NY Office of the Attorney General Alleges Bitfinex Engaged in $850 M Fraud

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On April 25, 2019, the New York Office of the Attorney General (“OAG”) announced that it obtained a court order against the operators of Bitfinex1 demanding the online digital asset exchange turn over a plethora of important documents related to previous subpoenas the OAG issued to Bitfinex. The order’s accompanying petition alleges that Bitfinex “borrowed” funds from its affiliate, Tether,2 the issuer of the “tether” virtual currency that trades under the symbol “USDT,” after Bitfinex could no longer access approximately $850 million of assets to process customer withdrawals from Bitfinex. The OAG’s main allegation is that both companies, Bitfinex and Tether, were not only owned by the same people, but were also willing to shift risk around in order to avoid a potential collapse of either company.

The order’s extensive list of documents demands that Bitfinex produce materials related to its transactional activity, that Bitfinex identify all Eligible Contract Participants (“ECP”) operating on its platform, and that both Bitfinex and Tether send their tax filings for 2017 and 2018, among other requests. The order also enjoins Bitfinex from accessing or borrowing any of the USD reserves that Tether holds.

Furthermore, the order states the OAG’s decision to commence an action against Bitfinex and Tether pursuant to the Martin Act, NY Gen. Bus. Law art. 23-A, §§ 352– 359-h (2019). Considered one of the most severe blue-sky laws in the country, the Martin Act allows the OAG to investigate and combat fraud related to securities and commodities marketed to New York residents when it “appears to the attorney-general, either upon complaint or otherwise” that a fraud has occurred or is about to occur.3.  In order to enforce the Martin Act, the OAG may bring civil or criminal actions against the alleged violators. Pursuant to the OAG’s order, Bitfinex and Tether must appear before the Honorable Steven E. Liebham in New York State Supreme Court on May 3rd at 10:00 am.

The Allegations Against Bitfinex and Tether

The OAG’s petition describes how Bitfinex lost access to $850 million of co-mingled client and corporate funds. In 2014, Bitfinex began a relationship with Crypto Capital Corp. (“Crypto Capital”),4 an entity the OAG believes is located in Panama. Crypto Capital is a bank used by both Bitfinex and Tether that custodies some of Bitfinex’s and Tether’s funds and processes Bitfinex’s customer deposits and withdrawals.  By 2018, Bitfinex had placed over $1 billion of commingled customer and corporate funds with Crypto Capital. Around mid-2018, Crypto Capital started refusing to process Bitfinex’s customer withdrawal requests and either refused or was unable to return any funds to Bitfinex. In turn, Bitfinex could no longer honor its customers’ withdrawal requests. Crypto Capital claimed that it could not return Bitfinex’s $850 million because the funds were seized or restrained by governmental agencies in Portugal, Poland, and the U.S.

Under increasing pressure to honor customer withdrawal requests and rumors that Bitfinex was insolvent, Tether transferred $625 million held in its account Deltec Bank and Trust Limited (“Deltec”) 5 to Bitfinex’s account at Deltec. In return, Bitfinex transferred $625 million from its account at Crypto Capital to Tether’s account at Crypto Capital. Bitfinex effected the Crypto Capital transfer through only a ledger entry as the $625 million was part of the inaccessible $850 million.

In December 2018, however, Bitfinex and Tether grew apprehensive about Crypto Capital’s representation regarding its $850 million and began to suspect that Crypto Capital was engaged in fraud. Bitfinex then negotiated a secured, revolving line-of-credit of up to $900 million with Tether that allows Bitfinex to borrow from Tether’s USD reserves to fulfill customer withdrawal requests. This line-of-credit includes the $625 million originally transferred to Bitfinex in November 2018. This transaction closed on or around March 19, 2019.

Until late February 2019, Tether represented USDT as a “stablecoin.” One USDT supposedly was equivalent to one USD and every USDT was backed 1-to-1 by traditional currency held in Tether’s reserves. Yet, the petition alleges that this was not the case. In reality, Tether transferred hundreds of millions of dollars of its USD cash reserves to Bitfinex in November 2018 to cover Bitfinex’s liquidity crisis. Thus, the USDT was backed by significantly less USD than Tether expressed.

Interestingly, Tether also edited its description of tether on its website in early March 2019. Now, Tether states that tether “is always 100% backed by our reserves, which include traditional currency and cash equivalents and, from time to time, may include other assets and receivables from loans made by Tether to third parties, which may include affiliated entities. . .” As of late March 2019, Bitfinex has accessed $700 million under the line-of-credit.  

Bitfinex’s and Tether’s Response

Bitfinex responded to these allegations in a blog post, stating that New York Attorney General’s court filings “were written in bad faith and are riddled with false assertions.”  Furthermore, Bitfinex claims that both Bitfinex and Tether, “…[a]re financially strong – full stop.” Stronger statements like this will likely raise the awareness of the OAG even more, especially considering the fact that the OAG is currently investigating both companies for fraud. Regardless, the blog post states that Bitfinex still cannot access the $850 million tied up at Crypto Capital because “they have been informed that” governmental authorities from Poland, Portugal, and the U.S. seized or otherwise restrained the funds.

On Tuesday, April 30th, both Bitfinex and Tether filed a motion asking the court to require the OAG to show cause, vacate, or modify its order and for an immediate stay of the order. In short, the motion refutes the allegations the OAG made in the order. The motion claims the OAG’s application for the order was “riddled with factual and legal errors” and that the order “serves no useful purpose, except to generate headlines (as appears to be the purpose of the exercise).” As a result of this motion, the New York Supreme Court ordered the OAG to explain to the Court why it should not vacate the OAG’s original order or to remove the freeze on the line-of-credit from the original order.  The OAG may file a response by May 3rd and it must appear on May 6th to provide the court with an explanation.

The predominate issue for Bitifinex and Tether – besides the massive amounts of documents they must produce – is the freeze on the line-of-credit. If Bitfinex cannot access Tether’s cash through the line-of-credit, it may not be able to process customer withdrawals on the Bitfinex platform. Interestingly, the motion states that “Tether’s reserves of cash and cash equivalents – without the line-of-credit – would cover approximately 74% of the outstanding amount of tether,” and that “this sort of ‘fractional’ reserving arrangement is similar to how commercial banks work.” However, Tether is not a commercial bank, it is not an FDIC-insured institution. If there is a run on Tether, many of tether users will be left short-handed.   

The Market’s Response

It is interesting how the crypto markets and the prices of stablecoins reacted to the latest news. Based on Coinmarketcap data, the overall crypto market capitalization dropped by $10 billion to as low as $167 billion around early Friday morning UTC time. It has since then climbed back above $172 billion as of press time. The market is reacting to the news, but the long-term effect remains to be seen.

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  1. Here, “Bitfinex” refers to the online platform and is operators, iFinex Inc., BFXNA Inc., and BFXWW Inc.
  2. Here, “Tether” refers to Tether Holding Limited, Tether Limited, Tether Operations Limited, and Tether International Limited.
  3. See NY Gen. Bus. Law § 352 (2019)
  4. Crypto Capital also served as the custodian and banking partner for the Canada-based exchange QuadrigaCX, whose late founder, Gerald Cotton, allegedly passed away in December 2018. At his passing, he held the private keys to more than $136 million in customer funds. Unfortunately, he did not share the private key information with any other party and customers cannot access their funds. QuadrigaCX is now embroiled in litigation before its creditors in Canada.
  5. Deltec Bank and Trust Limited is a bank in Nassau, The Bahamas.