The Tether Case – the Bitfinex audit
The Tether Case – the Bitfinex audit
Crypto

The Tether Case – the Bitfinex audit

By Patryk Karter - 14 Jun 2018

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Bitfinex audit for the control of the company’s financial statements ended abruptly without a final ruling by the auditor Friedman LLP.

The Tether Case – the Bitfinex audit: This is a translation of Alberto De Luigi’s article

Similarly, the subpoena launched by the US authorities was not followed by any official news.

If Tether is in compliance, why have neither Bitfinex nor the authorities issued any press releases?

In this article, we will give an answer to this question, but we will also understand why behind this story lies something much bigger, which could change the balance of the world’s economy and finance as we know it.

Index of contents of the article:

  • A few words about Tether and the Omni Protocol
  1. The Tether transaction on Bitcoin’s blockchain
  2. Tether’s main movements between exchanges
  • How does the relationship between Tether and Bitfinex work?
  1. Bitfinex deposits and withdrawals
  2. The issuance of new USDTs tied to the US dollar
  3. Where is the scam?
  • Bitfinex Audit and Subpoena: what’s going on?
  1. Auditors’ fear of making a false move
  2. Smaller banks fear exclusion from the system
  3. The subpoena to Bitfinex by the US regulator
  4. New financial balances

A few words about Tether and the Omni Protocol

On every platform where you can trade dollars with cryptocurrencies the USD ticker representative of the dollars that the user owns is shown.

If Alice buys $1,000 from Bob on Kraken, $1,000 will appear in her account. This is simply because some data is modified on the Kraken database thanks to inputs from the trading engine.

Alice is not certain that Bob really owned the $1,000 because the internal accounting operations of the exchange are not transparent to the public.

Bob could be an employee of Kraken who modifies the number in the database at will, crediting 1,000 “USD” to be exchanged for Alice’s bitcoins.

When Alice tries to reclaim her bank account, she will notice that those dollars do not exist, but she has now given up her bitcoins.

This scam is unlikely but theoretically possible, and a well-known Twitter account accuses the world’s largest cryptocurrency exchange, Bitfinex, of implementing it.

Bitfinex makes no difference between tether dollars and real dollars, USD and USDT, so the concept is the same: when we use USDT, we’re trusting that behind that number we read on the platform there really are dollars, just like the USD on Kraken or GDAX. Until we withdraw the dollars from the platform, we cannot be sure that they will actually be there. In reality, this certainly does not even exist for the euro and dollars in traditional banks, since they use fractional reserve and have literally never sufficient funds in cash to cover the quantities nominally available to current account holders.

The difference between the USD and USDT tokens we see on exchanges is essentially the way they are accounted for: USDT unlike USD is not just a number in a centralized database but is logged on the blockchain, which is why it is used as a cryptocurrency. In fact, USDT’s movements outside an exchange are public and transparent to anyone, which is why users can move tether dollars from wallet to wallet without having to rely either on Bitfinex or on any intermediary, bank or central bank. Tether thus becomes an asset, like a dollar note, redeemable exclusively on Bitfinex.

  1. The Tether transaction on Bitcoin’s blockchain

The Tether transaction (USDT) is written into the Bitcoin blockchain via the Omni Protocol, thus ensuring the certifiability and publicity of the transactions, which can be verified by querying the blockchain.

This is a Tether transaction seen with the well-known Bitcoin blockexplorer blockchain.info.

Blokchain.info is a blockexplorer used to see Bitcoin transactions. It does not recognize the output of this transaction, as you can see from the screenshot: “unable to decode output address”.

In fact, while taking advantage of Bitcoin’s blockchain and its security, the recipient address is not Bitcoin’s, but Tether’s.

There is obviously a bitcoin input, of a very small amount, which is used to pay the miner to insert the data in the blockchain.

This data can only be deciphered by using software prepared to read the Tether protocol, such as Omniexplorer.info. In this case, it is a 50 thousand USDT transaction, the hash of which corresponds exactly to the hash of the bitcoin transaction.

