The Trillion Dollar Lawsuit, Part Two

Two Truths and a Take, Season 1 Episode 30

Welcome back to the second half of a two-part newsletter, The Trillion Dollar Lawsuit - a story about cryptocurrency, Tether, and the staggering accusations spelled out in Leibowitz et al. versus iFinex et al., US District Court.

If you didn’t read part one last week, please do that first. (You can also find a permanent version of Parts 1 and 2 here.) 

The entire story is complex, and the lawsuit itself is admittedly over-the-top theatric (their trillion dollar damage estimate, for instance, is clearly for show rather than a sober legal petition.) But the accusations within it are real and serious. Over the past two weeks, I’m walking you through what’s being alleged here, both in the lawsuit and by others in the community who have been paying attention:

Allegation #1: The 2017 Bitcoin Bubble was market manipulation, and Tether was how they did it

Allegation #2: Tether became a systemically important, money laundering conduit for the crypto ecosystem

Allegation #3: They might’ve gotten away with it, too, if they hadn’t gotten robbed while busy scamming

Last week we walked through Stories #1 and 2; this week, we’re going to bring it home. 

As before, I want to make something really clear from the beginning: everything I’m going to talk about are accusations. They have not been proven in court. My retelling and interpretation here could be misunderstood, or flat out wrong. There’s a lot we don’t know, and a lot that I don’t know, about this story. But I’m committed to sharing my understanding of the situation with you, so here goes.


Allegation #3: They might’ve gotten away with it, too, if they hadn’t gotten robbed while busy scamming

Imagine you’re a scammer. You’re running a successful Ponzi scheme, and everything is going according to plan: your early clients have invested their money, you’ve shown them paper returns, and off of that gotten more investment capital, so you can start paying your early investors cash dividends. So far, everything’s on plan. 

Then you discover something very bad. You check your bank account, and all the money is gone. 

If you’re running a scheme of any kind, whether it’s a full-blown Ponzi operation or maybe it’s just a slightly off-books variant of a legitimate business, the cash in your bank account is your lifeblood for survival. Your cash is how you show legitimacy. It’s how you pay your bills on time. It’s how you keep the scam going. A scammer who gets robbed while they’re busy scamming is in big trouble. 

The first two stories we talked about last week are both big but kinda vague accusations. “Market manipulation” and “Money laundering” can mean a whole range of things, and it’s possible we may end up with multiple versions of what happened accepted as truth by different groups. 

The third story this week, on the other hand, is not. It’s fully literal, ties the whole story together, and is nearly stranger than fiction. It’s also a story as old as time: someone screws up, and they have to cover it up, and then they have to lie to cover up the cover up, and then they have to lie again to cover up the lie, building up a house of cards that you know will fall eventually. It’s just a matter of when. 

So here’s what we think happened:

Bitfinex, who as you know was once the world’s largest cryptocurrency exchange (and also owns Tether), faced a classic cryptocurrency exchange problem a few years back. Nobody wanted to be their banking partner (see story #2, last week). Specifically, the Taiwanese institutions that Bitfinex banked with used Wells Fargo as their US Correspondent Bank, which is the on-ramp into the US financial system that matters. Wells Fargo, at some point, concluded that the relationship was too toxic and refused to give Bitfinex US banking anymore. 

Bitfinex sued Wells Fargo over this, but it didn’t matter: they needed a new banking partner quick. After a brief foray with a Puerto Rican bank called Noble Bank, they settled on an institution called Deltec to hold customer deposits, and set up shop with our friends at Crypto Capital Corp to give Bitfinex the access to the mainstream financial system necessary to run an exchange. 

On the surface, these were two separate banking relationships for two separate businesses. In reality, the relationship allegedly worked like this: In order to purchase Tethers, customers would wire $100 to a shell company under CCC’s control under some fake pretence; CCC would then credit Bitfinex’s account $100, and then Bitfinex would issue the customer $100 worth of Tethers. To get money back out, you’d run the process in reverse. In order to make this work, both Bitfinex and Tether held CCC accounts, and money would routinely get “swapped” from one account to the other, depending on which direction the process was running. In a sense, they used the combination of the CCC and Deltec accounts like a “hot wallet / cold wallet” setup, respectively.

Bitfinex and Tether routinely took advantage of this relationship; the division between the two was nonexistent in practice. (Remember this, it’ll be important later.) Apparently, this banking relationship was carried fully under the table: there was no written contract or legal basis at all for this relationship involving hundreds of millions of dollars’ worth of customer funds. But the relationship seemed to be working well.

