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We all become MF Global eventually, Tether edition

YESTERDAY By: Izabella Kaminska

We were about to bring readers news, courtesy of anonymous blogger Bitfinexed (who has been tirelessly warning everyone about the Bitfinex exchange, and its stablecoin Tether), that Tether had mutated even further into a conventional banking structure...

But then news broke Thursday night that the New York attorney-general's office, which has been investigating the group since 2018, had obtained a court order directing Bitfinex's parent company to suspend making transactions from Tether accounts into Bitfinex accounts for the purpose of masking a loss somewhere in the order of a $850m due to a suspected fraud by a partner processor.

The documentation that accompanies the court order contains some pretty stunning stuff. Like this, from a Bitfinex employee -- codename Merlin -- on August 15th last year, to his counterpart at a Panama-based entity called Crypto Capital Corp, which we go into more detail about further down (and which also, according to Decrypt, just happened to provide payment processing for Quadriga XS, the Canadian exchange whose founder "died" with the keys to about $140m of customer money):

Please understand this could be extremely dangerous for everybody, the entire crypto community. BTC could tank to below $1k if we don't act quickly.
Bitfinex shenanigans
It has long been speculated that all manner of shenanigans may have been occurring at Bitfinex, not least because crypto exchanges tend to operate in the opaque world of offshore unregulated structures, and are often managed by people with little to no core financial experience. Such opacity offers huge temptation with respect to wrongly taking advantage of customer flow information for prop trading purposes or for dipping into customer deposits for proprietary purposes without customer approval. Or just losing funds in other careless ways.

Separately, it has also long been understood that Bitfinex's KYC and AML-light attitude towards the sourcing of fiat and crypto funds has been posing the group a major banking challenge. With most reputable banks not keen to risk relations with the outfit, the group has instead been playing a game of whack-a-mole in its efforts to maintain gateways into the fiat system. Whenever the gateways close, the search for a new banking partner begins and with it the capacity of customers to both withdraw and deposit new sums of fiat is restricted. This leads to major discrepancies in the prices of cryptocurrencies quoted on Bitfinex versus other more regulated exchanges.

You can read the full claim by the office of the attorney-general (OAG) here.

But the key points are as follows.

Number one: According to the OAG, the multiple arms of Bitfinex, iFinex, BFXNA, BFXWW are operated by the same small group of executives and employees, and registered in the famously opaque British Virgin Islands. They do not have a New York Department of Financial Services license to engage in virtual currency business in New York.

BVI-incorporated Tether Holdings Limited is the holding company of Tether Limited. Tether Operations Limited and Tether Interanational Limited are believed to be incorporated in Hong Kong. None of these entities carry an NY virtual currency business license. The OAG believes the Tether entities are owned and operated by the same small group of executives and employees who operate the Bitfinex entities. Some of their employees are believed to reside in New York. The ultimate majority owner of both the Tether entities and iFinex is an entity named Digfinex Inc.

Number two: At various times throughout 2017 and 2018 both Bitfinex and Tether held accounts at two New York-based banks, Signature Bank and Metropolitan Commercial Bank.

Number three: According to the OAG, the Bitfinex model like most banking models relies on having sufficient US dollar deposits on hand to fill withdrawal orders submitted by traders.

Number four: In 2017 and 2018, the Bitfinex group started to limit access to its services for US individuals and enterprises, unless the entities maintained an offshore incorporation registration. These sorts of investors are known as Eligible Contract Participants (ECPs). But the OAG suspects that the Bitfinex groups still allowed US and New-York-based ECPs to transact on the platform, as well as New-York based individuals.

Moving on to Tether...
Tether has long maintained that every dollar's worth of Tether in circulation is matched by a dollar they hold securely in a reserve somewhere in the world. And yet, much of the crypto world has long speculated that there is not sufficient proof that this is really the case. Even when auditors' reports were supposedly made available publicly to reassure customers, these failed to convince due to the fact they never qualified fully as formal audits.

We have long argued this renders Tether a type of MMF, and/or shadow banking entity.

More recently, however, our blogging friend Bitfinexed noticed that the description of how Tether manages its reserves had changed on their website. Rather than just backing all Tethers with dollar deposits, the group's website now maintained that from time to time the funds would be backed by assets and receivables from loans made by Tether to third parties, which may include affiliated entities.

With this change, Tether had all but admitted that its Tether reserves were potentially being used as a slush fund for its own corporate purposes. But, equally, it had also de facto admitted that it was operating as an unlicensed bank, since the only entities usually allowed to lend out depositor funds to third parties without depositors knowing the full details of where the funds are going while maintaining the promise of par value redemption to depositors are licensed banking institutions.

The OAG's claim also noted the website change and provided an archived screenshot of it in the accompanying evidence.

The OAG then went on to outline the series of unsuccessful banking relationships Tether and Bitfinex were forced to pursue after Wells Fargo had suspended its relationship with the group due to concerns about its offshore and unregulated status. Eventually, the OAG notes, the group ended up being banked by a subsidiary of a New York-based entity named Noble Markets LLC.

Fascinatingly, the complaint also says that the Bitfinex group closed its accounts with Noble due to low interest rates and a lack of capacity to process a high volume of wire transfers to clients, among other reasons. (Alphaville has always warned that float management at par is really hard especially in a low interest rate environment not least because intermediation is not costless, and every transaction eats into the par you are supposedly protecting.)

