The Bit Short: Inside Crypto’s Doomsday Machine

This is the story of a Bitcoin trade — the most financially impactful trade I’ve ever made in my life. It’s also the story of the deep-yet-frantic investigation of the crypto ecosystem that led me to make that trade. And it’s the story of what’s really going on in crypto — and what we should do about it.

If you own meaningful amounts of cryptocurrency or you’re considering buying some, you’re the reason I wrote this. Please do read to the end.

Before I begin this story, there’s a bit of background you need to know first.

There are things in crypto right now called Tethers. To simplify a bit, Tethers are issued by a crypto company called Tether Ltd. — meaning that if Tether Ltd. says you own a Tether, then you do.

Tether Ltd. also says one Tether is worth exactly one US dollar. Can they do that? Well they say they can, because they hold $1 worth of assets for each Tether. But are those assets actual dollars? No, they are not. So what if the assets go down in value? Don’t worry; they will not. Okay, but can we at least see the assets? No, you may not.

Who in their right mind would use something like Tether? Well, the short answer is that many people use Tethers to buy Bitcoin and other cryptocurrencies. The long answer, though, is astounding — but more on that later.

Because Tether sounds exactly like a currency fraud, it may not surprise you to learn that Tether Ltd. is currently under investigation by the Office of the Attorney General for the Southern District of New York. That investigation was announced to the public on April 25th, 2019.

Now fast-forward one year. In March of 2020, I bought a large amount of Bitcoin. At the time, I saw a market dislocation and the likelihood of significant dollar inflation due to the US Government’s likely response to the unfolding pandemic.

I suspected Bitcoin would be inflation-resistant because of its enforced scarcity. To the extent that I thought about Tether at all, I remembered the OAG’s investigation, assumed Tether was now old news and would surely have been pulled from the markets, and dismissed it as a factor in my buying decision.

That was a huge mistake.

For the rest of 2020, my inflationary thesis looked right. Unrest in the United States, combined with anticipated high levels of lending and consumer spending post-pandemic, seemed likely to fuel substantial USD inflation in real terms through the end of 2021. During the same period, Bitcoin was becoming increasingly scarce on a secular basis.

The market appeared to agree with my thesis. My Bitcoin position doubled in value, then doubled again. By the end of the year I was sitting on a 600% gain, and decently wealthy in nominal dollars.

I had intended to hold my Bitcoin for the very long term — it never even crossed my mind to sell it, regardless of its day-to-day price variations.

And then, in early January, a forum post caught my eye.

On January 8th, I saw this post on Hacker News about Tether manipulating the price of Bitcoin. That shook me: I’d assumed Tether had been purged from the crypto markets, yet apparently it was still around. But how much Tether could there really be in the crypto markets? Surely not that much.

Still, I took a look. The answer, I was surprised to see, was a lot:

Source: Coinlib BTC.

The left-hand side of this chart shows which currencies are flowing into Bitcoin (that is, are being used to buy Bitcoin) across all crypto exchanges. The right-hand side shows which currencies are flowing out of Bitcoin (that is, that Bitcoin is being used to buy). The chart is showing typical numbers for early January 2021.

The upshot: over two-thirds of all Bitcoin — $10 billion worth of it — that was bought in the previous 24 hours, was being purchased with Tethers.

What’s more, this pattern wasn’t unique to Bitcoin. I saw the same thing for all the other popular cryptocurrencies:

Source: Coinlib ETH, LTC, ADA, and BCH.

It seemed I’d been wrong to dismiss Tether. Tether wasn’t just in the crypto markets — Tether was the crypto markets.

This worried me. Most of my wealth was exposed in the form of Bitcoin, and Bitcoin seemed like it might be exposed to Tether. And Tether’s issuing company was under active investigation. I urgently needed to find out if this risk was real.

I cleared my schedule and started digging. Right away it was obvious that if Tether flows were partly or wholly fraudulent, that would have a significant effect on the correct market price of Bitcoin. (Even though $10B of Tether flows only constitutes 1.4% of Bitcoin’s $700B nominal market cap, all that really matters is what fraction of Bitcoin’s daily buying volume Tether accounts for — and that number is closer to 70%.)

How could I find out if Tether was fraudulent? One quick proxy might be what kinds of exchanges it traded on. I knew that some exchanges, like Coinbase, used solid due diligence to curb money laundering, while many other exchanges weren’t as well-run. Was there a pattern to which exchanges supported Tether and which didn’t?

