There is a narrative among the Bitcoin faithful that what they have bought offers not only investment potential, but freedom from the powers that dominate government-issued “fiat” money. Cryptocurrencies are described by their fans as a people-powered revolution, digital banking unchained from the interests of the wealthy and powerful.
This may well have been the original intention. But the modern reality is that almost all Bitcoin investors own less than one per cent of one Bitcoin. These “retail” investors make up more than 75 per cent of addresses, but own a tiny fraction – 0.22 per cent – of the market. The top 100 Bitcoin accounts own more of the currency than the bottom 38 million. In the crypto economy, businesses and wealthy individuals control currencies more actively than any central bank. They do so not to maintain the market, but to further their own interests.
Through successive booms and busts, the price of Bitcoin has been manipulated by a handful of large players, using fake transactions, imaginary assets and sophisticated timing. In doing so they created real demand, as celebrities and financial institutions responded to the attention and encouraged millions of people to gamble money on a product they barely understood, in the hope that it would make them rich.
The first Bitcoin bubble took place in 2013, when people began trading the currency on an exchange that came to a messy end. Mt Gox, as the exchange was called, was never supposed to be a financial market. It was set up by Jed McCaleb, an American programmer, for players of an online fantasy game (of the wizards and dragons variety) called Magic: The Gathering. In 2010, when McCaleb heard about Bitcoin, he repurposed his website as a platform on which people could exchange it for other currencies. Less than a year later, he sold it to Mark Karpelès, a Tokyo-based programmer.
Under Karpelès, the site became responsible for 70 per cent of Bitcoin trades, but also a series of high-profile security breaches and outages. Those who worked with Karpelès have claimed he devoted much his time to opening a Bitcoin-themed café, while the exchange lost 650,000 of is customers’ Bitcoins. Mt Gox eventually collapsed into bankruptcy, and Karpelès was handed a 30-month suspended sentence for falsifying records. Bitcoin’s first boom was over; the price would not recover its gains for three years. But in the aftermath, all of Mt Gox’s trading data made its way to the internet.
For the first time, researchers were able to see inside the normally opaque world of cryptocurrency trading, and to associate 18 million trades with accounts. Neil Gandal, a professor of economics at Tel Aviv University, led a study into the data. The study confirmed that what looked like many different accounts were in fact two “bots” – automated trading software – that were named Markus and Willy by the traders who identified them. The bots were controlled by a single entity.
For three months in late 2013, Markus and Willy bought and sold bitcoins on Mt Gox. Their trading was unusual: Markus paid no fees, and Willy could execute trades even when the exchange was offline. They bought Bitcoin for nothing and sold it at the market rate. As a detailed, anonymous report on the bots noted, “Markus is somehow buying tons of BTC [Bitcoin] without spending a dime”.
Gandal’s paper showed that Willy and Markus greatly inflated the amount of trading that appeared to be happening on Mt Gox – and with it, the price of Bitcoin. “On the  days when they were active”, says Gandal, “Bitcoin’s price… went up by five per cent [per day]. And on the 40 days they weren’t active, Bitcoin’s price actually dropped.”
The effect of this fraudulent trading was such that the price of Bitcoin rose from around $100 to over $1,000 in two months. In that first Bitcoin gold rush, a narrative began to emerge that lots of people were buying Bitcoin because they thought it was the future of money. And indeed some people were, but it was not a huge surge in demand that was pushing up the price: it was fraud.
The short boom of 2013 was a fake, but it told a story to investors. It looked as if a new type of asset had been created, a “digital gold” that gained in price very rapidly. “In those days, there weren’t that many traders, and there weren’t that many exchanges”, says Gandal. “When there was an increase in activity, it brought other people into the market”.