However! Bitfinex’s execs failed to notice that while they were busy running Bitfinex and running Tether and keeping whatever it is they were doing alive, the good folks at Crypto Capital Corp were quietly embezzling their money. As US authorities noted when charging CCC’s principal architect Reggie Fowler with a variety of crimes:

Incredibly, it seems that Bitfinex failed to notice this was going on for some time. I mean, I guess it makes sense - if someone is laundering your money, you probably shouldn’t ask too many questions! That’s sort of the point! So long as you can get your money in and get your money out, the fact that it’s an un-auditable black box is a feature, not a bug. To CCC, you just need to make sure you can honour any withdrawal requests, and that 10% can go unnoticed for quite some time.

But then last year, something inconvenient happened: CCC got nailed by US authorities in a bid to uncover crime associated with Backpage, specifically money laundering and prostitution. One week later, CCC’s bank account got raided, as Polish authorities seized around $375 million worth of funds controlled by CCC companies. Fowler was arrested shortly afterwards. 

This is obviously a problem for CCC, because the money they need to keep up their money laundering operation has been seized. It therefore created a bigger problem for Tether, because the money they need to keep their exchange and stablecoin running was seized / embezzled. 

Did Bitfinex know that the money had been seized? It seems like no, they did not; at least not at first. But a few soon enough, Bitfinex started getting their withdrawal requests ignored or denied. This sure wasn’t ideal, as it accompanied a prolonged Bitcoin selloff that put pressure on Tether’s ability to maintain their peg (which, you’ll recall from last week, was allegedly held up partially with Bitcoin and other cryptocurrencies, as opposed to real dollars). If you’re Bitfinex, you’re panicking over the next couple months. Where is the money??

You can read a pretty fabulous chat log exchange, which was presented as an exhibit in the Leibowitz court complaint, allegedly between someone at Bitfinex (Merlin in the log) and someone at CCC, addressed as Oz, on October 5 last year:

Merlin: Hey Oz, sorry to bother you every day, is there any way to move at least 100M to -----? We are seeing massive withdrawals and we are not able to face them anymore unless we can transfer some money out of Cryptocapital. 

Merlin: I understand some of the funds are being held by -----, but what about the rest? 

Merlin: under normal circumstances I wouldn't bother you (I never did so far) but this is a quite special situation and I need your help, thanks 

Merlin: I have been telling you since a while

Merlin: too many withdrawals waiting for a long time 

Merlin: is there any way we can get money from you? Tether or any other form? Apart with cryptocapital we are running low in cash reserves 

Merlin: please help 

CCC: I know. We are following the banks we post as many as we can and let them process as much as possible according to them. Everytime we push them they push back with account closure without reason 

Merlin: dozens of people are now waiting for a withdrawal out of cryptocapital 

Merlin: I need to provide customers with precise answer at this point, can't just kick the can a little more 

Merlin: the international I mean 

CCC: I will keep you posted here 

CCC: On the process of all international payments. 

Merlin: please understand all this could be extremely dangerous for everybody, the entire crypto community 

Merlin: BTC could tank to below 1k if we don't act quickly (Emphasis mine; see Story #1)

Meanwhile, incredibly, Bitfinex continued to send their customers through CCC, even while panicking about not being able to access their funds. Unsurprisingly, at some point they faced a liquidity crisis on the exchange. And so, we arrive at the real centrepiece of this whole story, a truly bonkers lawsuit from the New York State Attorney General’s office this past April. As spelled out in the lawsuit, Bitfinex truly went the extra mile in order to keep the exchange intact:

During November 2018, Tether transferred $625 million held in its account at Deltec to Bitfinex’s account at Deltec. Bitfinex, in turn, caused a total of $625 million to be transferred from Bitfinex’s account at Crypto Capital to Tether’s account at Crypto Capital, through a ledger entry at Crypto Capital crediting Tether’s account in the amount of $625 million and debiting Bitfinex’s account by a corresponding amount. The purpose of this exchange was to allow Bitfinex to address liquidity issues unrelated to tethers. 

To spell this out if you didn’t catch it: 

Bitfinex had a liquidity crisis on its exchange, because their money at CCC (the “hot wallet”) had been embezzled / frozen and they couldn’t meet outflow demand. Meanwhile, Tether has real money in their reserves account at Deltec (the “cold wallet”). 

So Bitfinex does one of those swaps we talked about earlier, except at much bigger scale: they take $625 million of reserves backing Tether and transfer them to Bitfinex, and use it to plug their liquidity crisis. Then, they wrote an IOU against a matching $625 million in Bitfinex’s CCC account (which was frozen / stolen / didn’t exist) in order to credit their CCC account for Tether. 

