Stephen Diehl:  Let’s talk about the Tether scandal, why recent disclosures about it are such a big deal, and why it represents a form of systemic risk for the already shady crypto market.

Stablecoins are virtual currencies that are always supposed to have the same real-dollar value. People that day trade cryptocurrencies often want shift their unstable tokens to safe real currencies (like the dollar) because wild market fluctuations make it unsafe to hold.

However when a company transacts in dollars they have to follow the rules of the bank that holds them and by proxy the rules US govt imposes on the bank. If you’re trading crypto, then you probably don’t like those rules since you’re probably doing something shady.

The crypto exchange ecosystem has major problems getting access to normal banking. So enter Tether or USDT, a surrogate crypto dollar that theoretically has the same value as a dollar, but can be traded without following regulation on dollars.

The model is simple, you give the company a real dollar, they store that real dollar and give you one tether. You trade that tether for whatever you want, and at any point you can redeem that tether back for one dollar. Simple enough.

It’s a simple pitch: Have dollars, buy tether, do shady things, redeem tether, get dollars. “The virtual dollar for regulatory arbitrage.”

However this depends on one centralized point. The company that runs this service needs to keep an accounting book of all the money that flows in and out. Every dollar in has to be matched with a tether issued, every tether redeemed a real dollar that flows out.

The real dollars held in the so-called “reserve” has to be precisely equal to the number of tether dollars issued. If that’s not the case, (i.e. unbacked tethers) then a certain percentage of holders of this coin can’t actually redeem because the money is not there.

What is clear is that the company has allegedly issued $59 billion virtual dollars. At that scale, it is highly unlikely any bank in the entire world would those reserves on behalf of a crypto company. Not even the dodgiest banks would take on that insane level of risk.

So where is the money? Most financial journalists have speculated that the company is engaged in some opaque accounting skulduggery where instead of matching tethers to inflow dollars, they produce *vast* amounts of tethers that aren’t backed by anything.

Now the company that issues these products is notoriously opaque and set up shop in the tax haven of British Virgin Islands to avoid any regulation and reporting obligations. So we really don’t know much. What we do know comes from lawsuits and investigative journalists.

Now this is a huge problem because by volume Tether is BY FAR the most traded cryptocurrency in the entire world. Surprising every other token by a significant margin.

A significant portion of bitcoin price formation is therefore quoted in dollars, but paid for in USDT dollars that are only actually backed by three cents. Which would make most of the price formation of bitcoin completely synthetic.