Towards the end of 2017 John Griffin, professor of finance at the University of Texas and an expert on forensic finance, had begun hearing “speculation on the internet” about a cryptocurrency called Tether. The price of Tether is pegged to the US dollar, and it is used as a substitute for the dollar in crypto markets, to store value in a stable way. The prices of cryptocurrencies are so volatile that using them for transactions is risky – imagine taking out a mortgage in a currency that could triple in price overnight – so “stablecoins” such as Tether help to make them usable. They also offer faster trading and lower fees, which has made them integral to cryptocurrency markets.
When Tether launched in 2014, the company that issues it, iFinex (which also owns Bitfinex, one of the biggest cryptocurrency exchanges), claimed every Tether was backed by a US dollar in a bank account. The company still claims that every Tether is backed and can be redeemed for a dollar.
But Griffin had heard otherwise. The rumours alleged that the price of Bitcoin, which was then rising rapidly once more, was climbing because large volumes of Tether were being created unbacked – without corresponding dollars to anchor them to financial reality – and used to buy Bitcoin. “It seemed like a far-fetched story that one cryptocurrency could be ‘printed’ and move another,” he told me. However, it also represented a new opportunity for a financial forensics.
“If I wanted to examine, say, money laundering”, explains Griffin, “I don’t have access to major banks’ records. But with cryptocurrencies, they put those records on the internet. And the records are what I would call quasi-anonymous… if you run the right algorithms and look hard enough, you can see links that help reveal the identities of the players behind them.”
To do this, Griffin and his colleagues collected more than 200 gigabytes of trades, prices and blockchain data from cryptocurrency exchanges covering a three-year period. They used algorithms to group transactions together and attribute them,. This process showed them where the money went, and when.
The data showed that whenever Bitcoin’s price began to fall, Tether was issued by Bitfinex and sent to two other exchanges, where it was used to buy Bitcoin – which would then rise in price. The team conducted 10,000 simulations see if this could be a chance occurrence. Not one gave the same returns. The algorithms attributed the Tether flows that occurred at the same times as these price rises to a single entity. As they explained in the paper, “this one large player… either exhibited clairvoyant market timing or exerted an extremely large price impact on Bitcoin”.
This time, Bitcoin’s price wasn’t pumped by a few hundred dollars, but by thousands of dollars. In December 2017, its price reached almost $20,000 dollars and the total value of the Bitcoin market exceeded $237bn. Griffin is confident that at least half of this price rise was manufactured using Tether.
But Griffin also noticed something else in the data: “large crashes in the price of Bitcoin, prior to the end of the month”. These crashes happened at the points when iFinex needed dollars in its bank account to support its claim that Tether was backed by real money. It looked very much as if the company was selling large amounts of Bitcoin at the end of each month – enough to push the price down – in order to show an auditor dollars in the bank. Bitcoin would then recover quickly, as it was repurchased. “It was very conspicuous timing, that could not be explained by chance”, says Griffin.
After Griffin and his colleagues published their paper, “nothing seems to have happened”, he says. Investors did contact him, but not to thank him for exposing the risks they faced. “People in the crypto space were angry at our paper”, he recalls. “I got one email that said: ‘Don’t you understand? It’s a good thing, because it keeps the prices high!’”
Tether issued a strongly-worded rebuttal, in which it described the 50-page paper a “clumsy assertion” based on “incomplete and cherry-picked data”. Then the company went back to business. “They printed even more Tether”, says Griffin. “They printed a lot more Tether. And Bitcoin rose, a lot.” In 2020 alone, Tether printed more than $50bn of its own stablecoins; there are now more than $62bn in circulation.
Between the middle of March 2020 and the middle of March 2021, Tether increased its “market cap” – the number of Tethers issued – by a factor of about ten. The price of Bitcoin increased, over the same period, by a factor of about ten.
At the same time, Tether was being investigated by the New York Attorney General, Letitia James, who in February banned the company from trading in New York and fined it $18.5m for having “recklessly and unlawfully covered-up massive financial losses”. James noted in her statement about the case that for some of the period investigated, “Tether had no access to banking, anywhere in the world, and so for periods of time held no reserves to back tethers in circulation at the rate of one dollar for every tether, contrary to its representations.”
