The following is a summary of the speech given by Gavin Smith, XBT / First Global CEO at the conference on Blockchain Capital Markets held at the BT Auditorium – London on September 9, 2016.
I’m not going to focus on the details of the Bitfinex hack itself and subsequent attempts at resolution – there are already many thousands of column inches devoted to that subject available on the internet. Instead I’m going to touch on the immediate effects on the newly formed capital market structures, how the market in general and my company in particular responded to the hack and what changes we’re seeing in the market as a result of this event. Just keep in mind that these are our experiences and our customers’ who have a very particular expectation from the marketplace.
The initial and most obvious impact following the Bitfinex hack was the decline in the price of bitcoins. The market still remembers the persistent slide in bitcoin value after Mt GoX, so the immediate knee jerk reaction of price reduction was not unexpected. In parallel to price decline, volume in the market became very sporadic.
I believe many active market participants followed the same course of action that First Global followed. We took any collateral that was not required to fund existing position hedges and immediately pulled these back to our cold storage wallets. While there was no immediate suggestion of contagion risk, we felt it was better to take action first and then watch how the situation developed.
However, it is the behaviour of deposit markets that is more interesting. Initially, any volume in the market dried up, but since then as markets have started to return to normal we have seen a substantial change in the spread offered on leverage exchanges between USD and BTC deposit rates. Prior to the Bitfinex hack it was possible to get 15-20% return on USD rates used to finance margin positions but bitcoin deposits were down at 1.5-2%.
To us a 20% premium on USD deposits implied a huge credit risk premium, and if the credit risk premium on USD was correct, then the risk adjusted return available on BTC deposits was, effectively, negative. Something that is unsustainable unless there are forces at work to manipulate the market.
Now, this anomaly has started to unwind. Since the Bitfinex credit event BTC rates have risen to 9-10%, still lower than the rate available for loaning US dollars, but a narrower spread than we’ve previously seen.
We believe that this rate starts to approach something that is more sustainable and reflects the true level of counterparty risk – it also provides a lot of exciting opportunities to structure yield products that will be of interest to market participants.
The final point I want to make on this topic is the bitcoin futures markets. Implied spreads in this market still haven’t adjusted to reflect, what we believe, is the new norm; they still imply a 15-20% spread between USD and BTC rates. It will be interesting to see which is correct.
A Growing Market Recognition of Counterparty Risks
The other interesting development that has, understandably, happened following Bitfinex’s difficulties is a greater acknowledgement of the risk taken when placing assets on an exchange – especially an exchange with a murky ownership structure or one headquartered in an offshore jurisdiction.
Something we, as an organisation, have always done is assessed the counterparties we do business with based on transparency and location; favouring counterparties headquartered in well documented jurisdictions that provide financial customers with acceptable levels of legal protection – we’re now seeing a similar level of due diligence from customers of exchanges – a welcome development.
Among reputable market participants there’s always been an expectation that companies will perform KYC and AML checks on their customers – we are now seeing customers requesting a similar level of disclosure from their exchange partners; something we should all encourage.
The final observation we’ve noted is how customers, post-Bitfinex hack, have started spreading risk much more pro-actively across multiple exchanges.
We’ve picked up numerous new customers over recent weeks who, when asked, confirm that they are splitting their trading capital across multiple companies and opportunities.
While beforehand they may have used a single exchange they are now recognising that multiple accounts minimises their risk of losing everything through an exchange failure – they have recognised that simply relying on the exchange being large and established doesn’t provide any real protection.
It also means that they can be sure to have funds available to take advantage of opportunities when they arise – not shut out because their selected exchange has gone offline either temporarily or permanently.
So where does this leave our industry moving forward?
From our perspective we believe the industry has handled the challenge well and is surprisingly healthy and robust. Even 6 months ago if a major exchange such as Bitfinex had failed there would have been media headlines that “bitcoin was dead” or “bitcoin had been hacked”, but today, because of the ongoing education of mainstream media by the industry as a whole, we see much more measured headlines. The discussion has focused on whether Bitfinex would survive – not whether bitcoin would survive.
While nobody wants to see failures of this type – the market has absorbed the shock remarkably well and in some ways has improved the functioning of the market – providing a much more realistic pricing of risk. So while liquidity is lower than it was prior to the event, we are seeing clear evidence of recovery and as for the bitcoin price; that has all but recovered everything lost on the initial collapse.
Participants in the bitcoin capital markets are starting to learn to be cautious and spread their capital across multiple exchanges and counterparties – they are also learning to avoid the companies that hide behind a veil of secrecy or are headquartered in offshore jurisdictions where recovering funds would prove all but impossible.
And the underlying capital market has absorbed the shock and still performing well. In some ways better than before the hack by pricing risk at a more realistic level.
This all creates an environment that sets the bitcoin industry up well for the next big move in the industry – smart contracts. The promise of smart contracts is the reduction or elimination of counterparty risk from the equation. While the DAO hack has temporarily dampened the speed of adoption for this technology it is inevitable, in our opinion, that this is the way the industry will move.
Exposing customers to the full counterparty risk of all their assets is not acceptable long-term and we’re working on some interesting structures with some of our larger customers to resolve this problem and make that first step toward a more secure way of trading.