Some exchanges have installed Tether wallets to list USDT, so that users can withdraw Tether from Bitfinex and deposit them on Poloniex, Binance, Bittrex etc..

An exchange trading USD is forced to verify users through KYC & AML procedures, but at least in certain jurisdictions, it can bypass these checks completely if it exchanges only cryptocurrencies, including USDTs (not in the case of Bitfinex, which requires verification of identity in each case).

Therefore as long as Tether is, in fact (regardless of its legal status), considered a valid security on the underlying dollar, it is possible to transfer a security on the dollar completely bypassing the banking circuit and in a pseudonym way, moving value freely across geographical barriers and jurisdictions.

However, this security can only be redeemed on Bitfinex, so the system only holds if for every Tether in circulation there is actually a dollar in the pockets of the exchange.

Currently, there are 2.5 billion USDT in circulation, which should mean that users have deposited at least this amount of dollars with Bitfinex and that these dollars have remained in the coffers of the exchange.

The question that many people ask themselves is whether these numbers are real or whether there is anything unfamiliar about them.

  1. Tether’s main movements between exchanges

Tether’s main movements are between exchanges (especially between Bitfinex, Poloniex and Huobi) because users, especially large traders (the so-called whales) send large sums from one platform to another to do arbitrage.

Thanks to Tether, moving a token with a stable and dollar-related value is possible and above all very fast (and without “bureaucratic” restrictions) compared to a transfer in dollars, so traders use this speed to move value from one platform to another, thus being able to speculate on price differences of other cryptos.

The Binance wallet alone contains more than 700 million tether dollars. The trading volumes on Binance are higher than those of Bitfinex, however, it is not possible to deposit or withdraw fiat money on Binance, which is why the exchange is exclusively between cryptocurrencies and, as with the other two giants Huobi or CeX, tether replaces the dollar.

The display board is not updated to the last minute.

For example, the cold wallet of Poloniex with 220 million Tether (at the time of writing) is not present in the table. For quicker updates, it is also worth checking the Blockspur’s rich list

Here at the moment, I see 220 million Tether in Poloniex’s cold wallet.

This is Poloniex’s hot wallet.

The Bitfinex hot wallet counts about 130 million (click on the link to see it live):

At the time of the audit, as can be seen from the following statement from the auditor’s (Friedman LLP) document, Tether’s treasury address (the cold wallet) was 3BbDtxBSjgfTRxaBUgR2JACWRukLKtZdiQ.

Today the cold wallet moved to the address 1NTMakcgVwQpMdGxRQnFKyb3G1FAJysSfz:

You can easily track tether movements from the creation address to Bitfinex’s cold and hot wallets, starting from Tether’s creation address.

It is also curious to observe the transactions between Huobi’s hot and cold wallets (from about 80 and 330 million dollars respectively): between these two addresses there is a continuous path with infrequent transactions but of very high amounts (12 million each on average).

A curiosity: the following address is that of the hacker who attacked Tether, his USDTs have been frozen and can no longer be moved.

As we can see from the blockchain, there are billions of USDT actually circulating between the various exchanges (and probably some personal wallets), which means that in Bitfinex’s reserves there should be at least an equal amount of dollars. But what if that were not the case?

If there were no dollars to cover, the truth sooner or later will come to light and the price of the Tether will collapse. However, exchanges like Poloniex or Huobi don’t worry about this at all, the loss would be for users who at that moment hold tether in their accounts, not for the exchange, just as it would be for any other cryptocurrency.

Those who believe that Tether will fail drastically are free to open a short in Tether against the dollar on the Kraken platform, which allows this type of operation just to test the solidity of the Tether. Thanks to Kraken’s ability to bet USD against USDT, the market’s confidence in Tether is extraordinarily transparent and does not seem to have been damaged by news of the subpoena launched by CFTC against Bitfinex either.

How does the relationship between Tether and Bitfinex work?

