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[Giovanni]

Bitcoin Only Has One Way To Go If This Is True

(A lot more at link)

Dec. 4, 2017 3:06 PM ET|215 comments| About: Winklevoss Bitcoin Trust ETF (COIN), Includes: BITCF, BTCS, BTSC, GBTC, MGTI, RIOT
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Event-driven, long/short equity, long-term horizon, special situations
MARKETPLACECore Value Portfolio

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Summary

I believe that Tether's surging supply is the major driver behind Bitcoin's explosive appreciation.

Tether Limited is likely issuing bogus Tethers, which is equivalent to 1 USD, which can then be used to buy Bitcoin.

Confidence in Tether Limited and active arbitrage between Tether/Bitcoin/USD allows Bitcoin to go in one way only.

The scheme will unravel if confidence in Tether Limited evaporates, or if Bitcoin rises to a point such that there is a sudden wave of selling pressure such that there can be no liquidity to complete the arbitrage.

Despite numerous indications of fraud, Tether's peg to the dollar is holding. Which begs the question, if enough people believe a lie, does it become the truth?

This idea was discussed in more depth with members of my private investing community, Core Value Portfolio.

I remain a Bitcoin (OTCQX:GBTC, COIN, RIOT, OTC:BITCF, OTCPK:BTSC, OTCQB:BTCS, OTCQB:MGTI) skeptic as I believe that the fundamental value of the cryptocurrency is zero (read Why Bitcoin Is Worthless). However, I cannot deny that it has market value. That value has been increasing, which means that some people somewhere are buying. But who? I believe that question can be answered by Tether. Through a very clever scheme, the people behind Tether can continue to send Bitcoin into the stratosphere until it reaches a not-yet-known breaking point.

What Is Tether

Tether is a cryptocurrency controlled by Tether Limited. Unlike Bitcoin, Tether is issued (not mined) and seeks to maintain a stable exchange against the dollar (i.e. tethered). This is accomplished through a reserve based model, whereby each Tether is backed by one US dollar in the company’s bank. One can acquire Tether directly through the website or trade through an exchange. One can convert Tether to USD at Tether Limited, though Tether Limited has the right to refuse for any reason. The mechanism of the reserve-based model means that the Tether/USD pair will hover around 1:1 on the market, because there would be an opportunity to arbitrage otherwise (i.e. buy/sell on the market, convert at Tether Limited, or vice versa).

Traders like tether for its portability across platforms as it is a digital token whereas transacting in USD would require much more hassle involving banks.

Surge In Supply

Now that we know how Tether works, let’s examine its supply.

Source: coinmarketcap.com

Source: coinmarketcap.com

Pretty amazing stuff. The supply of Tether has increased from virtually nothing prior to 2017 to 845 million as of the time of writing, corresponding to 845 million USD. That’s the asset size of a large community bank.

Interestingly, the surge in supply corresponds with the massive price increase in Bitcoin. I don’t have primary data in CSV form, however, an anonymous author has compiled the data as of October 30th. A quick check will show that that the following graph consolidating the various data points corresponds with graphs available on major cryptocurrency websites (e.g. coindesk.com, coinmarketcap.com)

Source: anonymous author

The next graph illustrates the high statistical significance between Tether supply and the price of Bitcoin using linear regression.

Source: anonymous author

Implications For Bitcoin

Causality is difficult to prove, but based on the correlation between the supply of Tether and Bitcoin and Tether Limited operating model, I am highly confident that the issuance of unbacked Tether is driving the insane rise of Bitcoin in USD.

To understand why, I’ll have to add a couple more pieces of information in addition to the facts in previous sections.

Tether Limited management also runs Bitfinex, one of the largest cryptocurrency exchanges.
Tether Limited has not been audited, and the management actively dodges any request for an audit, with the CFO of Bitfinex stating that “Writing that some non specified "third party" audited our numbers and found nothing wrong with them is something what will re-assure you about our honesty?” Note that no one is asking for a “non specified third party.”
It is unclear where Tether Limited banks (given reason is protection privacy), but we do know that Wells Fargo has severed its relationship.
Tether Limited recently engaged Friedman LLP to perform an “audit,” but all the legalese from the filing signals that Friedman absolutely does not want its efforts to be viewed as an audit, stating “this engagement does not contemplate tests of accounting records or the performance of other procedures performed in an audit or attest engagement.”
Tethers have been issued in large lots of tens of millions.
If one believes that this is all a legitimate operation, one would have to believe that there are some astute traders/investors willing to write checks each worth tens of millions dollars multiple times in several days to an offshore corporation that is unaudited, in exchange for digital tokens for which they legally have no recourse should conversion to USD be denied; the management is allergic to an audit because it has nothing to hide, thus doesn’t need an audit; and that high correlation between Tether’s supply and the price of Bitcoin is purely coincidental.

If you do, then I have a bridge to sell.

The Scheme

I believe that Tether Limited issues Tether at will, transfers Tether to Bitfinex, buys Bitcoin with Tether, then sells Bitcoin for USD.

The combination of Tether and the popularity of Bitfinex makes this scheme very difficult to break. Through this scheme, Tether Limited can seamlessly “create” USD without a clear victim.

