A New York judge has ordered Bitfinex, a cryptocurrency exchange that shares a parent company with the "stablecoin" Tether, to turn over a bunch of documents to New York Attorney General Letitia James. James announced the order in a Thursday press release. She also unsealed her office's legal filings requesting the order.

Those documents suggest that Bitfinex could be in serious financial trouble. The company has been unable to recover $851 million in cash it had entrusted to a little-known Panamanian payment processor called Crypto Capital. James' office writes that information uncovered during the investigation "raised serious questions about the viability of Bitfinex as an ongoing concern."

In a statement, Tether said that the filings from New York's attorney general were "written in bad faith and are riddled with false assertions." According to Tether, the missing $851 million "are not lost but have been, in fact, seized and safeguarded." The company added that "both Bitfinex and Tether are financially strong."

Bitfinex's plight matters not only because its customers stand to lose hundreds of millions of dollars, but also because tether has become a kind of global monetary standard in the cryptocurrency world. Tether (the company) has promised that every unit of tether (the cryptocurrency) will have a value of $1, and the company has been remarkably successful at maintaining this peg over several tumultuous years. That stability has led a number of exchanges to treat tethers as a substitute for the dollar—a substitute that can be bought and sold without attracting unwanted attention from US regulators.

Bitfinex has allegedly tried to paper over its financial problems by borrowing funds from Tether, calling into question Tether's promise to keep a dollar in the bank for every tether issued. Although you might expect this to shake market confidence in tether's peg to the dollar, that doesn't seem to have happened. As I write this on Monday afternoon, tether continues to trade for between $0.98 and $1 on a variety of exchanges.

Bitfinex has long been dogged by solvency worries

Bitfinex is a popular cryptocurrency exchange that seems to operate mainly out of Hong Kong and Taiwan. The exchange allows people to buy and sell bitcoins, ether, litecoins, and other blockchain-based assets, and it shares a corporate parent with Tether.

Over the last three years, critics have repeatedly raised questions about the two companies' financial health. After hackers stole $70 million worth of bitcoin from Bitfinex in 2016, the exchange issued customers IOUs to cover the shortfall. In April 2017, Bitfinex purportedly paid back all outstanding IOUs. But people wondered if the exchange had dipped into its Tether reserves to finance this.

Bitfinex promised to publish a professional audit of its books, but the firm never made good on this promise. In early 2018, a firm Bitfinex had hired to conduct the audit abruptly withdrew from the job without publishing its results.

During this same period, Bitfinex found that obtaining banking services was more and more difficult. One bank after another severed its relationship with Bitfinex and Tether. Banks haven't publicly explained their reluctance to work with Bitfinex, but it's widely believed that banks are worried about possible regulatory headaches.

Limited access to the conventional financial system has made it difficult for Bitfinex and Tether to honor customer withdrawal requests. In late 2017 and early 2018, customers began to experience long delays in fund withdrawals. Bitfinex began to heavily rely on a Panamanian payment company called Crypto Capital to make payments to customers.

"By 2018, Bitfinex had placed over $1 billion of co-mingled customer and corporate funds with Crypto Capital," wrote New York Assistant Attorney General Brian Whitehurst in a legal filing last week. The companies told New York officials that "no contract or similar written agreement was ever entered into between Crypto Capital and Bitfinex or Tether."

This went about as well as you'd expect. "By mid-2018, Bitfinex was having extreme difficulty honoring its clients' requests to withdraw their money from the trading platform," Whitehurst reports. "Crypto Capital, which held all or almost all of Bitfinex's funds, refused to process customer withdrawal requests, and refused or was unable to return any funds to Bitfinex."

Chat logs obtained by New York officials show that, in the second half of 2018, Bitfinex sent increasingly desperate messages to Crypto Capital.

"Dozens of people are now waiting for a withdrawal out of cryptocapital [sic]," an October message said. "We are at the end of the month and you haven't been sending out one wire," the same Tether rep wrote in late November. "I am not your enemy. I am here to help you and have been very patient so far. But you need to cut the crap and tell me what is going on."