  1. Deposits and Withdrawals on Bitfinex:

Common users deposit and withdraw funds on Bitfinex through Cryptocapital, a company that deals with payment, anti-money laundering and customer recognition procedures on behalf of Bitfinex and other exchanges, such as CEX. Cryptocapital specialises in opening banking channels so that, if flows are closed by certain institutions, an alternative channel is always found. This solution was necessary following the historic closure of the transfers to Taiwanese banks that Bitfinex requested from Wells Fargo. Until the summer of 2017, Bitfinex relied on many different banks, but all in the same jurisdiction: With the ban by the correspondent banks, the world’s largest trading platform suddenly suffered the closure of channels to and from the United States. Given the difficulties in moving dollars, users have quickly adapted to an alternative system and the use of Tether has grown disproportionately: the graph shows the increase in movements between June and December. Note that the 12 billion moved is far greater than the circulating supply, since a coin can be moved back and forth many times.

  1. The issuance of new USDTs tied to the US dollar

Tether dollars are issued when Bitfinex’s USDT hot wallet is about to finish. Let’s assume that a user has deposited 1,000 USD through Cryptocapital on Bitfinex: at the time of the bank deposit in dollars, it is not necessary to create tether, simply the depositor finds 1000 USD on his account. If this user, however, buys 1000 Tether on his own personal wallet or sends them to an exchange like Poloniex, the user’s account is emptied of 1000 USD and the Bitfinex hot wallet sees an output of 1000 USDT. It is likely that the dollars on Bitfinex are more than the Tether dollars in circulation since we expect that there are not as many traders who move Tether outside Bitfinex as users who deposit dollars to keep them on the platform. As a result of a USDT withdrawal from Bitfinex’s wallet to another exchange, Bitfinex may run out of USDT, so it requests new USDTs from Tether Ltd so that it can cover subsequent withdrawal requests from users.

The procedure of issuing Tether, therefore, involves two consequential steps:

A dollar transfer is made from the Bitfinex bank account to the Tether Ltd bank account. This transfer is internal to the same bank with which Tether Ltd and iFinex Ltd have an account, so it is almost immediate (see below which bank).

When Tether Ltd receives the money, it moves USDT from the creation address to the Bitfinex wallet. The transaction is done on Bitcoin’s blockchain via the omniprotocol, so the speed depends on the blockchain.

Tether issuance is exclusive to a Bitfinex wallet, there is no other USDT distribution hub. For every Tether in circulation, there is a dollar deposited on Bitfinex, because if a user withdraws 1000 USDT he necessarily deposited at least 1000 USD, or he traded cryptocurrencies for USD deposited by other users.

Could there be USDTs not covered by dollars? It is absurd, but even if this were the case, it wouldn’t necessarily be a case of fraud. We can understand this by keeping a theoretical examination of pure accounting: the creation of USDT is not instantaneous and automatic for every dollar deposited, because Tether is created in blocks and if the user wants to transfer them, he will not be able to do so without there having been a new issue before. If therefore the hot wallet of Bitfinex tends to be zero, we can foresee that Tether Ltd will issue a block of USDT in order to face not only a request of withdrawal already forwarded by some user but to a future series of expected withdrawals, so as not to have to chase the requests of the users continuously issuing new tokens. In this case, therefore, there would be Tether dollars temporarily uncovered. However, as can be seen, such a situation could also be legitimate. After all, even if there was more USDT than the underlying dollars, it does not mean that any user can spend USDTs buying bitcoin or other cryptocurrencies. As long as Bitfinex users have empty balances in USD, they cannot transfer and therefore put Tether dollars into circulation, unless they have made new deposits in USD. So the Tether dollars would have been created in advance for a mere technical issue.

  1. Where is the scam?

Let’s assume that there are criminals behind Bitfinex, in what way would their scam activities benefit from the use of Tether? As we have already said, any exchange that does not use Tether could “from nothing” credit a fictitious amount of USD to the platform and exchange it for other cryptocurrencies, keeping in reserve only a fraction of the USD deposited on the exchange by the users so as to cover a moderate demand of withdrawals (the one foreseen in the short term). This system is well known to traditional finance and it is called fractional reserve, used by all common banks. The exchange after creating fictitious USD (or USDT) on some of its accounts within the platform may disappear into thin air with bitcoins, ether and other cryptos purchased without actually giving anything back. From this point of view, Bitfinex does not have an advantage over any other exchange, since it is a scam that everyone could potentially carry out.

