Last week, the price of Ethereum increased by over 35% to a record high of $490 USD, and Bitcoin crossed $11000 USD, also a record high. The same week, Tether was hacked for $30 million dollars, which had a few very important effects on the cryptocurrency ecosystem. The Tether hack is larger in scope than just the $30 million that was hacked and we will explain how these events are related. Furthermore we’ll explore how this hack happened, and the results of it.
Bitfinex is currently one of the largest cryptocurrency exchanges on the market, and they are the sole source of the Tether cryptocurrency (though they’re ambiguous about their involvement with it). Tether is unique in that it is pegged to the US dollar which makes it a requirement that Bitfinex/Tether co have the financial capital to back every Tether they issue.
Bitfinex was cut off from the US banks in early 2017 (with a large lawsuit involving Wells Fargo), which makes it impossible for them to clear USD-denominated wires. However, they still have clients who have collectively deposited about $400M with them.
For this reason, in order to get US dollars they issued a cryptocurrency called Tether which is claimed to be 100% backed by USD and furthermore say that it is redeemable 1-to-1 for US dollars. That said, they do not mention that there is no way to trade it directly with USD.
Somehow this has worked for Bitfinex so far and they have issued approximately $600M USD in Tethers, with over 90% of them issued in the last 6 months, even though they have no access to USD banks, and since April 2017 their Taiwanese bank also froze their accounts which further sheds doubt on their ability to clear their liabilities. They’re tradable on other exchanges for different cryptocurrencies (primarily BTC and ETH).
On Nov 21st Tether claimed that someone had stolen 5% ($30 million) of their $600 million Tethers. In short, someone got careless and keys were compromised — The digital claims, not the underlying dollars sitting in the bank account that supposedly holds the backing USD by getting a hold of the private keys of the underlying contract. They’ve made a technical change to their client to disallow transactions on the stolen tokens, but there is no guarantee that they succeed in convincing all other exchanges to honour this change. There is no explicit information about how the thieves got these keys.
This is very problematic for Tether and Bitfinex since if any of the exchanges say they have no incentive to apply the patch, instead they actually require Tether to have the backing money. So either they prove they have a way to release the backing money or they’ll be delisted. Bitfinex cares about Tether being listed on other exchanges because they need to exchange the money to support their exchange business. Tethers are institutionalizing pseudo-crypto-Liberty Reserve, allowing the physical transfer of real money to happen in an area of legal remoteness to the cryptocurrency exchange.
If they are delisted, the thief will immediately withdraw everything to Bitcoin, and suddenly 30 million hacked Tethers are now in the money stream at the exchange, and cannot be conveniently distinguished from clean (non-hacked) Tethers. This will probably lead to large withdrawals from the exchange similar to a bank run, eliminating all liquidity from bitfinex.
The reason this is all tied to the price rise in ETH and BTC is that this large withdrawal scenario will lead to massive buys of both BTC and ETH. If you don’t believe Bitfinex’s $600 million in liabilities are actually backed by US funds and aren’t worth a copper shilling, the only option for getting your value out of Bitfinex is to swap your liability for Bitcoin (or Ether), which drives up the price of Bitcoin at the margin.
This is exactly what happened in the final months of Mt. Gox, which was bankrupt in 2014, even though the previous year they were handling most of the Bitcoin transactions, a huge warning sign which should be well heeded by everyone in the cryptocurrency community.
Let this be a cautionary tale about keeping keys in unsafe environments, and the trust people have in stable tokens. With both ETH and BTC at an all-time-high we are looking forward to the development of this news.
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