Should Bitfinex Get the Coins?

For those who have found a way to avoid cyptocurrency news, the United States Department of Justice published a press release on February 8th 2022: Two Arrested for Alleged Conspiracy to Launder $4.5 Billion in Stolen Cryptocurrency¹.

According to court documents, Lichtenstein and Morgan allegedly conspired to launder the proceeds of 119,754 bitcoin that were stolen from Bitfinex’s platform after a hacker breached Bitfinex’s systems and initiated more than 2,000 unauthorized transactions.

Notice the language: "stolen from Bitfinex's platform". The coins belonged to the users of the platform. Unfortunately for them, the old "not your keys, not your coins" adage rung true.

The hack was reported by Bitfinex on August 2nd 2016.

Today we discovered a security breach that requires us to halt all trading on Bitfinex, as well as halt all digital token deposits to and withdrawals from Bitfinex².

If this was heart-wrenching for Bitfinex users to read, the update published four days later would give them a full-on heart attack.

After much thought, analysis, and consultation, we have arrived at the conclusion that losses must be generalized across all accounts and assets. This is the closest approximation to what would happen in a liquidation context. Upon logging into the platform, customers will see that they have experienced a generalized loss percentage of 36.067%³.

Unable or unwilling to eat the losses themselves, Bitfinex passed it on by taking 36% of customer funds: BTC, ETH, USD, etc.

In place of the loss in each wallet, we are crediting a token labeled BFX to record each customer’s discrete losses. Tokens will be distributed without release or waiver. The BFX tokens will remain outstanding until redeemed in full by Bitfinex or possibly exchanged—upon the creditor’s request and Bitfinex’s acceptance—for shares of iFinex Inc³.

Think of BFX tokens as IOUs. They were unregulated, came with no defined payback schedule, offered zero interest, and were provided to users in a forced sale.

The number of BFX a user received was based on their "discrete losses" as opposed to "continuous losses". Suppose a user WarrenPuffett had 3BTC on Bitfinex pre-hack. The hack occurs and Bitfinex takes 36% of their BTC, about 1BTC, in exchange for around 600BFX tokens. $600 was roughly the USD price of Bitcoin at the time of the hack. Of course the actual numbers were precise but round numbers are easier to think about. Bitfinex significantly reduced their debt by "snapshotting" the price as Bitcoin rallied until December 2017 when it reached an all time high of $20,000. It seems 1BTC == 1BTC until shit hits the fan.

Obviously, this methodology upset a lot of users but some saw it as the best chance for recouping their losses and were understanding⁴. WarrenPuffett's options going forward are:

1. Hold their BFX tokens in the hopes that Bitfinex would redeem them for the full amount,
2. sell them for cents on the dollar to other traders,
3. or convert them to iFinex shares, Bitfinex's parent company.

I'll be referring to iFinex, the owner of Bitfinex and Tether, moving forward.

iFinex was redeeming BFX tokens albeit slowly⁵. Confidence that all coins would be redeemed was low and the roughly $0.30 price reflected that⁶. Sellers wanted to recoup a portion of their losses and be done with the ordeal waiving all legal claims against iFinex on account of the losses⁷. Buyers and holders were betting that iFinex would repurchase their tokens for the full dollar amount. iFinex partnered with a company called BnkToTheFuture to create a Special Purpose Vehicle [SPV], which surprisingly is not a Delorean that time travels to before the hack, but a way for users to convert BFX tokens into equity⁸. Conversions to equity would reduce the supply of BFX tokens resulting in less debt owed by iFinex. To push users in this direction they introduced the Recovery Right Token [RRT].

RRTs are nearly identical to BFXs in that they represent a $1.00 debt owed to the holder and are tradeable on the exchange. The difference is that iFinex is only obligated to redeem RRTs when and if the stolen coins are recovered. A user who chose to convert would lose the chance of being redeemed prior to recovery but maintain the right to redemption if a recovery occured. Additionally, they would gain a stake in a highly profitable business assuming iFinex could make it through the choppy waters. Users wanting to go this route would need to act fast:

If subscribed on or before October 7, 2016, each investor will get 1 RRT for each BFX token exchanged for shares;

If subscribed after October 7, 2016, and on or before October 31, 2016, each investor will get ½ an RRT for each BFX token exchanged for shares;

If subscribed after October 31, 2016, and on or before November 30, 2016, each investor will get ¼ an RRT for each BFX token exchanged for shares; and,

If subscribed after November 30, 2016, no RRTs will be delivered⁹.

This FOMO based scheme incentivised users to convert to shares quickly. The longer users held their BFX in the hopes of redemption, the fewer RRTs they'd receive if they ended up converting. Always susceptible to FOMO, WarrenPuffett chose to go down this path.