The risk to those attempting such fraud is that users will find that they can no longer withdraw their dollars, understanding that the nominal quantities in their accounts do not have a real match. As soon as the exchange is discovered carrying out a fraud like this, it is the end, with serious consequences, including criminal ones, for the managers involved. In the MTGox case, the exchange failed and was forced to compensate users. MTGox’s history teaches us that the justice mechanism works better for crypto exchanges than for the “highly regulated” traditional banks: if Italian Bank Monte dei Paschi has an 8 billion euro hole, the ones to pay are the Italian taxpayers as a whole, not the bankers, and not even specifically the Monte dei Paschi accountants who have trusted to choose it as their bank. If Tether is not covered, it is Bitfinex and generally any user who owns USDT and who has badly placed his trust in the exchange, who pays.

The only “fraud” that the person who manages the issuance of Tether can do more easily than other executives of an exchange is issuing new Tether not covered by dollars, send them to another exchange and here exchange Tether for other cryptocurrencies. Although the trade took place on another exchange, the situation is not very different from the one described above. In fact, the risk to which the fraudster is exposed is exactly the same: sooner or later someone will return to redeem these USDT on Bitfinex and try to reclaim the USD. If this happens and the dollars are not there, it will be a legal battle and Bitfinex will lose its reputation and a large part of its business. when you run a money machine like the largest crypto exchange in the world, the motivations that can lead you to a scam of this type are not so crystal clear.

Bitfinex Audit and Subpoena: what’s going on?

 

If all the dollars are correctly in Bitfinex’s coffers, why not declare it and show it openly to the world? There are mainly two problems that Bitfinex has to face.

  1. Auditors’ fear of making a false move

Until 2002, there were 5 large auditing companies, the so-called Big Five:

Ernst & Young

Deloitte & Touche

KPMG

PricewaterhouseCoopers

Arthur Andersen

They are called the Big Five because they audit 99% of FTSE 100 companies, which are the 100 companies with the highest market capitalisation on the London Stock Exchange (and 96% of companies on the FTSE 250 index). In short, they are giants with stellar turnovers, only Deloitte reaches 38 billion dollars. However, the enormous visibility of these companies puts them under such media pressure that a single mistake can permanently compromise their reputation and their business, as history shows.

Of the Big Five, only four remained in 2002, following the fraudulent bankruptcy of Enron Corporation, a company based in Houston, Texas, which had for years maintained very rapid income growth through accounting tricks. The scandal affected both Enron and Arthur Andersen, the auditor who had previously approved the accounts. Arthur Andersen was one of the Big Five, but this single episode brought an end to it: the company returned its Certified Public Accountant license and dissolved, disappearing along with its 9 billion dollar turnover.

The big auditors are overpaid for their work and they are terrified that they might make a false move. It is not surprising, therefore, that the cases in which they prefer not to express their opinion are known everywhere, even in Italy: let us think only of KPMG in situations that have gone into the news, such as the case of the Zucchi group, or the Bari interport (to which EU funds were nevertheless granted) or Arquati s.r.l. It happens to read news on which the auditor refrains from “expressing a judgment”, generally concluding with a ritual formula such as: “due to uncertainties about the company’s ability to continue as a going concern, the company is not able to certify its financial statements”. If the situation is complicated, why should an auditor risk their business when they can simply leave the customer?