In Tether’s response to the NYAG’s statement, the company emphasised that “under the terms of the settlement, we admit no wrongdoing” and stated: “there was no finding that Tether ever issued tethers without backing, or to manipulate crypto prices”. In May, as part of its agreement with Letitia James, Tether issued a simple, two-page breakdown of its reserves. It claimed that 76 per cent of Tether’s value was covered by cash or cash equivalents – but mostly equivalents, and mostly “commercial paper“ (corporate debt, borrowed by unknown parties on unknown terms). The actual cash in the bank behind each Tether appeared to be less than three cents.
In the crypto markets, speculators continue to urge new investors to join their scheme, and media coverage that urges caution is dismissed as an attempt to sow “FUD”, (Fear, Uncertainty, Doubt) through disinformation. But the risks posed by stablecoins have now become too big to ignore.
At the beginning fo this month, Fitch Ratings – one of the “big three” ratings agencies in the US – warned that the growth of stablecoins “could, in time, have implications for the functioning of short-term credit markets”. If a lot of people suddenly decided they want to cash in a token backed by hard-to-sell corporate debt, they might find themselves unable to do so. This, Fitch warned, could lead to “asset contagion” – a run on a stablecoin could also mean a run on any assets used to back it. This echoes comments made by the Chair of the Federal Reserve, Jerome Powell, who said in January that stablecoins “could become systemically important overnight”. But Fitch does not see a bail-out happening for crypto markets: “authorities are unlikely to intervene to save stablecoins in the event of a disruptive event”.
On Saturday (17 July), the Federal Reserve and Yale University published a paper on “the systemic risks created by stablecoins”, and at a meeting on Monday the US Treasury Secretary, Janet Yellen, “underscored the need to act quickly” to curtail the risks from this unregulated $100bn market. Everywhere policymakers speak about “rapid growth”, but the truth is that the whole cryptocurrency market has been questionable for more than a decade. The question now is whether regulators have woken up too late.
As for investors, the market is now split between faith and regret. From its peak in mid-April, when it briefly commanded a price of over $63,000, Bitcoin has dropped to less than half that, and the total amount invested has now been falling for two weeks. All of the more than ten million “wallets” opened by investors to buy Bitcoin since January have lost money on it as China – where Bitcoin has for most of its existence been mined, using the cheap electricity from the state-sponsored coal industry – has restricted using or mining cryptocurrencies. Last month, the Financial Conduct Authority (FCA) banned one of the world’s largest cryptocurrency exchanges, Binance, from regulated activity in the UK, while the Advertising Standards Authority (ASA) has requested the removal of adverts by four different companies that irresponsibly promoted risky speculation as a straightforward investment. The governor of the Bank of England, Andrew Bailey, has called cryptocurrencies “dangerous” and said that investors “should be prepared to lose all their money”.
But in this opaque and largely unregulated business, the conditions for more inflation can still be created. As John Griffin warns, the techniques he and his peers have studied are “not the only source of manipulation in the market”. And however illusory the prices created, large numbers of real people are now risking their savings. A single forum on the social network Reddit for discussing Bitcoin has three million members. On Twitter, where Elon Musk has more than 55m followers, the Tesla CEO can move the price with a single emoji. Financial institutions, payments services and credit card providers have all jumped on board.
The FCA’s most recent consumer research estimates that the number of people buying cryptocurrency in the UK had grown to 2.3 million people, around half of whom plan to buy more, but that “the level of understanding of cryptocurrencies is declining, suggesting that some crypto users may not fully understand what they are buying”.
Griffin says periods of mass speculation – from Railway Mania to the dot-com boom – always begin with the widely touted promise of a new technology, and end in a familiar fashion.
“If you look at the history of speculative frenzies… They always end with some people making lots of money, usually the people that got in early, and the people that got in at the end, end up losing a lot. I don’t see why this would be any different.”