(Now is a good time to reiterate, by the way, that this is my best attempt at piecing together what happened. I could have elements of wrong. Anyway, read on.)

What Bitfinex is doing, in other words, is using Tether’s reserves as slush money in order to keep above water. Needless to say, they did not inform Tether holders that their deposits were no longer fully collateralized. Strangely, Bitfinex responded to this lawsuit by largely admitting that, yes, they actually did most of these things - but they did all of these things out of an abundance of caution protect their customers. (O..kay!)

So Bitfinex plugged their liquidity problem, but now they have a new problem, which is that $625 million worth of Tethers are now no longer backed by real dollars, but instead by IOUs for embezzled frozen dollars. Then, according to Bitfinex and Tether’s own lawyers (!!), the two entities “negotiated” a deal where the $625 million credit in CCC’s account was instead re-clarified as a loan from Bitfinex to Tether, now larger ($900 million) and that paid 6.5% interest. (Bitfinex had actually sort-of-successfully executed a similar tactic a few years earlier in order to make its customers whole after losing a bunch of Bitcoin in a hack, which is another story. There are so many stories! There is truly no bottom to this, people.) 

By the way, there’s an interesting side question here which is: is it possible that Tether was actually fully collateralized prior to all of this mess? I mean, maybe? It still certainly looks like Bitfinex and their friends used their position in order to print Tethers as loans as opposed to deposits in order for their whale friends to pump the market, see Story #1. But if they had, then in fairness to them, they’d at least pulled it off. Until it stopped working, due to their money disappearing. 

That’s why, as all of this came to light, Bitfinex backed up and dug into a position: “Yes, okay, we admit that Tethers aren’t fully fully collateralized with dollars. But they’re three quarters collateralized! That’s pretty good! Show me a bank with reserves that deep!” Of course, three quarters collateralized sounds a lot better than “backed by claims on seized assets, which we swear we’ll get back, we promise.”

Folks, repeat after me: if you’re going to run a scam (and please don’t do that, but if you must): don’t get robbed while doing it! Or, perhaps more specifically: try not to get into a situation where your bankers, who are robbing you while you’re out scamming, get busted by the feds! You’re gonna have a bad time! Oh and while we’re at it, you probably shouldn’t put down in writing something like “BTC could tank to below 1k if we don’t act quickly”, that won’t look good in front of a judge. That’s free advice. 

So, now what? Well, Tether has a two-sided problem now. On the one hand, they need to somehow be able to honour their client requests, or else the stablecoin collapses. So it seems like they’ve resorted to a kitchen sink approach of throwing everything against the wall until it sticks, including now satisfying Tether withdrawal requests with cryptocurrency, Bitfinex’s assets (again, according to their own lawyers!), or anything they can get their hands on. Embarrassingly, seeing as they lost their main banking conduit in CCC, they’ve had to resort to asking “friends of Bitfinex” to help facilitate transactions, sometimes via their own personal bank accounts.

But on the other hand, they have to maintain kayfabe and keep up this absolute conviction that the IOU on the stolen money is still good! So they’ve had to make this public pivot towards arguing, “We are a legitimate business who was robbed by the criminals at CCC; once all of this gets sorted out, our money will be rightfully returned to us.” As more arrests get made and the curtain gets pulled back on what went down, it becomes an increasingly ridiculous charade. For instance, on October 25 - so, around two weeks ago - Bitfinex posted this official statement on their company website: 

Several months ago, Ivan Manuel Molina Lee, a principal of Crypto Capital, was detained by authorities in Greece. This week he was extradited to Poland to answer charges there. Also, Oz Yosef (also known as Oz Joseph), another principal of Crypto Capital, has been indicted on three criminal counts by the U.S. Attorney for the Southern District of New York. As has already been mentioned publicly in court filings, Crypto Capital processed certain funds for and on behalf of Bitfinex for several years. During that period, Bitfinex relied upon various systematic representations from Crypto Capital, including from Molina and Yosef, that proved to be false. Among those misrepresentations, Crypto Capital regularly referred to its integrity, banking expertise, robust compliance programme and financial licences. This was designed to assure us that Crypto Capital was capable of handling Bitfinex's transactions.

Bitfinex is the victim of a fraud (emphasis mine) and is making its position clear to the relevant authorities, including those in Poland and the United States. We cannot speak about Crypto Capital's other clients, but any suggestion that Crypto Capital laundered drug proceeds or any other illicit funds at the behest of Bitfinex or its customers is categorically false. This week's developments do nothing to affect or otherwise deter Bitfinex's claims to funds in Poland or anywhere else. We will continue to work to recover all funds for and on behalf of our stakeholders.

