Audit Firms Couldn’t Audit the Financial Crisis, How Could They Audit Tether?

Audit Firms Couldn’t Audit the Financial Crisis, How Could They Audit Tether?

Patrick Tan 08/11/2018 6
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Let me begin by saying unequivocally that I have no opinion behind the veracity of Tether’s claims about it’s dollar-backed stablecoins. I do not work for Tether nor am I affiliated with any organization which has any commercial or any other form of dealings with Tether. Legal disclaimer out of the way, I just wanted to go at some length about audit firms, their role in the last financial crisis and their inadequacy in performing their core function and why we expect far more from them than they are likely capable of delivering — especially when it comes to something as advanced as cryptocurrencies.

 

Not so easy to audit after all.

Just slightly over a decade ago, as the financial storm that would become known as the Great Financial Crisis (what was so great about it?) was brewing, two juggernauts of the financial industry were duking it out in New York City — sort of like a Godzilla versus King Kong kind of thing (it’s a bigger deal in the financial world), arguing over a little-understood but high stakes accounting principle regarding the valuation of highly complex assets (see Tether). American International Group’s London-based financial products arm had written billions of dollars’ worth of insurance against a mountain of Goldman Sachs’ mortgage-backed securities — also known as credit default swaps or credit derivatives. To the uninitiated, basically the good people at Goldman were buying insurance policies from American International Group (AIG) in the event that the mortgage-backed securities which they were selling to their clients ever went bad. Now if that’s not a conflict of interest then I don’t know what it is. But we’re not here to judge the moral integrity of Goldman, we’re here to see if their auditors did their job.

 

Who suffers when Godizlla battles King Kong? New York City suffers that’s who.

As credit conditions started to dry up in 2007 and these mortgage-backed securities started to cave, the value of these insurance policies were suddenly called into question. As the U.S. mortgage market grew increasingly weaker (what do you expect when you issue credit to borrowers with no job and no prospect of repaying their debt?), the value of Goldman’s insurance policies on its mortgage backed securities started to increase and naturally the bank wanted to recognize the gain it was making on its derivative positions. By Goldman’s calculation, AIG owed US$5.1 billion on its outstanding swap positions — a large chunk of which was in favor of Goldman. AIG of course was of the view that the liability was capped off at no more than US$1.5 billion, a sum which interestingly allowed it to continue to post quarterly profits at the time and allowed for the top brass to make rosy earnings calls with media. How convenient!

But given the huge disparity in valuation of these credit default swap obligations, bot sides sought the judgement of auditors for the valuation of these assets, or in the case of AIG, liabilities.

Again by coincidence (this happens a lot in the financial world), the auditors for both sides were the same firm — PriceWaterhouseCoopers (now more elegantly known as PwC). Now for those of us who have done even the most basic course in accounting, logic would dictate that one side’s gain in a zero-sum trade should mirror the other side’s losses. So if AIG’s liabilities were on the credit default swaps it owed to Goldman was US$1.5 billion, then logically, Goldman’s booked gains could not be a cent about US$1.5 billion. Not so it seems in financial alchemy. Instead, the even better people at PwC allowed both sides to have their cake and eat it (accounting rules be damned). So Goldman booked US$5.1 billion in credit default swaps while AIG only carried US$1.5 billion in liabilities. God bless creative accounting.

 

Only an auditor worth their fees would allow you to view two sides of the same coin.

As credit conditions continued to deteriorate in the freezing conditions of 2007’s winter (isn’t it interesting how weather conditions sometimes mimic market conditions?), PwC took a tougher stance and forced AIG to take a substantial writedown on its credit default swap positions, forcing it to cough up tens of billions of dollars in 2008 — a sum it was only able to pay because the American taxpayer fronted AIG the cash in a government-led bailout.

When last I checked, “audit” is defined to mean a “survey” or “inspection.” Whereas once, an auditor’s role was to source facts, certifying information to assure investors that a company’s numbers were “true and fair,” PwC’s treatment of the credit default swaps in the case of Goldman and AIG was akin to Schrodinger’s cat — you were both dead or alive until it was observed otherwise. Because credit default swaps were so unique, with few credible market prices to support key valuations, profits and/or losses were booked based not on observation, but instead on mathematical calculations based on highly contrived computer models.

If this is starting to sound familiar to you — it’s precisely because Tether, the company behind the stablecoin USDT encountered a similar problem when trying to prove its stake of dollars to back its stablecoin.

It’s convenient to imagine that Tether is fudging its dollar balances backing USDT, but the reality is not so straightforward — as reality often tends not to be.

Whenever a “buy” order is made for USDT, it’s not always a 1-for-1 with a fiat dollar (the green stuff), a “buy” for USDT sometimes represents a “sell” order for Bitcoin (BTC), because one way that traders shore up gains in cryptocurrency trading is to “buy” into a stablecoin — like USDT. Likewise, a “sell” order for Bitcoin, could also represent a “buy” order for USDT, which can prop up prices of USDT. And because the Tether issuance of USDT is so complicated, it’s not easy for an auditor, let alone a layperson to understand the true value of the dollars backing USDT. That’s not to say that USDTs are backed by dollars — there’s sufficient reason to form the opinion that at least some of it is backed by Bitcoin which presumably can be sold out to dollars, but to say that USDT is not backed by dollars is also not fully reflective of Tether’s state of affairs. So if this all seems rather confusing, don’t be alarmed, it is confusing. It’s so confusing that even the auditors which were hired by Tether to audit its dollar backing of USDT gave up.

