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Why the SEC should reject a Bitcoin ETF

The crypto market needs to grow up and tackle rampant manipulation and fraud

Bitcoin tether

The tethering of Bitcoin (via Shutterstock)

The bitcoin trading market is rampant with manipulation and fraud on even some of the largest exchanges. We therefore believe it would be a grave mistake for the Securities and Exchange Commission to greenlight a bitcoin exchange-traded fund (ETF) at this time. The SEC is currently accepting public comments on the proposed launch of just such a product, via a joint bid by the investment firm VanEck and the financial services company SolidX.

Those of us who believe in free markets hail the proliferation of crypto exchanges that has occurred since the start of the decade. The hope is that, eventually, the fairest and most honest exchanges will attract the most capital and—with added pressure from the relative ease to conduct private transactions—starve dishonest and corrupt bourses.

Unfortunately, we’re not there.

While the crypto market has the ability to police itself, it has shown it lacks the will. The community desperately needs to reckon with behavior that shows just how immature its market really is. And there are many dark clouds hovering over Cryptoland.

Tethered noose

No token is more aptly named than “tether,” which is acting like a rope around the bitcoin market’s neck as everyone waits for the drop to occur in the form of indictments or some other legal action.

Tether markets itself as a “stablecoin,” claiming to be backed entirely by U.S. dollars. The firm says it takes in greenbacks and issues tokens on a 1-to-1 basis. Those tokens can be used to, say, buy bitcoins on exchanges like its sister company, Bitfinex, or on other major platforms like Kraken.

Yet we can’t be sure that is really the case. That’s because Tether insists it can never be audited despite claiming, “Our reserve account is regularly audited” on its site. It’s charged by many critics that Tether’s management—or else entities close to them—is essentially “printing” money to buy hundreds of millions of dollars worth of bitcoins essentially for free.

Back in April 2017, Tether and Bitfinex lost their banking relationship with Wells Fargo (and given Wells Fargo’s history, that should have been a flashing red light right there). At the time, around 50 million tether tokens were outstanding. Since that time, Tether’s virtual printing press has been issuing its currency like it was the Banco Central de Venezuela. As of this post, there are some 2.7 billion tethers floating around the markets but unlike the bolivar, the exchange rate between USDT and USD remains at parity.

Curiously (okay, maybe not), the run-up in tether issuances coincided with the rally in bitcoin. And when tether’s growth ground to halt at the beginning of this year—around the time it was reported that it had received banking with ING—bitcoin prices began their fantastic tumble from record highs. Along the way, Tether and Bitfinex were subpoenaed by the Commodity Futures Exchange Commission.

At first blush, tether’s market cap of $2.7 billion is inconsequential since that’s merely 1 percent of the total cryptocurrency market. But tether has an outsized influence on that market. For some exchanges, it’s the only way traders can buy and sell bitcoin if they want dollar-like exposure. According to data from CryptoCompare, some days saw nearly half of all bitcoin trades traded were done against tether, though it’s usually about a third of trades. Still, it has largely displaced trades against the U.S. dollar itself (for those interested, most of the rest of bitcoin trades are done against the Japanese yen).

CryptoCompare

Bitcoin trades versus currencies. Note the rise of the tether (USDT) over the past year while exponential amounts were issued (via CryptoCompare)

Over the past 30 days, tether’s daily transaction volume has averaged the equivalent of its total supply. In other words, on average, every tether changes hands once per day. Though the ratio of trades to supply is half of what it was in December around bitcoin’s peak, the velocity is double what it was when Wells Fargo walked away from Tether. But recall that the supply is now 54 times what it was in April 2017.

Backing most of those tethers may be nothing more than the warm Caribbean air.

Tether’s relationship with its auditor, Friedman LLP, was “dissolved” in January. It was later revealed that Friedman was also subpoenaed by the CFTC.

A month ago, Tether published a report from the law firm run by former FBI director Louis Freeh. It claims that as of June 1, Tether had enough dollars to back each tether token.

That may indeed have been the situation on that very day because of an interesting phenomenon noticed by two professors at the University of Texas at Austin, John M. Griffin and Amin Shams. Based on their research, they speculate that “printed,” unbacked tethers bought bitcoins that were then sold for U.S. dollars before the end of the month, thus showing a dollar balance to roughly match the amount of tethers outstanding.

(It should be pointed out that Freeh’s partner, former federal judge Eugene R. Sullivan, was the author of the Tether report. Sullivan was an advisor to Noble Bank, a Puerto Rico-based bank that has been identified as where Tether keeps its money these days. And Noble is run by John Betts, a former business partner of Tether co-founder Brock Pierce).

Thus, while the process is supposed to be that U.S. dollars are converted to tethers and those tethers are used to buy bitcoins, the fear is that instead, the company’s management “prints” tethers as they please and uses them to buy bitcoins that, in turn, are then sold for real U.S. dollars.

However, for the general public, redeeming tether tokens for dollars from Tether the company is a near-impossible task.