I couldn’t help but emphasize “Bitfinex is the victim of a fraud” in their statement, because, look, they are the victim of a fraud! I honestly feel bad for them. Two years ago, they (allegedly) were doing illegal stuff all right, but if they had pulled it off, it could have ended up being one of those so-called “victimless crimes” where everybody in the ecosystem gets rich, they helped play a part, everyone loves them, and all of this gets swept under the rug of history. Instead, they got robbed by their own bankers, and then their bankers got arrested for being comic book villains who attracted too much attention to themselves by buying football teams

So what did we learn here?

I can’t help but think of the incredible ending of Burn After Reading, where J.K Simmons is grasping at anything he can comprehend, and finally asks, in reference to John Malkovich’s character Osborne Cox: “Is he dead?” “No, sir, he’s in a coma.” Is Tether dead? …No, it’s not. It’s still there, like a weird half-conscious cryptocurrency protocol, like a grenade full of evidence with the pin pulled and the whole crypto community nervously staring at it, unsure of where to toss it or who to blame. 

What did we learn here? I think my only honest answer as of right now is I’m not sure. I don’t know what this means for Bitcoin. I don’t know what this means for anyone with an investment thesis in any direction. I don’t even know what this means for Bitfinex and Tether, except for that I expect some people to go to jail. 

But I do actually have one real lesson I hope you all learn from this. It has to do with the Monkey Trap analogy I touched on earlier. 

The basic idea of a monkey trap is you have a narrow-necked jar with a bunch of treats in it: your hand can fit through it while it’s open and loose, but not while it’s clenched in a fist or while holding anything. Your hand is free to enter the jar. It’s also free to leave the jar, but only by letting go. If there’s nothing interesting in the jar, there’s no trap. But if the jar is really interesting, and especially if your hand is free to move, uninhibited, while inside the jar, it’s going to be really hard for you to quit. 

The cryptocurrency ecosystem is like the jar. Inside the jar, people are legitimately building really interesting things, many of which are quite cool, and I look forward to seeing how it evolves in the future. But if you’re thinking about joining in, you need to understand the neck of the jar, which is the on- and off-ramps into traditional financial systems. Even if Tether were 100% legitimate, what it essentially does is supercharges our ability to do stuff inside the jar. But it does not make it any easier to enter or leave. (Unless, of course, you’re using Tether as a money laundering conduit to enter the jar through an illegal side door, like CCC.) 

If the neck of the jar changes size for any reason - like, say, banks start to crack down on which cryptocurrency exchanges they’ll deal with - and it becomes harder to pull your hand out, it becomes all the more tempting to keep your hand inside the jar - you have total freedom inside! You can do anything! Look how much value we’ve created inside the jar! Look how amazing it is! This is true, but wait enough time, and you’ll learn the hard way how much the contents of the jar and the value inside the jar is really just levered on top of itself. 

The crypto community may well learn the hard way that the only thing worse than systemic risk is systemic risk plus illiquidity. “Liquidity" inside the jar does not count. The only real liquidity that matters is through the neck.

I am nowhere near smart or qualified enough to predict what will happen from here on out. But if the people who’ve been paying attention are right, we’re in for a lot of pain when this band aid gets ripped off. And, unfortunately, it’s possible that a lot of people and projects who you’d never expect to be involved may get taken down with it: if you’re inside the jar, watch out. And just about everyone in crypto is in the jar. 


There are four people I’d like to thank specifically for what they’ve written: 

@bitfinexed

@CasPiancey

@davidgerard

@patio11

Give them all a follow. You’ll learn lots. 

Permalink to this story is here: The Trillion Dollar Lawsuit | alexdanco.com


By the way, here’s an update that I should mention which took place between this week and last week:

The Griffin study which I mentioned last week has since been updated after I wrote part 1 of this section in my newsletter. The updated study is even more bold with its claims, even suggesting that one single trader was responsible for the 2017 bubble.

I’m not sure I buy this. I do more or less believe that a group of people successfully moved and manipulated the market, but that is not the same thing as what this paper claims. The updated Griffin paper, from what I can tell, mis-identifies pooled wallets used by exchanges as individual traders. To the best of my understanding, the pooled wallet-based conclusions in the updated Griffin paper neither support nor refute anything that was already presented in this debate.


No reading links this week since I was busy, but keep your eyes peeled for a bonus interview issue with Jamie Catherwood, hitting your inbox in a few hours. You can also find a permalink to the interview here.

Have a great week,

Alex