The Bitfinex / Tether Controversy: Bitcoin Pricing in an Era of Crypto Fraud

It should come as no surprise that Tether’s structure has now garnered the limelight of the NY AG. Previously, Bloomberg reported that the US CFTC sent subpoenas to both parties, a Tether hack back in November 2011, Tether dissolved its relationship with its auditor, a UT study revealed Tether being used to manipulate BTC prices, and so forth. Despite the negative news for the industry, the underlying community remains strong and resilient to such occurrences.

We are now witnessing a “run-on-the-exchange”, a unique test case for Bitcoin Hodlers to prove that the sum of its parts can push through greed’s hold on using crypto for quick, scammy gains. As I type this out, a reported $185 million in BTC and ETH has been removed from Bitfinex’s cold storage wallets – about 20.0 percent of their total total balance. While additional losses (in terms of crypto pricing and faith in the industry) are expected over the short run, I remain confident that the industry players will find ways to effectively manage the risk of these illicit activities.

The history of our community demonstrates powerful forces pushing forward, working collectively on unique solutions that bring us closer to the goal of blockchain entrepreneurs – to create trust and accountability in the digital world. After Mt. Gox, crypto security providers become more popular, a renewed focus on security culminated in the popularity of cold storage solutions, multi-sig authority, and updated private key protocol. Large companies like IBM and Fidelity took the opportunity to release their own technology solutions for crypto custody.

We have also observed the shakeout of ICOs in favor of a more measured, standardized approach to fundraising on the back of blockchain-enhanced infrastructure. ICO deal flow has experienced significant losses over 2018 and the first half of 2019, favored by a variety of STO projects that use blockchain solutions to go to market more efficiently. Scam artists, like those responsible for Centra Tech, are being brought to justice – clearing the way for focus to turn to real projects.

However, progress has all proven to take time and work in volatile cycles. The direct impact on the crypto community has yet to be seen; however, prior fraudulent activity and hacks have lead to negative BTC performance over the subsequent 30 days after an event. The average max drawdown over this period, net of S&P 500 returns for the events listed below, has been about 25% – indicating that we may be in for a bumpy second quarter.

However, after all of these prior events: Bitcoin mining hash rates continue to climb year after year and adoption marches on via new, exciting platforms that demonstrate the potential of crypto technology.

With December 2018 Rate Hike Locked In, Headwinds Accelerate for Cryptocurrency Exchanges

CME’s Group FedWatch is currently assessing the probability of a 0.25% rate hike in the federal funds rate to be 82.7%. In the most recent FOMC minutes, the group indicated “Almost all participants expressed the view that another increase in the target range for the federal funds rate was likely to be warranted fairly soon.” Compounded with the accelerating hacker problem faced by the exchanges, the long popping of the crypto bubble, and an SEC tightening their grips on registration requirements, exchanges are looking at material headwinds to attract capital.

Major Cryptocurrency Exchange / Platform Hacks

Why do Interest Rates Matter?

The response of cryptocurrency asset performance after last 5 or 6 rate hikes (represented by the dotted black lines below) has had a negative impact on crypto price performance.  The chart below demonstrates that the collapse of the crypto bubble during Q1 2018 coincides almost perfectly with the December 2017 rate hike decision. All subsequent rate hikes had a negative impact on crypto asset performance.

Cryptos Versus Rate Hikes

The interest hikes hurt the exchanges in two ways. First, the exchanges are primarily comprised of non-interest bearing deposit accounts. As interest rates rise, traditional deposit accounts will become more attractive. Second, the lack of a futures / forward market for cryptos means the exchanges are forced to be long commodity / crypto volatility with limited choices for risk management. Another item that compounds the issue is that these exchanges lack cash flow diversification such as fee-based services offered by traditional banks.

One area still unexplored is the impact of an inverted yield curve on the price performance of cryptos. Will they become more popular for individuals given the signal of a future recession? Will retail investors try to avoid Federal Reserve exposure by shifting to more digital asset classes? Per the chart above, the 10-2 spread is now sitting at 0.11%. In the past two decades, the 10-2 spread has never reached this level without the yield curve becoming inverted in the near future. The answers to these questions are certainly not going to be answered in the near future; however, observance of these trends may signal future retail investor behavior – especially as regulatory, security, and customer service standards begin to mature.

Change May be Coming

The innovative spirit of the blockchain community has not turned a blind eye to the problem. Coinbase recently invested in Compound, a platform that enables cryptocurrency holders to earn ‘interest’ on their holdings. The goal of Compound is to created tokenized versions of fiat currencies (like the US dollar). Other players such as the Winklevoss brothers’ Gemini Coin, MakerDao, Tether, and other ‘Stablecoin’ projects recognize the importance of creating a digital asset replicating fiat currency. Key features of a winning technology will likely include a secure platform, low volatility, and corporate governance transparency.