cryptocurrency

Fidelity’s Folly- Part II

Capital Markets , ,
bitcoin

I stopped writing about Bitcoin (BTC) in October 2020 because by then most people realized that, as an investment, BTC is foolish at best. My last article on the subject was about Fidelity Investments which was an outlier because it was a cheerleader for cryptocurrency.

At that time Fidelity was proposing to allow its brokerage customers to keep their BTC in Fidelity’s custodial “vault” and see their holdings valued on their Fidelity statement.  I suggested then that by just taking custody of its customers’ BTC, Fidelity might be considered a “facilitator” of its purchase.  Adding crypto holdings to the statement of mainstream investments might give people the idea that BTC is a mainstream investment, which it is not. 

Predictions

By October 2020 most of the predictions made by BTC self-styled experts in 2016-2018 had failed to come to pass. Banks had not been disrupted.  The US dollar and other fiat currencies were still accepted virtually everywhere. There was not a BTC ATM on every street corner.  No real change in the world banking system was on the horizon. Much of the hype in 2020 came from the same people who had been hyping BTC since 2016 and earlier.

My article was in response to a report published by Fidelity’s Director of Research that suggested that BTC was a “potentially useful” asset for “uncorrelated return-seeking investors”. The report said that “in a world where benchmark interest rates globally are near, at, or below zero, the opportunity cost of not allocating to bitcoin is higher.”   

Stock brokerage firms that merely execute their customers’ orders to buy and sell owe very little duty toward those customers. They are expected to handle the execution and bookkeeping by industry rules and practice, but little more.  Consequently, these “discount” brokerage firms have little liability if a customer loses money because they invested incorrectly. 

The report from Fidelity’s Director of Research in 2020 further suggested that bitcoin’s market capitalization “is a drop in the bucket compared with markets bitcoin could disrupt.” As I noted at the time, that report certainly sounded to me like a “buy” recommendation for BTC.

When a stock brokerage firm issues a recommendation more rules come into play. There must be a “reasonable basis” underlying the recommendation.  The rules governing research reports require more than a crystal ball look into the future.

Get Rich Quick?

Then as now, there is no real data about BTC for anyone to research. You cannot analyze BTC in any traditional way. They are merely a few lines of computer code, generated by a computer.  You can plug in and get rich but that is not going to disrupt the global banking system. 

Fidelity’s Director of Research based his recommendation to buy BTC, not on facts, data, or any traditional analysis, but rather on his speculation that BTC would result in a titanic disruption in the global financial system.  And that is what BTC is, not an investment but speculation. 

That fact is important because last week Fidelity announced that beginning mid-year it will permit financial advisors managing 401(k) retirement plans to invest in BTC as well.  Fidelity has about 23,000 of these advisors on its platform. If only 10% of those purchase BTC in the amount of 10% of the funds they are managing, the price of BTC is likely to sky-rocket.

Congress created 401(k) plans under the Employee Retirement Income Security Act of 1974 (ERISA).  Managers of ERISA plans are held to a fiduciary standard and are expected to invest the funds entrusted to them as a “prudent” person would. No one considers speculation in a retirement account to be “prudent”.

DOL Says NO

Congress assigned regulation of these retirement plans to the Department of Labor (DOL). There are about 800,000 different private pension plans in the US covering about 140 million people. Total assets held by these plans exceed $10 trillion, so it is pretty easy to understand that this is a big business. 

Fidelity has been planning this move for some time. It has been inching up to accepting crypto in 401(k) accounts for at least 2 years.  What is interesting here is that just about one month before its announcement, the DOL essentially told Fidelity, and all ERISA account advisors, not to purchase crypto in 401(k) accounts.

On March 10, the DOL issued Compliance Assistance Release No. 2022-01(CAR) on the subject of “401(k) Plan Investments in “Cryptocurrencies”.  The DOL is aware that firms were marketing investments in cryptocurrencies to 401(k) plans as potential investment options for plan participants.  The CAR lays out the DOL’s reasoning why cryptocurrencies do not belong in retirement plans.

The first reason the CAR lists is because an investment in cryptocurrencies is highly speculative. Highly speculative investments are never prudent for a 401(k) retirement plan.

No one asked Fidelity to respond to the CAR, but they did.  In this case, we get a rare glimpse of Fidelity’s rationale supporting this bold move to offer BTC to ERISA accounts and account managers. 

While Fidelity says that it understands that the CAR “effectively deems the selection of cryptocurrencies for investment in a 401(k) plan to be imprudent” it suggests that the DOL can’t possibly mean ALL cryptocurrencies. Fidelity suggests further study and guidance for the DOL as to which cryptos may be OK for 401(k) plans and which are not.

Notwithstanding its request for more clarity and its request that the CAR is withdrawn, Fidelity’s response can only be read as an admission that it understands the DOL means that crypto of any kind does not belong in a 401(k) or any retirement plan.

