Innovation or scam?
If you have been following the latest news in the realm of cryptocurrency, no doubt you are aware of the attack that felled Bitfinex, which was until then the largest cryptocurrency exchange in the world. If not, have a read of my previous article explaining the attack and its impact.
To summarise, Bitfinex lost USD$66 million due to a malicious attack involving taking advantage of its 2-of-3 security arrangement with BitGo. To deal with such a loss, Bitfinex has done two things that have never been done before:
- It has socialised the loss across all user accounts and asset classes, regardless of whether they had lost any Bitcoin or not due to the attack, to the tune of a 36.067% haircut on assets held on the behalf of users by Bitfinex
- It has created a new coin called BFX to represent this loss in dollar terms. Each coin has a face value of USD$1 and is tradeable on an open exchange.
At first glance, this looks to be the first instance of a debt backed cryptocurrency whereby Bitfinex owes holders of BFX the total amount held. Like a fixed income product, the market value of each coin is determined by how likely holders of BFX believe Bitfinex is to repay that debt. However, is this really an innovative way of repaying users for the losses incurred, or is it a backdoor for Bitfinex to get out of covering its obligations?
The first place to look for answers as to BFX’s validity are the terms (fig. 1) that Bitfinex gave when distributing these tokens to its users. The key points given are:
- The losses were calculated on the basis of what Bitfinex considers the likely value of creditor payments in the event of an immediate liquidation
- The repayment of the token is contingent on Bitfinex recovering the loss incurred as a result of the attack
- BFX tokens bear no interest and holders are not entitled to any dividends, distributions, or other income amounts of any kind
- The Bitfinex Group may in any event at any time redeem the face value of each BFX token
The last two points immediately stand out. Combined, they make it clear that these tokens are less a zero coupon bond, and more akin to an option which Bitfinex has the right to exercise upon recovery of the total amount lost. Already the exchange has entered murky ground, as such language implies that even were the Bitfinex group to recover the stolen funds, they still could choose to not repay their face value for whatever reason.
Digging further into the given terms and conditions, things become even more suspect with regards to what happens should a user decide to sell their BFX tokens on an open exchange:
The two key takeaways from this additional section buried within the first set of conditions (fig. 2) are:
- U.S. customers can only sell BFX tokens
- Selling BFX tokens forfeits any further claims against the Bitfinex group in relation to losses due to the attack
Whilst the former point likely has to do with U.S. laws and regulations relating to the sale of securities, it is still a restriction non-U.S. customers do not have despite the equal allocation of losses. The second point is far more problematic. The implication is that by trading these tokens, users not only agree to this whole scheme in the first place, but they forfeit the right to take any legal action should they decide to cut their losses by selling their tokens. This is despite it not being the users’ fault the losses were incurred in the first place. Regardless of whether or not it was fair to socialise losses in the first place, a troubling precedent has been set as to how companies can manage their contingent liabilities.
The overall view one gets by looking at BFX tokens is that this is a scheme aimed at stacking the deck entirely in Bitfinex’s favour. It is a cryptocurrency that passes on losses to the users without giving any recourse beyond “wait and see.” Worse, despite being responsible for the loss, Bitfinex have admitted that they themselves are not contributing any funds to help cover the losses. Instead, they are seeking to cover the losses only via recovering the stolen Bitcoins or through raising additional funding as per the conditions (see fig. 1). Whilst Bitfinex have later stated they have “committed all of the company’s reserves to compensate customers,” no customer has yet been repaid. In short, these BFX tokens appear to be nothing more than IOUs wrapped up in the guise of a digital token.
Are there any alternatives for recourse for users who have lost monies due to this attack? Unfortunately, it does not seem like it would be a simple task to take Bitfinex to court over these losses. Note in fig. 2 that the Bitfinex Group refers to two separate companies: iFinex Inc. and BFXNA Inc.. The former, iFinex Inc., is the relevant company registration that Bitfinex operates under for all non-U.S. customers. As per fig. 3, it is registered in the British Virgin Isles, a country notorious for the opacity it affords companies registered there. BFXNA Inc. is the company registration Bitfinex uses for those users located in the United States due to differing laws regarding money laundering, securities, and taxation. It too is registered in the British Virgin Isles likely for similar reasons. These registrations further complicate the picture despite Bitfinex’s registered offices being located in Hong Kong (see fig. 3). Due to the complicated laws regarding secrecy, and the separate registration of companies bifurcating Bitfinex’s users by their location, a successful class action lawsuit seems highly improbable.
The markets reacted as could have been expected towards this bail-in. As soon as BFX went live, the value dropped. Bitfinex users, who had been anxiously waiting to get their holdings out as quickly as possible, sold their tokens, demonstrating their acceptance that they would never see the full value of their assets again. Many justified such losses on the basis that should Bitfinex go bankrupt, they would lose far more than what had already been lost. Amazingly, the value of BFX is currently sitting at 38.09 cents to the dollar (fig. 4), indicating that enough buyers exist who believe that there is both value in BFX, but also that Bitfinex will not go bankrupt before those buyers see some profit on their investment.
The big question is “will Bitfinex pay the face value of BFX in the near future?” Whilst it is too early to give any definitive answer, all indications are that it would be unlikely users will see any repayment anytime soon. There is no reason why Bitfinex should incur the cost of repayment whilst the stolen money is outstanding. Even if that money gets repaid, it is still at Bitfinex’s discretion as to when and who they repay. The bottom line is that BFX is a token that only those willing to lose their money would buy. There is therefore no sound reason why anyone should buy in. As for those who are unfortunate to be left holding BFX due to being a Bitfinex user, the decision to sell comes down to personal circumstances. The less risky option is to accept the loss, sell for some 40 cents to the dollar, and move on.
Whilst not a scam in the traditional sense, BFX sets a worrisome precedent when it comes to managing losses, and one should be wary should such a practice become more commonplace. That being said, if Bitfinex do repay all their outstanding obligations, many will see this as having been a very clever way of avoiding endless bankruptcy proceedings akin to Mt. Gox where creditors have yet to see a single cent. However, the way the tokens have been set up indicates a solution that very much favours the embattled exchange, where there is no real reason why any payment should occur. BFX tokens are the crypto equivalent to an IOU, and hence should be treated in the same manner.
Matthew Mills researches cryptocurrencies and blockchain based applications at the University of Sydney. He is also a director at Liberté & Co and holds investments in Bitcoin and Ethereum. If you have any questions, or would like to get in touch, email him at firstname.lastname@example.org