Bernie Madoff Move Over: 'Stablecoins' Have You Beat

Everybody is familiar with the Ponzi scheme: the scammer dupes investors into giving him their money, paying out early investors with incoming investments, thus presenting a veneer of respectability.

The great thing about Ponzi schemes? They really work. Investors are all happy with their returns, whether they stay in or get out.

Ponzi schemes work, that is, until they don’t. Eventually losses steamroll, and the Ponzi schemer is quickly out of business.

Today’s cryptocurrency world is rife with scammers to be sure, and the number of different scams is as great as the number of marks willing to fall for them.

But with the price of Bitcoin and other cryptocurrencies in the doldrums, a new scam is rising to the top, like bits of toilet paper in sewage: stablecoins.

How the Con Works

A stablecoin is a cryptocurrency whose value is pegged to an existing asset – potentially gold or some other commodity, but most commonly to a fiat currency like the US dollar.

The stablecoin con begins with a simple value proposition. “[Stablecoins’] main use case is to provide cryptocurrency users with the ability to convert volatile crypto positions into anti-fragile or ‘stable’ alternatives,” explains Sam Ouimet, market analyst at CoinDesk.

In other words, if Bitcoin or some other crypto is too volatile for your liking, move your crypto investment into a stablecoin. Its value will go up or down with the value of the underlying asset, but will be far more stable than the crypto you had invested in before.

Just one problem: as with any Ponzi scheme, the value of your investment is stable until the bottom falls out, and it becomes worthless. Your money, meanwhile, is in the pockets of the scammers.

The Three Types of Stablecoin: From Bad to Worse

Confusion about the inner workings of a con is itself part of the confidence game – and stablecoin is no different. Case in point: stablecoins can be algorithmic, crypto-based, or collateralized with fiat (or potentially gold or other commodities with value).

With algorithmic stablecoin, the vendor of the coin in question maintains its market value by buying its coins on the open market when its value goes down while selling them when its value goes up, thus bringing its value back to whatever fiat value it has pegged each coin to (typically $1). Furthermore, the vendor pays for its coins with IOUs, or ‘crypto-bonds.’

Even Stablecoin aficionados see risk in the algorithmic approach. “The smart contracts and sometimes the incentivized participants of the network will affect the supply and demand of the available tokens and fix the price around a predetermined amount,” explain analysts at BlockShow. “This particular approach carries the advantages of decentralization and doesn’t require the trust of the main issuing entity but could be prone to the attacks that affect the price of the stablecoin.”

Such attacks, however, are the least of this approach’s problems. “The bonds are supposed to appeal to investors because they trade at a discount — so that, in principle, their price can rise,” explains Barry Eichengreen, professor of economics at the University of California, Berkeley, and a former senior policy adviser at the
International Monetary Fund
. “Here, too, the flaw in the model will be obvious to even a novice central banker. The issuer’s ability to service the bonds depends on the growth of the platform, which is not guaranteed. If the outcome becomes less certain, the price of the bonds will fall. More bonds will then have to be issued to prevent a given fall in the value of the coin, making it even harder to meet interest obligations.”

In other words, a Ponzi scheme.

Crypto-Based Stablecoins: ‘Perpetual Motion Machines’

Crypto-based stablecoins are no better. In this approach, the vendor of the stablecoin collateralizes its coins with other crypto. Take, for example, the Dai stablecoin from MakerDAO, which runs on the Ethereum blockchain. “[The MakerDAO Dai stablecoin] system makes zero sense and is broken to the core: it only works if the price of Ether goes up,” says Preston Byrne, attorney/solicitor at Byrne & Storm, P.C. “Unfortunately for them, history shows that this investment thesis has been wrong 100% of the time, and Ethereum is as user-friendly and scalable as an angry rhinoceros experiencing heroin withdrawal.”

The bottom line: “Crypto-collateralized stablecoins are the perpetual motion machines of modern finance,” according to Byrne. In fact, MakerDAO has a plan it calls ‘emergency shutdown’ for when the bottom falls out and it is no longer able to maintain Dai’s stable value – which, in fact, happens to every Ponzi scheme sooner or later.

The Fiat Collateral Shell Game

The third approach to implementing a stablecoin is to collateralize it with real money (or other assets with value). In other words, for every stablecoin worth $1 the vendor issues, it maintains at least $1 in the bank, held against the eventuality that there will be a ‘run’ on the stablecoin, where everybody wants their money back.

Just one problem: many vendors choose to partially collateralize their stablecoins, maintaining a reserve of cash insufficient to cover such a run, vaguely similar to the fractional reserve system that banks use to lend more money than they receive in deposits.