 

Unlike in audits, there are no backsies on the blockchain. | Credits Picture: btcmanager.com

Accounting standards have also changed. In the past, historical cost accounting meant that a standard statement of accounts would reflect what had already happened. Today, the key purpose of accounts is to present information that is “useful to others.” The question then is, useful to whom? Because this process allows managers to pull forward anticipated profits and unrealized gains and book them as today’s surpluses, which conveniently allows executives to dole out generous dividends and stock performance linked bonuses. All this happened during a shift in accounting standards from historical accounting (an observable fact of events past) to fair value accounting (an opinions-based approach to assets and liabilities) leading to what one investor observed as,

“The problem with fair value accounting is that it’s very hard to differentiate between mark-to-market, mark-to-model and mark-to-myth.”

And although in theory, fair value should not preclude sounds audits, it does make it that much harder to do. Take for instance goodwill, a measure that takes the difference between the purchase price paid for an acquisition and the net value of the assets actually acquired. Until the turn of the century, there was a general convention that when one company bought another, goodwill was an effective “cost” of the transaction that needed to be amortized — or written down annually against profits. Not to do so, while simultaneously counting the additional profits from the purchased asset was a form of double-counting that inflated the benefits of the acquisition. Yet that is precisely what happened from 2000. Such acquisitions could be recognized on the balance sheet permanently and only reduced if there was evidence that the discounted future cash flows from the underlying asset had fallen sufficiently to warrant impairment (taking a write down). But acquisitions are painfully hit-and-miss, yet many companies do not take hits on their balance sheets or recognize the costs of their acquisitions.

And if you think that the auditors are starting to take a closer look at the problem, think again. To begin with, there are now only four major audit players in the market, KPMG, Deloitte, EY and PwC, who combined raked in about US$134 billion in fees and employed 945,000 people globally last year, making them painfully difficult to regulate. Add to that, audit firms are now starting to churn out what’s known as “tick box” rules designed to achieve robotic “neutral” outcomes. In other words, an auditor will talk a lot, but say nothing at all — like a politician. And with an endless list of caveats, the value of an audit these days is suspect at best.

Yet it is precisely that the auditors failed to bless Tether that critics harped on. To begin with, the value of an audit is suspect even in traditional companies, let alone for an entirely new form of asset class.

So where does that leave us?

The fact that USDT’s value has not dropped to absolute zero and still trades about US$2.5 billion a day should be telling. It means that there are sufficient scores of traders who understand the complexity behind Tether’s complicated USDT issuance schedule and the value of Tehter’s tie with BitFinex and its trading deposits. And even if we don’t trust Tether, we can still trust the blockchain. BitFinex is an important part of Tether’s equation, one that cannot be understated. BitFinex regularly makes available the public keys of its cryptocurrency deposits readily available for inspection. These are actual deposits and not “projections.” With the amounts in these deposits far exceeding the circulating value of USDT, there is more than enough reason to take the opinion that the value of the USDT while it may not be backed by a fistful of dollars in the traditional sense is at a value something other than zero. Parity, where one USDT can be hot-swapped for a greenback is another matter altogether, especially when you factor in the primary purpose of USDT — which is to provide a stablecoin for traders who are moving in and out of cryptocurrencies. It’s generally easier to swap into USDT when you’re selling Bitcoin or Ethereum than it is to move directly into fiat from cryptocurrencies. And especially if you intend to keep trading, USDT is far more liquid and far more efficient to on and off-ramp with major cryptocurrencies.

Auditors have their role, but with the rise of fair value accounting, the pressure on the profit-hungry Big Four accounting firms to churn fees, it’s more sensible to view audits as opinions (which many caveat themselves as being) than to be statements of fact or observations of a state of affairs — they are far from either. So at least from an accounting standpoint, Tether’s inability to hold up to traditional audit standards says very little about the integrity of the USDT and whether or not it’s backed by dollars, in fact, even if Tether had somehow managed to pass an audit, it would still need to be examined from a more circumspect position. Instead, since we’re dealing in cryptocurrencies, let’s focus on the one immutable arbiter of truth — the blockchain. If we want to know whether or not the USDT is backed by the dollar reserves that it claims to be backed by, search the blockchain, search the public addresses of the cryptocurrency deposits which BitFinex provides. To examine one without searching the other is to view a half truth or a whole lie.

Ultimately, audit firms are already hamstrung in a traditional corporate setting, to expect them to take the extra leap is a leap of the imagination.

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  • Michael Cosgrove

    Transparent, concise, well researched, and non-biased information.

  • Josh Fenwick

    Great info Patrick.

  • Andrew Mcguinness

    Keep the amazing content coming!

  • Brian Healy

    Patrick, I value the hell out of your opinion and think it comes from a very well-reasoned place.

  • Andy Williams

    Wow wonderful analysis !!!

  • Luke Holderbaum

    First time I really understood about the auditing process of cryptocurrencies.

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Patrick Tan

Crypto Guru

Patrick is an innovative entrepreneur and a lawyer passionate about cryptocurrencies and the business world. He understands the business concerns of founders and business people helping them to utilise the legal framework to structure their companies to take advantage of emerging technologies such as the blockchain in order to reach greater heights. His passion for travel, marketing and brand building has led him across careers and continents. He read law at the National University of Singapore and graduated with Honors in the Upper Division and joined one of Singapore’s top law firms, Allen & Gledhill where he was called to the Singapore Bar as an Advocate & Solicitor in 2005. He created Purer Skin, a skincare and inner beauty company which melds the traditional wisdom of ancient Asian ingredients such as Bird's Nest with modern technology. In 2010, his partner and himself successfully raised $589,000 from the National Research Foundation of Singapore under the Prime Minister’s Office. He has played a key role in the growth of Purer Skin from 11 retail points in Singapore to over 755 retail points in Singapore and 2 overseas in less than a year. He taught himself graphic design, coding, website design and video editing to create the Purer Skin brand and finished his training at a leading Digital Media Company. 

   
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