Friedman LLP collected several hundred thousand dollars from Bitfinex for months of work, where he had to deal with issues that touch on technologically unexplored issues and borderline jurisprudence. At one point they were faced with a crossroad: either cash the cheque already signed by Bitfinex and drop the shack, or approve the business model of Tether Ltd, amidst a thousand legal uncertainties. To give just one example of the many thorny issues: can a company freely issue a security on the dollar, allowing anyone to pass it peer to peer without any possibility of intervention by the public administration? Are there enough legal cases to have a clear idea of what would happen if the SEC or the US legislator were to intervene in this matter? Is there any certainty about the “business continuity” of Tether Ltd? In a new business like cryptocurrencies, you can’t stay too comfortable, even a collapse due to external circumstances like a hack could ruin FLLP’s reputation if it fully approves the customer’s actions.

That said, during the months of Bitfinex’s internal audit activities, FLLP had access to data and financial statements and also produced detailed documents, as drafted in the latest report of 28 September 2017, before the customer relationship was broken off. Here FLLP wrote that what is traced by the Omniexplorer.info matches the information provided by the Client” (see https://tether.to/wp-content/uploads/2017/09/Final-Tether-Consulting-Report-9-15-17_Redacted.pdf). In September, the issuance of Tether was only $440 million and FLLP certifies the existence of a $382 million bank account in the name of Tether Limited, plus a further $61 million in an account not owned by Tether, but on which there is a written agreement that those securities are for Tether’s benefit. The sum is therefore sufficient to cover the 440 million Tether.

It is important to note that in this official report there are black bars censoring the name of the bank of Bitfinex, where the dollars to cover the Tether are kept. Why all this secrecy? Where does Bitfinex hide its money? And here we come to the second problem that the exchange had to face.

  1. Smaller banks fear exclusion from the system

The operators of the traditional banking system are indifferent towards the cryptocurrency world, so the medium-small banks fear to be excluded from the principal channels of the credit because of their activities inherent to cryptos, just as it had happened to the Taiwanese banks which were used by Bitfinex in the Wells Fargo case. In this respect, the fragility of smaller banks to media exposure is similar to that of audit firms.

For this reason, the bank where Bitfinex holds its funds prefers not to officially disclose its partnership with cryptocurrency service companies, so as not to expose itself to the media and not to attract attention. Some evidence, however, makes it easy to discover their identity: both Bloomberg and a BitMeX report agree that it is Noble bank, based in Puerto Rico. Being in unincorporated US territory, Noble is effectively an American bank. By statute, it offers only the service of custody of funds, so it does not make investments and does not practice fractional reserve, holding in cash 100% of what is deposited by the customer. In addition, Noble may not accept transfers to or from other banks if the account holder of the destination account is different from the person or company to whom the account of origin of the funds is addressed. Like most smaller institutions, they do not hold the funds directly, but with a third party that in this case is the Bank of New York Mellon. With 371 billion dollars, the BNY Mellon is the tenth largest American bank, and if we consider only custodian banks, it is even the largest in the world.

To stay muted, Bitfinex adopts an interesting system to receive the large deposits of traders and companies: the user creates his own account with Noble, then makes a rebalancing of his funds between his account at the bank of origin of the funds and the new account created in his name at Noble bank. At this point, to pass the funds to Bitfinex’s account, the transfer is internal to Noble, and therefore invisible to the other banks. This maintains a high degree of confidentiality and makes it easier for the depositing user to justify transfers since a rebalancing of funds between their traditional bank account and the one created on a US custodian bank does not give rise to too many suspicions. The same type of transaction that takes place with Noble bank is replicated in other regions of the world with several support banks since Bitfinex has a partnership with institutions strategically located in order to avoid larger customers transcontinental money transfers. Users who transfer smaller amounts rely on Cryptocapital.

Bitfinex’s regard for its own and customers’ confidentiality also explains the exchange’s reluctance to publish official information relating to the location of the funds.

  1. The subpoena against Bitfinex from the US regulator

Apparently, the American regulator does not like the lack of transparency in the name of privacy. The U.S. Commodity Futures Trading Commission (CFTC) opened an investigation on December 6 of last year: technically it performed a subpoena against Bitfinex (and also Friedman LLP).