Nonetheless, as the complaint also notes, as of 2019 Noble bank appeared to no longer be in operation anyway.

From thereon, the Bitfinex group began a banking relationship with a Bahamas-based entity called Deltec Bank & Trust Ltd. But, and this is important, at no point had Bitfinex/Tether ever explained to customers that they were also hugely dependent on third-party payment processors. One such processor was Panama-based Crypto Capital Corp. According to documents obtained by the OAG, by 2018 Bitfinex had placed more than $1bn dollars of co-mingled customer and corporate funds with Crypto Capital.

But this wasn't the only way Bitfinex/Tether was getting around its processing challenges, according to the OAG. They were also relying on companies (some owned by Bitfinex/Tether executives) as well as simple friends of Bitfinex -- meaning friends of Bitfinex employees who were willing to use their bank accounts to transfer money to clients who had requested withdrawals.

Long story short, by mid-2018 Bitfinex was having real trouble honouring withdrawal requests because Crypto Capital had failed to honour its agreements with Bitfinex/Tether.

By October 2018, due to the problems honouring withdrawal requests, rumours started to circulate that Bitfinex/Tether were insolvent, according to the OAG. This was denied by the group who claimed in an echo of the famous Bear Stearns denial that the rumours were a targeted campaign based on nothing but fiction.

This as the OAG notes, was not true. To the contrary Bitfinex employees had been writing distressed messages to Crypto Capital, in a bid to get the money out and processed, such as the quote at the top of this piece, as well as:

Is there any way we can get money from you? Tether or any other form? Apart with Crypto Capital we are running low on cash reserves.
And then:

Please help.

Eventually, Crypto Capital claimed they couldn't send the money because $851m of it had been seized by government authorities in Portugal, Poland and the United States. This, however, was also not true according to the OAG. To the contrary, the $851m was now missing and Bitfinex/Tether were yet to reveal the loss to their clients.

To deal with the lack of available liquidity, by February 2019 Bitfinex decided it would have to structure itself a loan from the Tether reserves -- something its counsel communicated to the OAG investigators. But in the course of further dialogue it emerged Bitfinex had already drawn on Tether's reserves to the tune of $625m in November 2018, via a transfer between the two entities' Bahamian bank accounts (albeit matched by a corresponding transfer from Bitfinex's Crypto Capital account to Tether's Crypto Capital account).

By late December 2018, however, the Bitfinex team had become concerned that the Crypto Capital sums had actually been lost to a fraud, rather than seized by authorities. It was at this point that the executives decided to engineer a secured revolving line of credit of up to $900m on commercially reasonable terms from Tether to Bitfinex. This was to be secured by 60,000,000 iFinex shares owned by DigFinex, a transaction which closed on March 19.

On March 27, executives initiated a transaction debiting $625m from Tether's Crypto Capital account and crediting the equivalent Bitfinex account. A few days later the bitcoin price finally began to challenge $5,000 per bitcoin again (chart courtesy of Coinbase):

Engaging in such transactions without a banking license is pushing the boundaries of legal financial activity. Doing so and not disclosing what you're doing to customers is positively not in the realms of compliant activity.

As OAG notes, the Bitfinex group have only produced limited relevant information regarding the facts and circumstances of the $625m transfer and subsequent line of credit transaction. It is for this reason they have sought a court order restraining Bitfinex from making any further transfers of this kind.

Bitfinex contests the OAG's assertions, describing them as written in bad faith. The company posted the following on its website (our emphasis):

Earlier today, the New York Attorney Generals office released an order it obtained without notice or a hearing in an attempt to compel Bitfinex and Tether to provide certain documents and seeking certain injunctive relief.

The New York Attorney Generals court filings were written in bad faith and are riddled with false assertions, including as to a purported $850 million loss at Crypto Capital. On the contrary, we have been informed that these Crypto Capital amounts are not lost but have been, in fact, seized and safeguarded. We are and have been actively working to exercise our rights and remedies and get those funds released. Sadly, the New York Attorney Generals office seems to be intent on undermining those efforts to the detriment of our customers.

Bitfinex and Tether have been fully co-operative with the New York Attorney Generals office, as both companies are with all regulators. The New York Attorney Generals office should focus its efforts on trying to aid and support our recovery efforts.

Both Bitfinex and Tether are financially strong full stop. And both Bitfinex and Tether are committed to fighting this gross over-reach by the New York Attorney Generals office against companies that are good corporate citizens and strong supporters of law enforcement. Bitfinex and Tether will vigorously challenge this, and any and all other actions, by the New York Attorney Generals office.
The OAG might argue that whether the missing funds were seized or embezzled probably doesn't change the fact that Bitfinex/Tether had a duty to inform its clients of the issues.

What's fascinating about the group's reply -- something also indicated by the group's attempt to sue Wells Fargo for suspending their relationship with them -- is that it believes itself to be a victim of discriminating attitudes that seek to limit the company's legitimate trading activity.

Yet at no point does the group seem to acknowledge that all its banking challenges stem from a lack of regulated status and a known reputation for not conducting proper KYC or AML checks. One could ask: why won't a group that describes itself as a good corporate citizen and a strong supporter of law enforcement just bite the bullet and get regulated?

Source : https://ftalphaville.ft.com/2019/04/26/1556291388000/We-all-become-MF-Global-eventually--Tether-edition/

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