Bubble? What Bubble?
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By Capital Thinking · Issue #835 · View online
In 2017, the price of Bitcoin rocketed up from around $1000 all the way up to 5, then 10, 15 and close to $20,000 in less than a year, and then in the next year fell most of the way back down.
If you include the other cryptocurrencies that rose and fell along with it, and measure from peak to trough, the total amount of speculative value that got created and then destroyed was over 450 billion dollars.
Why did this happen?
The simple explanation is human nature: this was a bubble. No one knows what a Bitcoin is really worth, but if other people get greedy we get greedy too, and if they get afraid, we get afraid too. That’s why bubbles happen, like with the dot coms in 1999.
Now, Occam’s Razor is usually right: sometimes the simple explanation is the correct one. But not this time.
We now know that what happened in 2017 was not just a bubble. It was also a scam.
The Trillion Dollar Lawsuit, Part One
To understand what happened here, you need to appreciate that the price of Bitcoin isn’t “real” like the price of Apple stock is - not only because it’s more subjective, but also for more serious reasons.
Apple stock trades at high volume, every day, on stock exchanges that have rigorous, transparent rules in place to prevent market manipulation and abuse.
Not Bitcoin. Bitcoin trades in the dark, on exchanges whose rules you don’t know. Bitfinex is one of those exchanges. At one point, it was the largest cryptocurrency exchange in the world.
As you probably know by now, they worked with (and secretly owned) a Stablecoin called Tether that issued a cryptocurrency token pegged to a value of $1.
Tether’s offering was essentially: approved customers could mail Tether a cheque for 100 US dollars, Tether would stick them in the bank for you, and then they’d issue you $100 worth of Tethers on a blockchain.
You could go spend those Tethers on buying crypto, or doing whatever you want; when you’re done with them, send the Tethers back, and you get your 100 US Dollars back.
If Tether were acting honesty, and all Tethers in circulation were backed by genuinely invested dollars sitting in a genuine, safe bank account, then there’s nothing wrong with this. But that’s not what they did.
Bitfinex and Tether, together with their business partners, figured out that they could use this money printing machine to their advantage. Here’s the basic playbook:
- Print a whole bunch of Tethers into existence - not backed by real dollars, but instead collateralized by other stuff - cryptocurrency, their own equity, IOU receivables, sometimes nothing. But most importantly, Bitcoin. Bitfinex held a lot of Bitcoin, which makes sense given they were the world’s largest Bitcoin exchange.
- Working with partners, flood those Tethers onto crypto exchanges all around the world (who treated Tethers as equivalent to dollars, sometimes indistinguishably so - more on this in part 2) to buy Bitcoin, pumping and stabilizing the price, and therefore pumping up the value of Bitfinex’s own Bitcoin holdings.
- If anybody asks questions (“Where did all those Tethers come from? Prove to me they’re collateralized”), sell some of your inflated Bitcoins for real US Dollars at a profit, stick those dollars in your bank account, and then say “Look! Here they are! Just like we promised.”
- Repeat. Now here’s what I mean when I say that the price of Bitcoin isn’t “real”: when you see a Bitcoin price quoted on an exchange, you assume that the price reflects a bid/ask spread that’s genuine and deep. You assume that the bid and ask here represent actual investor interest, with real dollars - not an artifact of a thinly traded float, or from unbacked Tether dollars that were printed into thin air.
Trading activity in the float makes it look like there’s demand to support the entire inflated “Market Cap” of Bitcoin and other cryptocurrencies, which is absolutely not true. But it looks true, temporarily.
However, because the price of Bitcoin is “whatever people want it to be”, and because humans are herd animals who get greedy when they see other people getting greedy, a surging price can bring in a new wave of retail investors, and turn the pump into a self-fulfilling prophecy.
Even Bitcoin insiders, who may be more clued in to what’s going on, have no reason to be upset - they’re getting rich! Once the price is successfully boosted, Tether is also useful for keeping things that way.
If too many people try to cash out at once, Bitfinex can simply print more Tethers, buy Bitcoin with it, and keep the price up. Fortunately for them, many people who are actually investing into Bitcoin with real money are doing it because they believe it in over the long run. They’ll proudly carry their Bitcoin bags, and aren’t going to give up and sell on this week’s news.
Photo credit: André François McKenzie on Unsplash