According to Whitehurst, Crypto Capital told Bitfinex that the $851 million was unavailable because the funds had been seized by officials in Portugal, Poland, and the United States. Interestingly, Whitehurst reported last week that Bitfinex and Tether "do not believe Crypto Capital's representations that the funds have been seized." Tether now says that the funds "are not lost but have been, in fact, seized and safeguarded."

Bitfinex borrows from Tether

Instead of disclosing this situation to customers, Bitfinex responded by dipping into Tether's cash reserves. Bitfinex acknowledged to New York regulators that in November it had taken $625 million from Tether's account at the Bahamian bank Deltec and transferred it to Bitfinex's account at the same bank. In exchange, Bitfinex transferred $625 million of its frozen Crypto Capital funds to Tether.

Obviously, that wasn't a very good deal for Tether, since it gave up $625 million in real cash for $625 million whose realness was up for debate. A month later (December), Bitfinex "grew concerned that Crypto Capital's principals may be engaged in a fraud."

One again, Bitfinex didn't tell customers what was happening. Instead, the exchange tried to paper over everything by making another dubious transaction with Tether. Tether extended Bitfinex a $900 million line of credit secured by stock in Bitfinex's parent company (which in turn shares a corporate parent with Tether). Bitfinex used this line of credit to "buy back" Tether's $625 million in stranded Crypto Capital funds. Of course, none of these maneuvers changes the fact that their shared parent company was missing $851 million.

Around this time, Tether changed the language on its website. Previously, the website stated that "every tether is always backed 1-to-1, by traditional currency held in our reserves." Now, the site says that "every tether is always 100 percent 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."

Markets seem unfazed by Tether’s difficulties

So how has the market reacted to this news? In the hours after last Thursday's announcement, bitcoin's price plunged by almost 10 percent. It's still about 6 percent below its value from last Thursday.

Meanwhile, bitcoin has traded at a premium on Bitfinex relative to other cryptocurrencies. This is a common situation when an exchange freezes dollar withdrawals. Customers anxious to get their cash out become willing to pay a premium to get bitcoins they can withdraw immediately—rather than taking the risk that they might never get their dollars back.

But remarkably, recent news seems to have had little impact on the value of Tether. As I write this on Monday morning, CoinMarketCap shows Tether trading for between $0.98 and $1 on a variety of exchanges.

It's unclear why Bitfinex's financial problems have apparently had so little impact on Tether's price. Tether's value has been remarkably stable over the last three years of turbulent news, suggesting that the company has developed ways to maintain the peg in the face of hostility from the official banking system.

In the short term, Tether may simply have enough money in the bank—it's supposed to have more than $1 billion even after the loss of $851 million—to support the currency's value. As long as total demand for tethers never falls below $851 million, Tether will be able to buy tethers whenever they fall below $1.

Still, currency pegs are fundamentally built on confidence. If the market started to worry that demand for Tether was declining, it could become a self-fulfilling prophecy, triggering a run on the currency as people scramble to cash out while there's still money left.

But...

So far, that hasn't happened. And that may be a testament to the central role tether plays on a number of cryptocurrency exchanges.

Because of frictions between cryptocurrencies and the conventional banking system, there are a number of "crypto-only" exchanges that don't offer payment in conventional currencies like dollars or euros. On these exchanges, tether is the closest traders can come to getting dollars for their cryptocurrencies. As long as there's a lot of demand for tethers for use in day-to-day transaction, demand may never fall enough to raise serious questions about Tether's viability.

If that is what's going on, it would be an ironic parallel here to conventional currencies like the US dollar, which was backed by gold until the 1930s. Between 1933 and 1971, the US government gradually severed the link between gold and the dollar. That led to the modern dollar, which can't be redeemed for anything. The dollar maintains its value because it's a convenient way for people to make day-to-day transactions.

By the same token, tethers have become the most convenient way to make dollar-denominated trades in the cryptocurrency world. As long as that's true, there may continue to be a robust demand for them, whether or not every single tether is backed by a dollar in a bank account somewhere.