Fidelity also argues that it is not specifically designating BTC or any crypto as investments that they are offering to these plans. If a plan manager wants to add some BTC to the portfolio, Fidelity will guide the manager to a different landing page, where the purchase will be made through a different Fidelity company, not the ERISA plan funnel.

That argument is unlikely to hold water as what the DOL was complaining about in the first place, was people marketing crypto to these retirement plans. However Fidelity books these trades, it is still Fidelity’s cheer-leading for BTC that is causing those trades to occur.

To be clear, even though the primary regulator of these 401(k) plans has said no, Fidelity has gone ahead and decided that it will facilitate the purchase of BTC in these accounts. The lawyers and compliance officers who gave Fidelity the green light, need to stand up and explain themselves.  

In its most recent research, (April 2022) Fidelity asserts that BTC is an “aspirational store of value”. Fidelity’s argument for BTC is specious at best, but that does not matter. In that report, Fidelity specifically acknowledges that BTC is a speculative investment. Notwithstanding, Fidelity continues to target retirement fund administrators with positive commentary about BTC.

I would suspect that the DOL was addressing Fidelity when it issued the CAR.  As any lawyer will tell you, Fidelity is essentially telling the regulator to shove it. Fidelity knows that the CAR has not been withdrawn.  In my experience, regulators hate to be ignored. 

I also suspect that the DOL has a contingency plan for this. It has already gotten support from the AFL-CIO which has specifically and publicly supported the issuance of the CAR. The CAR alone will dissuade some of the fund administrators Fidelity is targeting, but Fidelity apparently intends to offer crypto to any retirement account that wants it.

The DOL also has the benefit of several US Supreme Court decisions that support the idea that ERISA accounts require “prudent” investments and that plan fiduciaries need to help eliminate “imprudent” investments.  As Fidelity can be shown to be trying to influence plan administrators to purchase imprudent investments, some courts might just agree that Fidelity has stepped into a fiduciary relationship with the plan investors.     

I suspect that any court that looked at the facts presented here might support a cease-and-desist order against Fidelity. I would not be surprised if it came from the securities regulators in Fidelity’s home state of Massachusetts.   

I cannot for the life of me figure out how Fidelity got itself into this mess. Fidelity enjoyed a reputation as a company that sold mutual funds to mom-and-pop investors. There are more than 25 million people in the 401(k) plans that Fidelity services. Why would Fidelity go against the DOL for the right to sell highly speculative investments that most of those people would never want in their retirement plan?

Sooner or later, I suspect someone will write a book about Fidelity’s attempt to put lipstick on the pig that is BTC and pawn it off on retirees.  The SEC has been threatening to hold compliance directors responsible for allowing practices that harm investors. If Fidelity moves ahead, as I suspect this would be an ideal opportunity for the SEC to make a statement and demonstrate that they are serious and ask the compliance director at Fidelity to explain himself.

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The Troubling Tale of Tether

Capital Markets, Investors , ,
the troubling tale of tether

I had intended to stop writing about crypto currency.  Despite the massive buzz in 2016 and 2017, crypto has largely shown itself to be irrelevant to any serious discussion about finance or economics.  

The same people who were screaming back then that bitcoins would be trading at $100,000 each are still “certain” that it will happen “soon”.  The promised institutional investors never materialized and probably never will.  The bitcoin ATMs promised for every street corner must still be on order. 

The “un-hackable” online wallets and accounts still get hacked.  People who invested good old fiat currency in more than 1000 “alt-coins” saw those coins disappear into thin air. 

There were and still are people who favor crypto currency because they hate banks. Many have moved on to other battles against the establishment.  Some, having fattened their own wallets as crypto currency consultants, now have very high limit American Express cards. 

There are still people who defend crypto currency despite the fact that there have been so many scams and losses. A common argument is that the losses in crypto are not significant compared to consumer losses caused by banks.  That follows the same logic as the sentence “Ted Bundy killed more than 30 people and I only killed one”.

Perhaps the most disappointed people in the crypto world will be the many who favor crypto currency because of what they see as a lack of transparency and over-concentration in the traditional banking system.  I cannot imagine how they must feel when they realize that the future of crypto currency may be in the hands of Facebook. 

Lawyers no longer have to lecture on the Howey test or lament that they cannot do what they do without more guidance from the government. The best lawyers work with the regulators to “tokenize” this project or that, even when those projects could likely raise money without tokens.

Whatever becomes of the crypto or token market it is a lot cleaner than it was because regulators became more and more active, not because crypto investors have gotten any smarter.  But there is still a lot of crypto-trash to clean up.

The enforcement action of the month involves an action by the New York State Attorney General (NYAG) against iFinex Inc. which operates of the Bitfinex trading platform and Tether Limited, issuer of “Tether” a self–styled crypto currency.  Both, apparently, are controlled by the same people.

