By Sarit Markovich
December 5, 2017

Bitcoin’s (BTC) recent rise to $11,000 raises important questions around risk and transparency for investors and exchanges alike, and whether a crash is looming.

The issue is that, like any investment vehicle, the value of bitcoin and other cryptocurrencies (forms of digital money) is subject to manipulation by large entities that have a stake in it, especially large-scale traders. The cryptocurrency exchange Bitfinex is the main actor to think about here.

Bitfinex’s CEO is also the CEO of a company called Tether Limited, which issues tethers (also known as USDT), a pegged cryptocurrency; that is, the tether’s value is pegged directly to that of the U.S. dollar. To do so, Tether commits to keep the dollar equivalent of all USDT value in reserves at all times. Tether offers a way to own and move fiat currency across different cryptocurrencies and exchanges without the need to convert crypto assets into dollars. That means transactions are fast and cheap, yet the price of the currency is as stable as the U.S. dollar, in theory.

But that tether-to-dollar relationship seems weaker these days, partly because 50 million tethers were printed in just one week in November. It’s unlikely that these newly minted currencies truly represent $50 million in today’s dollars, which throws off the assumption about the tether’s real value.

So what does this have to do with investing in bitcoin?

A lot, potentially. The reason is that Tether sends these mint USDT directly to Bitfinex. While it’s unclear what exact transactions take place with them after, what we observe is that once these USDT enter the Bitfinex exchange, the price of bitcoin jumps, as has happened multiple times recently. That means it’s likely the new tethers are used to buy bitcoin. As demand for bitcoin surges, its price goes up, investors see that and want to get in on it, more bitcoin is bought, and the cycle continues.

On one hand, there’s nothing wrong with this. It’s just the way the currency markets work. And if the currencies involved are truly backed up by dollars, there’s not much risk in the system.

The problem is that it’s hard to say how well backed up the USDT really are. Bitfinex has assured investors that the cryptocurrencies it trades are backed up—but more vaguely than hoped: The exchange says it has adequate “resources” to back them up. If said resources aren’t dollars, it could be a problem.

Specifically, if Bitfinex doesn’t have the liquidity to survive a large-scale cash-out of tether, bitcoin, or any other cryptocurrency traded there, we could see something similar to what happened in 2014, when the Mt. Gox exchange collapsed under similar circumstances. Investors lost everything they’d put into the cryptocurrencies in question, though the currencies regained investor confidence afterward, led by bitcoin.

The group that should probably pay the most attention to the implications here is cryptocurrency investors or would-be investors less familiar with the dynamics of this currency. These investors may pay attention only to the exuberant rise in bitcoin’s value, not recognizing the steep plunge that could follow if that value is poorly backed.

This could be akin to the formation and bursting of the dot-com bubble in 2000, where those who “followed the herd” without a good understanding of the market dynamics that helped push valuations up felt the decline particularly strongly. In the case of Bitcoin, the impact of the fall might be even more widespread, as the collapse of one exchange directly impacts all other exchanges and cryptocurrencies.

The good news for crypto investors is that the potential entry of CME Group into cryptocurrency exchange may legitimize the currency further and offer buyers a “safer” place to invest. Still, many shadier exchanges will persist, and investors of all experience levels may still be exposed to the effect of such an exchange’s fall on the trading price of all cryptocurrencies, even though CME does not work directly with the defaulting exchange.

The exchanges, for their part, should offer better transparency. If Bitfinex isn’t acting out of self-interest, it is in the exchange’s best interest to explain its actions fully: why new USDT are being printed, what they’re backed up by, and the like. Vagueness raises justifiable suspicion, but only on the part of those who understand the market dynamics at play.

Cryptocurrency investors and exchanges need to do their part to avoid a steep fall for both.

Sarit Markovich is a professor at Kellogg School of Management at Northwestern University.

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