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CommentByte Me

Byte Me: a market untethered?

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When bitcoin futures were launched in December last year, there was excitement, fear and outrage all at once. Critics, including the Futures Industry Association, piled pressure on to US derivatives regulator the Commodities and Futures Trading Commission, demanding better safeguards for such products. Cheerleaders may see the asset class as a great way to earn big in markets dogged by low yields but the doubters, of which Byte Me is one, may yet be proven right.

This week, a paper by two academics made bold claims that, over the past year, the price of bitcoin has been serially manipulated to keep prices shooting up, adding weight to a theory that has been gathering momentum for almost a year..

John Griffin and Amin Shams from the University of Texas, have accused certain entities associated with Bitfinex, the biggest bitcoin exchange in the world by volume, of being involved in this manipulation. The allegations centre on Tether, a cryptocurrency that claims to be backed by dollar deposits. Both Bitfinex and Tether, which share several senior executives, were reported to have been subpoenaed by the CFTC earlier this year, following Tether’s dissolution of its relationship with auditor Friedman.

Byte Me tried to contact Tether but the email address provided was invalid. Bitfinex did not immediately respond to request for comment.

Tether is mostly used by cryptocurrency investors to lock away gains made in other cryptocurrencies by moving their holdings into one that is seen as a proxy for the dollar. Each token is supposedly backed by a dollar in a reserve bank, with some speculating that that bank is Noble Bank International of Puerto Rico. Tether has what might generously be called a “troubled relationship” with banks. Many major banks have refused its business.

Griffin and Shams claim “Tether is used to purchase bitcoin when returns are negative” but there are no “considerable” Tether flows following price increases. Tether is the 12th biggest cryptocurrency, and the flows could have propped up the price of bitcoin as it experienced its 15-fold price increase last year.

If, as the academics suggest, the “printing” of Tether is driven by its proprietor, and not demand from investors, it could be a matter of fraud charges for those involved. It would also be embarrassing for the CFTC, the Chicago Mercantile Exchange and the Chicago Board Options Exchange: everyone, in short, who signed off on futures contracts on a market that could be wracked by price manipulation.

Neither Cboe nor CME use pricing data from Bitfinex to mark their bitcoin futures, and while they are not responsible for manipulation in the cryptocurrency spot market, they have put their name to futures the value of which may well have been influenced by manipulation.

The allegations made in the academic paper suggest a wild west market unfit for serious financial players. Byte Me appreciates that efforts have been made by the SEC, CFTC and numerous regulators around the world to police the crypto spot market. It is also worth noting that the CFTC has asked CME, Cboe and other derivatives exchanges planning to list crypto contracts to properly consult with interested parties. The new rules involve a better look into the underlying markets that help drive futures prices, which is a step in the right direction.

But neither the CFTC nor the SEC have a mandate to properly oversee cryptocurrency exchanges. Both agencies have relied on adapting existing legislation and definitions of commodities and securities to have some sight into the spot market. But it is simply not enough yet.

Crucially, the SEC blocked ETFs back in February partly because of concerns of manipulation in the underlying crypto spot markets. In a letter to parties interested in creating a cryptocurrency ETF, the SEC noted that while these funds may hold futures rather than cryptocurrencies, the “pricing, volatility and resilience of these derivatives markets generally would be expected to be strongly influenced by the underlying markets”.

This week’s revelations prompt Byte Me to ask once more if the crypto market is not clean enough for the SEC, why is the market good enough for futures?

This week’s paper is another reminder that cryptocurrency markets have a long, long way to go before they are ready for the big boy world of finance. And after a financial crisis that tarnished the reputation of derivatives in the eyes of the public, the last thing markets need is another scandal.

Will Swarm sting?

An unexpected boundary was pushed this week. Cryptocurrency start-up Swarm has launched a platform to allow accredited investors to trade tokenised equity (so far so good)… in private companies (ah)… without their permission (hmm).

The concept of equity on the blockchain is nothing new. Back in 2017, the US state of Delaware passed a bill allowing companies to issue and trade shares via blockchain. But Swarm has taken it a step further. It allows its investors to trade stock in such hot tech properties as Coinbase (a popular cryptocurrency trading platform), Ripple (founder of Ripple, a cryptocurrency for institutional settlements) and RobinHood (a retail focused trading app).

All three are private companies and none gave Swarm permission to do this. All three are less than enthusiastic at the prospect, putting out statements to the effect that they do not allow secondary market trading of their stock and would not have permitted Swarm to purchase stock for this purpose.

The stock Swarm offers its investors access to has apparently been obtained from venture capitalists and employees with vested options, possibly in violation of contractual lock-ups.

Of course, to get access to such an exciting opportunity, you first have to buy the Swarm token. Quelle surprise.

Securities law just won’t go away

The cryptoworld is obsessed with innovation creating solutions to problems so new they often haven’t been invented yet. Regrettably, the fusty old luddites at the SEC regularly point out that if something is illegal, it does not magically become legal simply because you are doing it in a new and shiny way.

Thus, selling investment contracts, even if you call them tokens, even if you call them Utility Tokens, is still selling investment contracts — and the SEC will have you if you do so without registering or sheltering in a safe harbour.

However, even the SEC is having trouble applying its own rules. William Hinman, a senior SEC official, said on Thursday that Ether does not seem to be a security. That should be a relief for a lot of people as Ether is second only to bitcoin in volume and only a fraction of the users are likely to meet the benchmark for being an accredited investor.

But troublingly, Hinman appears to concede that Ether may have been a security when it was sold in its initial coin offering in 2014 (which would therefore be deemed an unregistered securities offering), but that since it is no longer guided by a central third party that takes actions to increase the token’s value, it is now not a security.

It would be pretty remarkable for Ether to have been a security at one time, but no longer, particularly as the notorious Howey Test, which establishes whether or not an asset is a security, was established in a case in 1946 over the very same issue.

Even if the SEC decides that Ether is in the clear, the criterion of a central party with a stake managing the asset’s value could well see the third largest cryptocurrency, XRP, scuppered by the same problem, since Ripple, its founder, is well known to hold huge volumes of it.

So at least one of the top three cryptocurrencies may be in legal trouble. It might be Ether. It might be Ripple. Place your bets (and stay short).

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