There was. Here’s how crypto trades flow through Coinbase Pro in a typical 24-hour period:

Source: Coinlib Coinbase Pro data.

Notice that the money going into crypto is almost all dollars, Euros and British pounds — currencies that are subject to rigorous controls by their countries’ respective authorities.

And here are the flows of crypto trades through Binance, Bit-Z, and HitBTC — the three biggest crypto exchanges in the world by nominal volume:

Source: Coinlib Binance data. (Note: Excludes Binance US.)
Source: Coinlib Bit-Z data.
Source: Coinlib HitBTC data.

The pattern was obvious. Practically all the crypto sold on these three exchanges was being bought with Tethers. None at all was being bought with USD.

And the volumes were huge. Coinbase Pro is responsible for around $4B in crypto trades each day. But Binance alone accounts for over $50B worth of crypto volume, and each of the other two exchanges is bigger than Coinbase. Most of the crypto that gets bought each day, is getting traded for Tethers on those three exchanges.

Binance, Bit-Z and HitBTC are “unbanked” exchanges. That means they don’t have direct access to the US financial system — most likely because no US institution is willing to serve as their correspondent bank domestically. (Binance US, an affiliate of Binance, does allow dollar purchases. But its daily volume is only 10% that of Coinbase — and less than 1% that of its offshore counterpart — so its effect on the crypto markets is negligible.)

It’s hard for crypto exchanges to get banked, but Coinbase, Bitstamp, and several other high-quality exchanges manage it by maintaining strong know-your-customer (KYC) and anti-money-laundering (AML) controls internally.

But what I found most alarming was that neither of the two most reputable USD-banked exchanges — Coinbase and Bitstamp — supported Tether trades at all. If Tether was on the level, there’d be no reason for them to forego the fees on that trading pair — unless their risk and compliance departments had deemed the token too much of a liability to carry.

By now, I was concerned that my Bitcoin position might be too risky to hold. But I still needed more evidence before I unwound such a big trade.

I had to get more context on Tether — context that was as free of marketing distortion as possible. I found what I was looking for in the case docket for the New York OAG’s ongoing investigation of Tether Ltd. (Note that the inquiry’s respondent is listed as “iFinex Inc., et al” rather than “Tether Ltd.” on the docket, for reasons that aren’t worth getting into here.)

I’ll skip most of the content — I strongly urge you to review the files for yourself — and just list the three biggest takeaways that jumped out at me:

On February 26, 2019 — two months before opening its official investigation — the OAG requests a large number of documents from Tether Ltd. The purpose of the request is to help the OAG understand how Tethers are being issued, backed, and accounted for, and how Tethers are flowing through the crypto ecosystem.
From the beginning of the official investigation on April 25, 2019, through to July 9, 2020 — a period of nearly 15 (!) months — Tether Ltd. issues a series of legal challenges to the investigation that appear designed to delay their response to the OAG’s document request.
On July 9, 2020, the New York Supreme Court dismisses Tether Ltd.’s final challenge on appeal, effectively forcing Tether Ltd. to comply with the OAG’s document request. What’s more, Justice J. Gesmer’s opinion eviscerates all aspects of Tether Ltd.’s arguments (good commentary here), suggesting that Tether Ltd.’s appeal was never intended as a realistic challenge to the documentation request at all. But it could, plausibly, have been part of a strategy to delay the document disclosure by any possible means.

Things were looking bad. But then a question suddenly occurred to me: did any other significant event happen to Tether on or around July 9th, 2020?

So I looked. And I found something.

Source: Coinmarketcap USDT.

The chart above shows the market cap of all issued Tethers between January 13, 2019 and January 13, 2021 (the blue curve). Because one Tether nominally equals $1, the total market cap of Tether in dollars is always equal to the total number of Tethers. (The numbers on the y-axis don’t refer to the market cap. But for scale, the highest point of the blue curve corresponds to about $25B.)

The first red arrow on the chart points to April 25th, 2019: the announcement of the OAG’s investigation. Notice how, as the investigation progresses, the issuance rate of Tether begins to rise — initially in large single blocks, of around $1B, every few months.

The second arrow on the chart is July 9th, 2020: the date of the New York court ruling forcing Tether Ltd. to begin the process of disclosing its documents to the OAG. Two weeks after that ruling, Tether Ltd. issues one more large block of Tethers, nominally worth about $800M. And shortly after that — on September 1st — the issuance pattern for Tethers changes completely.