WarrenPuffett is a US citizen but he did not share that information with Bitfinex. To open "Basic" level accounts, no verification is required¹⁰.

When you create an account on Bitfinex by linking your email address, your account becomes verified on the Basic level.

With just an email address WarrenPuffett was able:

• to deposit and withdraw most listed currencies on Bitfinex;
• to make exchange trading;
• to have access to the Bitfinex OTC market.

In other words, it was enough for him to send his Bitcoin to the exchange and start his new life as a crypto day trader. However, his basic account level and US citizenship prevented him from taking advantage of all the options previously discussed.

A U.S. person may only transfer the token (BFX) to another iFinex customer, but may not purchase tokens. A customer who is not a U.S. person may purchase and transfer tokens without restriction if, in connection with each trade, the customer verifies to the Bitfinex Group’s satisfaction that the customer is not a U.S. person⁷.

So he could hold or sell his BFX tokens but not buy. What about converting to equity?

BnkToTheFuture does have a verification process and allows "qualifying" US citizens to participate on their platform¹¹. Let's assume that WarrenPuffett met those qualifications. He proved to Bitfinex and BnkToTheFuture that he is a "sophisticated" and "accredited" investor of "high-net worth". They in turn gave him equity and RRTs.

As the months went by, more users converted decreasing the supply of BFX. The price of Bitcoin began to rally and trade volume picked up on the exchange. With a healthy revenue stream, iFinex was able to buy the remaining BFX for the full $1.00 amount.

A combination of factors has led to this seminal moment for Bitfinex, including a dramatic uptick in equity conversions; record operating results in March; and, the decision to reduce our reserves in favor of this opportunity. We are tremendously grateful to all of our customers and new shareholders for helping us get to this point. By the end of this week, we will be sending notes directly to our shareholders with more information about what to expect in the coming months¹².

The users who held their BFX tokens had their discrete losses recouped and those who bought more BFX tokens could have recouped their continuous losses and even made significant profit--💎🙌. For users like WarrenPuffett who converted to equity it's hard to say how they may have interpreted the news. I do not have access to the price charts for iFinex shares but I imagine they were doing well.

About one year after the hack on Auguest 11th 2017, iFinex announced that they were ending the verification process for US citizens.

Bitfinex is making changes to the services we provide to U.S. individuals. These changes impact the verification process and trading of certain digital tokens for U.S. customers. Some changes are effective immediately, and others will be gradually implemented in the coming weeks¹³.

Two months later they announced they were kicking US citizens off the platform.

... we are terminating trading, deposits, and withdrawal functionality for U.S. individual customers by no later than November 9, 2017¹⁴.

WarrenPuffett had to move his funds and trade elsewhere. As Bitfinex is the only market for RRTs¹⁵, he was forced to sell for cents on the dollar long before the recent recovery of stolen funds.

U.S. individuals holding Recovery Right Tokens (RRTs), if any, which relate to the exchange of now-defunct BFX tokens to equity in iFinex Inc., may, starting on October 27, 2017, sell all of their RRTs on the exchange, if they so elect. This is an exception to the general terms of use for RRTs. U.S. individuals are not permitted to buy RRTs during this time period¹⁴.

Again, how a user like WarrenPuffett would have felt about this depends on the performance of the equity. If the shares outpaced what he would have earned on the 1BTC he lost, then being forced to sell RRTs only stung a little bit. Otherwise, it might have felt like a punch in the gut. Additional unknowns are the liquidity of the market and the "legitimacy" of BnkToTheFuture.

BNK To The FUTURE (HK) Limited (Company Number 2205217) is Incorporated and registered in Hong Kong under the Companies Bill 2011. This website (Trading name BnkToTheFuture.com) is operated by BNK TO THE FUTURE (Company Number CO-296093) Incorporated and registered in Cayman Islands under the Companies Law 2013. BNK TO THE FUTURE is registered with the Cayman Islands Monetary Authority (CIMA License No. 1189274).

...

We take your trust very seriously¹⁶.

Throughout all of this, iFinex was and is still managing another token called Tether [USDT]. Tether is a stablecoin pegged to the Dollar meaning it's price should always be at or very close to $1. A peg is most simply achieved by keeping a 1:1 reserve of the target currency. Print X Tethers when X dollars are deposited and burn X Tethers when X dollars are withdrawn. For years iFinex claimed to have a fully backed reserve but they never proved it.

Tether is the most important catalyst for cryptocurrency markets. USDT trading pairs account for tens of billions of dollars in 24h volume and it's circulating supply is currently 78 billion¹⁷. Like many commodities, Bitcoin is often priced in Dollars. For users and exchanges located in other parts of the world and/or without US banking, Tether and other stablecoins, provide access to "Dollars". In this heavily correlated market where coins often rise and fall together, Tether is supposed to be a "stable" place for active traders to temporarily store their value.