This alone would be enough to say an ETF—or any government-regulated exchange-traded product—should not have assets backed by bitcoin or indexed to bitcoin prices.

Sadly, that’s not the only problem.

Bitcoin’s dirty wash

Over the past six months, 39 percent of the volume in bitcoin trades takes place on Bitfinex, which shares just about the same leadership team as Tether. That makes it the largest bitcoin market by far. An additional 6 percent trades on Kraken, which happens to be one of the few places that lets people trade a few tethers for dollars.

Those exchanges, and a few others, are suspected of allowing “wash trades” (where someone—or a group—buys and sells something to himself—or among themselves—in order to “paint the tape”) and “spoofing” (where large buy or sell orders are entered below or above market, respectively, so as to give a false sense of supply and demand at certain price levels; the orders are removed before execution).

For about a year now, the most prominent Bitfinex critic, an anonymous blogger who goes by the name “Bitfinex’ed,” has been regularly posting examples he/she claims proves spoofing is going on at the exchange as well as possible wash trades on Kraken.

Wash trades and spoofing are both banned by regulators in the U.S. and in many other countries with well-functioning exchanges. However, many crypto exchanges believe they are either outside or above the law. Some countries (like Japan) are beginning to tighten the screws on exchanges but the behavior seems to continue.

In May, the U.S. Justice Department, along with the CFTC (under whose purview bitcoin currently falls because of its commodity-like status), began investigating possible price manipulation of bitcoin on the exchanges.

Grand Centralized Station

One of the biggest selling points of bitcoin—theoretically, at least—is that it is the first truly decentralized currency. Computers anywhere in the world can hold copies of its distributed ledger (the blockchain) and, in exchange, receive bitcoins as a potential reward. Everyone together can control it. Therefore, no one controls, least of all an undemocratic central government.

As with Marxism, theory and reality are quite far apart.

In January, “China accounted for nearly 80% of computer power devoted to global bitcoin mining,” according to the Wall Street Journal. And while the country has since banned cryptocurrency trading, it hasn’t stopped mining and could even one day strengthen its grip on that critical part of bitcoin’s functionality. China’s interests may be aligned with seeing blockchain technology grow right now but the concentration of mining there may become a threat to the survival of the currency and blockchain itself.

The case for FUD

The term “FUD” (fear, uncertainty, and doubt) is used pejoratively to describe criticisms of any cryptocurrency.

FUD that, we say.

Pretending that there is nothing to fear, that the future is certain, or that there’s nothing to doubt with  bitcoin or any other crypto is the sort of sophomoric thinking that got a lot of people in trouble in the last two big bubbles, the internet and real estate.

In both of those eras, the signs were blatantly there for all to see: internet companies with no earnings or even sales valued at hundreds of millions of dollars, “NINJA” (no income, no job or assets) loans going to risky borrowers with poor credit, etc.

The lessons from the past are lost on much of the current generation of crypto investors because they just weren’t old enough to learn anything. Nearly 60 percent are between the ages of 18 and 34.

They don’t particularly care that the past year’s bitcoin market may have been mostly fueled (or, at least, lubricated) by unbacked tethers. Though now trading at roughly one-third of where they were in December, bitcoin prices are still three times what they were a year ago. Many have gotten rich, but they anticipated that would happen. After all, half of all Millennials expect to be millionaires.

The recent returns validate their firmly held belief that a Lambo is waiting on the moon when they get there. Unfortunately for them, their lunar rocket may be vapor.

That isn’t to say the technology underlying bitcoin and other cryptos isn’t strong. On the contrary, it’s one of the Information Age’s most revolutionary and elegant innovations. One can even argue that the dot-com bust and the real estate collapse ended up leaving both industries stronger by clearing out the detritus, albeit with severe collateral damage along the way.

But we need to separate the fundamentals from froth. And that froth isn’t merely a product of hope and greed but the result of outright deceit and manipulation.

It’s up to the cryptocurrency markets to clean up its mess before governments do. The belief that the long arm of the law can’t reach the exchanges is terribly mistaken, particularly for those who may one day find themselves extradited and handcuffed on a plane back to face criminal charges.

A bitcoin-based ETF, in the meanwhile, exposes the capital markets to more unwarranted risk. Though the VanEck SolidX Bitcoin Trust ETF would have a minimum $200,000 investment requirement, it would open the door for institutional investment that hitherto had been restricted because of regulations or investment policy statement restrictions. That’s not cash from “rich Wall Street guys” but public servants’ pensions, Grandma’s retirement money, and Junior’s tuition fund.

Sure, that’s “real” money going into bitcoin, but it’s also easy pickings for fraudsters who continue to get off scot-free. It raises the reward to manipulate the market.

The crypto markets needs to grow up. It needs to police itself more forcefully, rewarding those who are honest and punishing those who aren’t.

Until that happens, the SEC shouldn’t give its stamp of approval to any bitcoin-based ETF.

Lawrence Lewitinn, CFA is editor in chief of Modern Consensus. Disclosure: Lewitinn owns no cryptocurrencies in his portfolio.

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