In the case of a subpoena, the person summoned to appear in court may not publish relevant information for the investigation or else they may face very serious sanctions. On the other hand, the supervisory body is not required to make a public statement. The fact that the CFTC wants to keep the (possible) investigation absolutely confidential is also clear from the fact that an FOIA (Freedom of Information Act) has been denied by an anonymous person precisely to clear up the matter. The CFTC said: “disclosure of that material could reasonably be expected to interfere with the conduct of the Commission’s law enforcement activities”. https://www.coindesk.com/cftc-denies-bitfinex-foia-request-citing-possible-investigation/ (the news is from 6 June)

If one, therefore, wonders why Bitfinex has remained silent in recent months, it is simply because the CFTC imposes the utmost confidentiality and cannot leak any official news. So how can we get an idea of what is happening and whether there really are any problems with Tether? One thing is clear to the whole world: on 6 December, the day of the subpoena, Tether’s market cap was only 800 million dollars. Today Tether is at 2.5 billion dollars. If the regulator had detected irregularities, would Bitfinex have dared, in the CFTC’s eyes, to triple the amount of Tether in circulation? If the numbers don’t add up the regulator will send a letter of “Cease and desist”, which means that Bitfinex has to terminate the activity immediately, or at least the transfers involving Tether. However, none of this has happened.

  1. New financial balances

Noble closed 2017 with as much as $3.3 billion, the year before they had only $191 million. Today we’re talking about more than 4 billion only in the Bitfinex account. Much of the growth in Noble’s numbers is a reflection of Tether’s growth, as reported by BitMex research. https://blog.bitmex.com/tether-addendum-new-financial-data-released-from-puerto-rico/

But the most amazing thing is that Noble has gone on to be the richest account within the Bank of New York Mellon. There are large companies that hold more but in shares, bonds and securities of various kinds. Instead, crypto exchanges must ensure maximum liquidity because users could withdraw at any time, so they hold value in the most liquid form, simply in dollars. Looking at it in perspective, this fact has something incredibly revolutionary: Bitfinex, the world’s first cryptocurrency exchange, holds the richest account in the world’s largest deposit bank. In light of this, how will the world change in a few years time?

Bitcoin in the last 7 years has seen an average daily growth of 0.46% (see https://www.albertodeluigi.com/2018/04/03/dieci-regole-del-bitcoiner/). If in the next few years it sees even a glimmer of the growth it has had to date, the amount of money deposited on exchanges like Bitfinex will be enormous. This can completely change the financial balance of the planet.

Since 2008, the FED has been paying an interest rate of 0.25% for excess reserves. Holding $4 billion in a custodian bank that does not make any fractional reserve means earning $10 million in interest annually transferred by the FED, practically free of charge. And these interests are not cashed by Bitfinex, but by the bank that holds its accounts. The more time passes, the more Bitfinex is in a risky position. At some point, people like JPMorgan or Wells Fargo will understand the opportunity, and when the big boys take the first step, all the smaller institutions follow closely. There will be no more to hide, no more doubts and fears to provide financial services related to cryptocurrencies. The inflated world of traditional finance, constantly under the threat of bank runs and credit crunches, will not be able to go on without the new accounts without fractional reserve used by exchanges. As Giancarlo Devasini exclaimed: “sooner or later these big names in traditional finance will say: You know what? I go to bed with them [Bitfinex & co., ed].

About Giancarlo, I had the pleasure of meeting him. Going into the subject, I told him: “In my opinion, in five or maybe ten years Bitfinex (and if not Bitfinex, another crypto exchange) will be the largest bank in the world”. He didn’t answer, but I interpreted his sly look as a printed phrase: “my boy, don’t tell me what I already know…”.

And this is the first phase. In phase two, exchanges will no longer be needed.

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Patryk Karter
Patryk Karter

Passionate about new technologies, nutrition, and philosophy, Patryk spends his days exploring the infinite universe of the web. He moved to London after living most of his life in Rome. He starts studying Computer Science at King's College of London but soon understands that it is not his path, instead he decides to invest his time and money in blockchain technology and in the meantime takes university courses available on the web. Now he is a trader and works as a freelancer.

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