Only the fractional reserve system is heavily regulated, the US Government (as well as many other governments around the world) guarantees many deposits, and banks pay interest and/or provide value-added services to depositors – characteristics that no stablecoin can offer.

What, then, are the benefits to holders of partially collateralized stablecoins? They get to give up control of their hard-earned real money in exchange for tokens that at best return their deposit, while at worst they lose everything. They even give up the possibility of another run-up in the price of their crypto.

Ask yourself: why would anyone take such a deal? And more importantly, why would any on-the-level business ever think it could make money offering such a value proposition to its customers?

From Tether to Circle

The most popular stablecoin, USDT from Tether, is an example of a supposedly fully collateralized stablecoin – only it has heretofore been unwilling to submit to a public audit of its fiat reserves.

In November 2017, Tether experienced an inevitable meltdown characteristic of all Ponzi schemes, as it was unable to maintain its peg to the US dollar, as the chart below illustrates.

The price of Tether’s USDT stablecoin relative to the US dollar from June through October 2018, showing its loss of peg to the dollar on October 15.TradingView

Note that in the chart above, USDT’s price relative to the dollar was quite stable – until suddenly it wasn’t. “Tether, which is pegged one-to-one to the dollar, claims to hold dollar deposits equal to the value of its circulation. But the veracity of this claim has been disputed,” Eichengreen continues. “This points to yet another problem with this model: expense. To issue one dollar’s worth of Tether to you or me, the platform must attract one dollar of investment capital from you or me, and place it in a dollar bank account. One of us then will have traded a perfectly liquid dollar, supported by the full faith and credit of the U.S. government, for a cryptocurrency with questionable backing that is awkward to use.”

Eichengreen concludes: “This exchange may be attractive to money launderers and tax evaders, but not to others.”

In response to Tether’s woes, Circle Internet Financial touts that its reserves exceed the dollar value of its ‘USD Coin’ stablecoin in circulation – and even posted a letter from accounting firm Grant & Thornton attesting to the fact.

However, the letter’s contents are fishier than week-old mackerel, as careful reading of the letter’s intentionally obscure fine print reveals that it states that the accounting firm essentially took Circle Internet Financial’s word on how much money it had in its accounts. (A Grant Thornton spokesperson confirmed that the letter is a legitimate Grant Thornton document, but stated that the firm’s policy is not to comment on client work.)

Propping Up Value of Bitcoin

Ever wonder why Bitcoin experienced such a dramatic spike in its price in late 2017? While feverish speculative interest is certainly partly to blame, one researcher has concluded that illegal market manipulation using Tether’s stablecoin was the primary culprit.

In their report Is Bitcoin Really Un-Tethered?, University of Texas at Austin McCombs School of Business professor John M. Griffin and his student Amin Shams uncovered the fraud. “Purchases with Tether are timed following market downturns and result in sizable increases in Bitcoin prices. Less than 1% of hours with such heavy Tether transactions are associated with 50% of the meteoric rise in Bitcoin and 64% of other top cryptocurrencies,” write Griffin and Shams. “These patterns cannot be explained by investor demand proxies but are most consistent with the supply-based hypothesis where Tether is used to provide price support and manipulate cryptocurrency prices.”

Another well-known economist and crypto naysayer, Nouriel Roubini, takes issue with how Tether props up the value of Bitcoin. “Tether Printing Press in High Gear, Issuing $400 [million] of Fake USD in 4 Days to Manipulate and Prop Up the Price of Bitcoin,” Roubini tweets. “Without this criminal manipulation Bitcoin would crash by 80% based on a recent econometric study. And regulators are asleep at the wheel.” (See my recent article on Nouriel Roubini.)

Tether, however, disputes the claim of fraudulent price manipulation. “The entire study relies on the assumption that USDT is unbacked and therefore not sufficiently driven by trader demand,” explains Leonardo Real, chief compliance officer at Tether. “This is flawed, and claims which suggest that USDT transactions aren’t driven by demand when it is consistently in the top 2 of traded cryptocurrencies in the space with regards to volume, are simply ridiculous by now.”

I am reminded of the scene in The Wizard of Lies where Robert DeNiro as Bernie Madoff receives redemption requests he can’t handle, signaling the unraveling of his massive Ponzi scheme.

Today, Madoff no longer lives in luxury – but I’m sure he’d welcome company. It looks like stablecoins will sooner or later grant that wish.

Intellyx publishes the Agile Digital Transformation Roadmap poster, advises companies on their digital transformation initiatives, and helps vendors communicate their agility stories. As of the time of writing, none of the organizations mentioned in this article are Intellyx customers. The author does not own, nor does he intend to own, any cryptocurrency or other cryptotokens, neither long nor short. Image credit: TradingView.

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