The scheme relies on two key criteria:

Confidence in the peg of Tether to USD
Active arbitrage between the Tether/USD/Bitcoin triangle across exchanges
Let’s think through a typical transaction step by step. Tether Limited first issues bogus Tethers to Bitfinex, who can then put massive (theoretically unlimited) buying pressure on the Bitcoin/Tether pair. As we can see in the following table, liquidity across exchanges is very deep for the Bitcoin/Tether, over $300 million in 24 hours.

Source: coinmarketcap.com

Because the Tether/USD pair is pegged at 1:1, a rise in Tether/Bitcoin will cause Bitcoin/USD to rise in value as arbitrageurs will move in. Once an arbitrageur spots that Bitcoin/Tether is trading at a higher price than Bitcoin/USD, he will short the Bitcoin/Tether pair and buy Bitcoin/USD. The final leg would be to sell/convert Tether for USD. Note how an artificial upward pressure created on the Bitcoin/Tether pair will automatically cause real upward pressure from arbitrageurs to push up the price of Bitcoin/USD.

This is truly the perfect “business model”. Through this scheme, Tether Limited is able to create profits out of thin air. While this does not look like a traditional pyramid scheme, I believe that the modus operandi remains the same. True, Tether Limited doesn’t solicit new investors, but the deep liquidity of Bitcoin/Tether solves that problem, as every sell order on the other side of the buy orders created by the bogus Tethers effectively loops them into the scheme. As long as there are no sudden conversion requests at Tether Limited, the scheme will never collapse. And why should traders convert at Tether Limited? Selling on the market is much faster, and for the purposes of trading (denominated in Tether that is), Tether has much less friction than USD.

Consequences

Despite my skepticism of Tether, one must wonder, who is Tether Limited harming? Unlike a traditional pyramid scheme, where the victims would have to redeem to realize the value, leading to the collapse of the pyramid, Tether is already a tradable security with a value that is completely backed by the faith of those using it. That is to say the need for withdrawal, which accelerates the collapse, has been removed. One could easily sell Tether to someone else that also have faith in the value of Tether. This means that it does not matter whether Tether Limited is issuing bogus Tether or not, as long as the collective thinking of the market believes that one Tether equals to one USD, and there are enough arbitrageurs to support this peg, then for all intents and purposes, the scheme will not unravel in the foreseeable future. Using Bernie Madoff as an example, if its investors could easily sell their inflated stakes to other investors who also believed in the value of the stakes, is there a real loss of value?

However, that does not mean there is no end game; it’s just that getting there is fairly difficult. If we accept that there is unshakable faith among traders (criterion #1), then the only way for the scheme to collapse is the second criterion.

Getting to the end game involves Bitcoin. Right now, its investors should be happy that Tether Limited is running the scheme, as perpetuating it will drive the price ever higher, as long as they all agree to “hold” that is (i.e. the current mentality). But there will come a point when the price of Bitcoin is so high that they will sell. Perhaps you’ve read somewhere that you are owning a piece of “real value” by holding Bitcoin, given its finite supply, but it is interesting to note that its proponents still compare the value of a Bitcoin to the all mighty dollar. In essence, despite the rhetoric that the dollar becomes worthless, Bitcoin investors are still interested in its value, because ultimately they do want to sell. We’ll see a lot more millionaires if Bitcoin goes to $1,000,000. Wouldn’t you think that more people will want to sell and translate that wealth into goods and services instead of holding it as a digital token? One may suggest that there is a “bitcoin economy” developing right now. That is unequivocally false as all goods and services are priced against the dollar, or whatever local currency the merchant accepts. By spending Bitcoin in such a fashion, the holder of Bitcoin is effectively selling as the first thing the merchant does when he or she receives the Bitcoin is to dump it in the marketplace through the payment processor (e.g. Bitpay).

All of the above is a long winded way of saying that somewhere down the line, at some price, Bitcoin/USD will likely see significant selling pressure that is not experienced today. When that happens, Tether Limited’s scheme will come under stress. Currently, it is the hope that arbitrageurs will step in to correct any inefficiencies between the Bitcoin/USD/Tether triangle that drives up the price of Bitcoin as more Tether is issued. Remember that the final leg of the arbitrage is to convert Tether into USD, so when selling pressure on Bitcoin/USD increases, there will be more selling pressure on Tether/USD as well. If the liquidity of the Tether/USD pair is insufficient, as it will be if there is monstrous selling pressure on Bitcoin/USD, the pair will begin to break away from the peg, withdrawal requests will follow, ultimately leading to Tether’s demise.

Conclusion

While Tether is not as well-known as Bitcoin, I believe that the meteoric rise of its supply plays an important role in Bitcoin’s explosive appreciation. The setup is truly genius, as it allows Tether Limited to print as much “money” as it wants without jeopardizing anyone on the surface. In fact, one could argue that this scheme has made many people very rich, at least on paper. Do I believe that the scheme will fall apart? Ultimately yes, but as I mentioned earlier, getting to that stage is difficult as, despite indications of fraud, there remains a fervent belief among market participants that the peg will hold. And as with anything in the market, as long as enough people believe a lie, it may as well be the truth, until their faith evaporates that is.

Bitcoin investors should have a keen interest in Tether, as it is my belief that its future will significantly affect the price of Bitcoin. If the correlation between Tether’s supply and the price of Bitcoin is causal rather than coincidental as I suspect, then Tether’s doom will be the end of Bitcoin as well.

Disclosure: I/we have no positions in any stocks mentioned, but may initiate a short position in TETHER over the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

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