Beginning in September, Tether Ltd. begins to issue multiple large blocks of Tethers per day. The pace accelerates, with $2.3 billion worth of Tether issued in the first week of 2021 alone.

This was consistent with the possibility that, as Tether Ltd.’s various legal challenges failed one after another in the New York courts, Tether Ltd. was choosing to issue Tethers faster and faster to maximize the amount of value it could extract from the crypto ecosystem before being shut down. The pace accelerates closer to Tether Ltd.’s final disclosure deadline — January 15th, 2021.

I still needed to answer one last question. Did Tether issuance actually correlate with the price of Bitcoin? A glance at the charts gave me a clear affirmative answer:

Source: Coinmarketcap BTC.

There are three major periods of high relative Tether issuance on this graph: 1) April 2019 through July 2019; 2) April 2020 through July 2020; and 3) September 2020 through to the present. All three periods overlap with visible increases in Bitcoin’s market price. (The red arrows here point to the same two dates as on the Tether chart above.)

This wasn’t a conclusive pattern: it still didn’t prove that Tether issuance was causing Bitcoin’s price increases. It was still possible that retail demand for Bitcoin was driving real USD into Tether Ltd. through some unknown mechanism; that Tether Ltd. was issuing Tethers in exchange for those dollars; and that those issued Tethers were then being used to buy Bitcoin. Under that scenario, Tether’s rise was being caused by Bitcoin’s demand, and Tether might be fully backed by dollars after all.

Nonetheless, based on this evidence, I concluded my risk was now too great. I was long Bitcoin up to my eyeballs; Bitcoin was clearly correlated with Tether; Tether was clearly being issued at a frantic rate; and that issuance had a high probability of being backed by nothing at all.

I made the call: it was time to get out.

On January 9th, 2021, I liquidated my crypto position for USD. In the process, I locked in a dollar-denominated gain that — in the interest of full disclosure — I can only describe as life-changing.

At this point, I still didn’t grasp the entire picture. For example, I still thought there was a chance Tether could be backed by real assets. My state of belief was something like: “Of the 70% of Tether flows into Bitcoin, some fraction is real; some fraction is real-but-illicit (e.g., buying drugs); and some fraction is pure fiction. I have no clue what the respective fractions of each are, but I do know that my personal risk threshold has been exceeded.”

I was still a bit concerned that I’d miscalculated. Tether might yet be largely real — and if it turned out it was, I’d have missed the boat.

And then, by pure luck, I had a conversation that blew my mind.

I was catching up with my friend Bob (pseudonym) over video chat. I’d just sold my Bitcoin position and was nervously awaiting confirmation from my bank that my USD wire transfer out of the exchange had cleared. Crypto was on my mind, so I asked Bob about it.

The conversation went something like this:

Me: You don’t own any crypto do you? I’m concerned some of the exchanges in the ecosystem might be fraudulent.

Bob: I actually have a whole bunch of crypto on this exchange called Bybit. Do you know if that’s one of the risky ones?

Me: I’m not sure. Does it let you trade in USD?

Bob: No, but a lot of other exchanges don’t either. In fact, you can’t even deposit USD directly into a Bybit account.

Me: Really? But then how do you get your money onto their exchange at all if they don’t accept USD deposits?

Bob: You send your USD to Coinbase and buy Bitcoin with it. Then you move your Bitcoin onto Bybit and trade with it there.

Me: Hang on. If that’s the case, then why would anybody ever use an unbanked offshore exchange that trades purely in crypto? What does Bybit offer you that Coinbase doesn’t?

Bob: Leverage. I personally only use 2–3X leverage, but they let you leverage your positions up to 100X if you want. You can’t do that on Coinbase.

Me: *Gasps audibly*

Bob: They also do a ton of promotions. They’ve got a bunch of timed missions where you can earn Tethers for doing stuff like inviting friends onto the exchange, joining their Telegram group, or trading on their platform.

Me: HOLY $#!@

Bob: But thanks for the warning! I’ll pull my crypto out as quick as I can. It might take me a few minutes though, I’ll need to fire up my VPN first.

Me: A VPN? But why, for the love of God?

Bob: Because I need to spoof a Bolivian ISP to access the exchange. They’re illegal to use if you’re based in America.

Me: *Head explodes*