Tether bills itself as a “stable coin”.  Its original white paper claimed that “each issued into circulation will be backed in a one to one ratio with the equivalent amount of corresponding fiat currency held in reserves by Hong Kong based Tether Limited.”

On its website the company still claims “Every Tether is always 100% backed by our reserves, which include traditional currency and cash equivalents” and “Every Tether is also 1-to-1 pegged to the dollar, so 1 USD₮ is always valued by Tether Ltd. at 1 USD.”

IFinex Inc. says it issued more than $1 billion worth of Tether.  The New York State Attorney General believes that the reserves may be short by $700 or $800 million or more and wants to see the books. 

People have actually been questioning the accuracy of the reserve figure for some time.  The company promised and then refused to provide any kind of audited financial information.  

The original white paper notes that Tether, Ltd. “as the custodian of the backing asset we are acting as a trusted third party responsible for that asset. This risk is mitigated by a simple implementation that collectively reduces the complexity of conducting both fiat and crypto audits while increasing the security, provability, and transparency of these audits.”

It should be cheap and easy to prepare a certified audit because the company should be able to easily demonstrate how many coins it issued. The reserves are all held at banks and should be easy to prove.  Instead of an audit the company offers a letter from their law firm that says that it looked at some account statements and it seems that there are adequate reserves.  The letter did not satisfy the New York Attorney General.

The idea behind stable coins was intended to fix a problem created by other crypto currency like bitcoins which were susceptible to volatile shifts in their exchange rate with US dollars.  Given that bitcoins were a intended to be “currency”, merchants take on a substantial risk every time transactions were denominated in bitcoins, instead of dollars.  It is a problem best solved by eliminating the bitcoins rather than adding the Tether to the transactions.

Actually the only thing new about stable coins is the name. The financial markets already have a class of securities that are pegged one-to-one to the US dollar and backed by cash or cash equivalents. We call them money market funds. 

Money market funds are registered with the SEC under the Investment Company Act and subject to specific disclosure and custody rules like other mutual funds. Issuing a stable coin on a blockchain is remarkably similar to buying a money market fund from a mutual fund company using a book entry system. Mutual funds are required to provide timely, accurate information to the public.  The management at Tether does not believe that they should be required to do the same.  

Bitfinex and Tether have had problems in the past. In early 2017, Bitfinex accounts were thrown out of Wells Fargo Bank.  At the time, many people in crypto saw this as “retaliation” by a legacy bank against the brave new world of crypto currency. The bank no doubt looked at it as a refusal to assist or participate in an obvious scam. 

In late 2017, Bitfinex announced that hackers had stolen $31 million worth of Tether from its own wallet.  No investigation was ever reported. Management did not even raise a fuss.

Jordan Belfort, the infamous Wolf of Wall Street called Tether a massive scam.  His comment got some press at the time. Most people in crypto just refused to see anything related to crypto as a scam in 2017.  That is largely still true and unfortunate.

IFinex and the other defendants argued that the Judge should refuse to let the NYAG look at their books because they never did any business in the State of New York.  The NYAG has presented the court with evidence that they did. Sooner or later the Judge will question everything the defendants tell her.  

In the meantime, Bitfinex claims to have raised another $1 billion by selling a new crypto currency token called the LEO.  As I said the best securities lawyers are now working with the regulators when they want to issue anything that purports to be a crypto currency.  It does not seem that any regulator, anywhere, reviewed the LEO paperwork.  The NYAG told the court that LEO offering “has every indicia of a securities issuance subject to the Martin Act, and there is reason to believe that the issuance is related to the matters under investigation.”

Sooner or later the Judge will want to see the records that prove that the reserves are indeed in the bank. No one, and I mean no one, should seriously expect that the reserves will be there unless the proceeds from the sale of the LEOs are meant to replenish them.  That will not solve the problem because the people who bought the LEOs were not told the reserves were missing or that their funds would replenish them.

Over the years I have read thousands of prospectuses and other documents that are given to investors when they purchase any new security. Among other things, the documents disclose specific risks that may adversely affect the investors’ returns.  I have seen those “risk factors” go on for pages and pages.

Still there is one “risk factor” disclosed in the original Tether white paper that I cannot recall ever having seen before.  Management at Tether Ltd. deemed it necessary to disclose to the initial buyers of Tether stable coins that: “We could abscond with the reserve assets.” Perhaps they were already thinking about it.

I have written about investment scams before, and as I said, I really do not think crypto is worth writing about. What makes Tether interesting is the potential magnitude of the loss. 

The NYAG says that as much as $850 million may be missing from the reserve account.  After that money was allegedly already gone, the company may have raised another $1 billion with the LEOs.  It is more than possible that a year from now the crypto industry will be staring at a $2 billion loss because the management of Tether just absconded with all of it. 

I actually wonder if the crypto zealots will consider that to be a “significant” loss.  

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 The Troubling Tale of Tether