockwise. Tether is created, moved to Bitfinex, and then slowly moved out to other crypto-exchanges, mainly Poloniex and Bittrex. Interestingly, almost no Tether returns to the Tether issuer to be redeemed, and the major exchange where Tether can be exchanged for USD, Kraken, accounts for only a small proportion of transactions. Tether also flows out to other exchanges and entities and becomes more widespread over time as a medium of exchange.

A similar analysis of the flow of coins on the much larger Bitcoin blockchain shows that the 3 three main Tether exchanges for most of 2017 (Bitfinex, Poloniex, and Bittrex) also facilitate considerable cross-exchange Bitcoin flows among themselves. Additionally, we find that the crossexchange currency flows are closely matched on the Tether and Bitcoin blockchains. This independently verifies our algorithm for categorizing the exchange identities, and in addition shows that wallets associated with Bitfinex send Tether to Poloniex and Bittrex in exchange for Bitcoin.

We then examine the flow of coins identified above to understand whether Tether is pushed or pulled, and examine the effect of Tether, if any, on Bitcoin prices. First, following periods of negative Bitcoin return, Tether flows to other exchanges are used to purchase Bitcoin. Second, these flows seem to have a strong effect on future Bitcoin prices. They are present only after periods of negative returns and periods following the printing of Tether, that is, when there is likely an oversupply of Tether in the system. A placebo test finds no evidence of Bitcoin price movements following large flows of Bitcoin from Poloniex and Bittrex to major exchanges other than Bitfinex. This phenomenon strongly suggests that the price effect is driven by Tether issuances.

To illustrate the potential magnitude and predictive effect of Tether issuances on Bitcoin prices, we focus on the hours with the largest lagged combined Bitcoin and Tether flows on the two blockchains. These 87 hours have large negative returns before the flows but are followed by large return reversals. These 87 events account for less than 1% of our time series (over the period from the beginning of March 2017 to the end of March 2018), yet are associated with 50% of Bitcoin’s compounded return, and 64% of the returns on six other large cryptocurrencies (Dash, Ethereum Classic, Ethereum, Litecoin, Monero, and Zcash).6 A bootstrap analysis with 10,000 simulations demonstrates that this behavior never occurs randomly.

Consistent with Tether being used to buy Bitcoin when prices drop, we find a statistically and economically strong reversal in Bitcoin prices, but only following negative returns. The Bitcoin reversal did not exist before Tether was prevalent in the market and disappears during the period when Tether stops being printed.

The printing of unbacked Tether also allows for outright fraud. Should the price of Bitcoin tumble and participants be unable to pay back their "loans," Tether could refuse redemption or claim it was hacked.

Third, the Tether issuers create a valuable put option in the case of a future crypto market downturn. The founders of Tether have a valuable option to not redeem Tether to dollars, and possibly experience an inside ’hack’ (perhaps, similar to the one on Mt. Gox) when Tethers and/or their associated dollars suddenly disappear.

The researchers conclude Tether is indeed being used to manipulate Bitcoin prices.

By mapping the blockchains of Bitcoin and Tether, we are able to establish that entities associated with the Bitfinex exchange use Tether to purchase Bitcoin when prices are falling. Such price supporting activities are successful, as Bitcoin prices rise following the periods of intervention. These effects are present only after negative returns and periods following the printing of Tether. Indeed, even less than 1% of extreme exchange of tether for Bitcoin has substantial aggregate price effects. The buying of Bitcoin with Tether also occurs more aggressively right below salient round-number price thresholds where the price support might be most effective. Negative EOM price pressure on Bitcoin only in months with large Tether issuance indicates a month-end need for dollar reserves related to Tether. Proxies for Tether demand receive little support in the data, but our results are consistent with the supply-driven manipulation hypothesis.

...If Tether is pushed out to other crypto exchanges rather than demanded by investors with dollars in hand, Tether may not be fully backed by dollars when issued. However, if the issuers wished to post monthly bank statements to shore up dollar reserves and appear fully backed, this would necessitate the liquidation of the purchased Bitcoins at the end-of-the-month (EOM).8 Interestingly, we find a significant negative EOM abnormal return of 6% in the months with strong Tether issuance. The EOM Bitcoin returns are highly correlated with the magnitude of Tether issuance, and no abnormal returns are observed in months when Tether is not issued.

In other words, these traders/manipulators are short Tether and long Bitcoin and for whatever reason (month-end reserve snapshot?) they must sell Bitcoin for U.S. dollars to cover their Tether short. That's not very dissimilar to what was happening in the Chinese banking system at quarter end in years past. There were cash crunched as bankers had to attract deposits in order to meet government reserve requirements. See for example this 2013 post, Chinese Deposit Wars Back On; Banks Refuse To Move Deposits and Poach Depositors With Enticing Rates

If this is true, it could deal a significant propaganda blow to the cryptocurrency market because one of the selling points is the deflationary, anti-bank qualities of a purely digital fiat currency. The real loser may not be cryptocurrencies however, but the exchanges. The current exchanges are a vulnerability for cryptocurrencies and a step backwards, introducing counter-party and cyber-security risk. The demand for a pure cryptocurrency exchange such as one proposed by Decred developers will gain more attention, but they will also have to deal with the potential risk of manipulative activities.

Update: FT described unbacked Tether as eurodollars back in September 2017: Crypto tethers as the new eurodollars

What Tether is is an issuer of eurodollar-like liabilities (effectively pseudo dollars) which it claims are backed by real dollar assets in its custody on a 1:1 parity basis. In that sense the company operates in a not dissimilar way to a money transmitter such as PayPal or even M-Pesa (which also issue units in exchange for 1:1 parity reserves), with the exception that the balances in its keep tend to stay deposited for much longer.

In recent months, however, some in the cryptocurrency community have come to doubt Tether’s asset-backed guarantee.

One anonymous blogger in particular, BitCrypto-ed, has come up with an elaborate theory about how potentially unbacked issuance of Tethers has become a key contributing factor in bitcoin’s epic price rise over the last few months.

To substantiate his claim the blogger points to Tether’s own T&Cs, which state bearers have “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.”

The greater irony is that if this is all true, what happened to Bitcoin is happening to the entire global economy in real time. The Chinese yuan is to eurodollars as Bitcoin is to Tether.