Since its inception, Tether has been surrounded by controversy and in April 2019 things came to a head. iFinex had entrusted $850 million of Bitfinex's reserves to a pseudo-bank called Crypto Capital running out of Panama. Polish authorities discovered that Crypto Capital was laundering money for its customers including Columbian drug cartels. As a result, the "bank"'s assets were seized including Bitfinex's $850 million¹⁸. With the Bitfinex reserve lacking the funds to service customer withdrawals, iFinex used the Tether reserve instead. Spotting a chance to apply legal pressure on the company, New York Attorney General Lititia James accused them of breaking their promise to investors of keeping Tether's reserve fully backed¹⁹.

If investors were to lose faith in Tether, USDT could "un-tether" from the Dollar and crash. Anyone holding Tethers would try desperately to sell for blue chip cryptos like Bitcoin and Ethereum. A Tether crisis does not necessitate a wider crypto-market crash but that is certainly a possibility. Market infrastructure like exchanges and DeFi applications could break down turning users into bag holders. This might spook investors, causing them to pull out of the market entirely. For the past two years, iFinex has been printing Tethers like J-Pow works there. Tens of billions of new Tethers have propelled prices to astronomical heights. If these Tethers do not represent real investor demand, then when the printing gets shut down by the authorites, prices will fall back to earth.

iFinex's defense against the accusations levied by the NY AG was that the funds were not moved they were borrowed. They essentially replaced the $850 million in the Tether reserve with BFX tokens. Additionally, the "fully backed reserve" goal posts were shifted:

Tether updated its terms of service to make clear that reserves could include loans to affiliates, and did so before the line of credit transaction that is at the heart of this case. This disclosure gave anyone holding or considering buying tether the opportunity to take their money elsewhere if they so chose, defeating any allegation of fraud²⁰.

Despite this admission that Tether was not backed 1:1 with cash, the peg held and there was no crisis.

To increase investor confidence, pay off the loan from Tether, and raise a middle finger towards the NY AG, iFinex came up with another Token based scheme. They ran what is known as an initial exchange offering [IEO]. This is when an exchange sells a "utility" token to its customers. It's a bit like rewards points. Despite everything previously discussed, their customers were happy to bail out the company again and purchased $1 billion worth of tokens.

The token is called UNOS SED LEO [LEO] which took iFinex a couple paragraphs to explain in the whitepaper:

Our company motto, Unus Sed Leo, is a Latin citation from Aesop’s fable, "The Sow and the Lioness." The fable (in short) details how a sow brags about how many children she has and then asks the lioness if she only had one child. The lioness replies "One, but a lion."

This ethos of quality over quantity and individual strength extends across several elements of iFinex, from being a privately-owned company to our recruitment and operational infrastructure. It is also an ideal that binds together persons linked to our company, from team members to shareholders, from communities to individual supporters²¹.

"Quality over quantity" seems antithetical to their philosophy on tokens.

LEO is like a more advanced BFX.

On a monthly basis, iFinex and its affiliates will buy back LEO from the market equal to a minimum of 27% of the consolidated gross revenues of iFinex (exclusive of Ethfinex) from the previous month, until no tokens are in commercial circulation. Repurchases will be made at then-prevailing market rates²¹.

Like more legitimate debt instruments, a schedule for paying down the debt was provided. Unfortunately there is no way for holders to verify that "a minimum of 27% of gross revenue" is actually being spent but they can verify that some tokens are bought back every month.

The scheduled reduction in supply of the tokens and the demand for them, based on their utility, ideally increases the price over time like an interest rate.

In addition to the above, an amount equal to at least 95% of recovered net funds from Crypto Capital (described more fully herein) will be used to repurchase and burn outstanding LEO tokens within 18 months from the date of recovery²¹.

Further, an amount equal to at least 80% of recovered net funds from the BitFinex hack will be used to repurchase and burn outstanding LEO tokens within 18 months from the date of recovery²¹.

These are similar to a stock buybacks and in theory should boost the price of the coin and provide profit to users who helped recapitalize iFinex in the initial sale.

US Citizens were not able to participate in the sale and cannot trade for the tokens on centralized exchanges. While they can trade for them using DeFi applications, I'd expect very few US citizens have actually done so²¹.

In February 2021, Tether payed a "slap on the wrist" $18.5 million fine and walked away without having to admit wrongdoing. This was most likely not the outcome the AG desired but she did force them to provide a transparency report¹⁹. Now, on the official Tether website there is a breakdown of the reserves. Actual hard cash makes up only 6% of the reserves and nearly 50% of the reserves are labeled as "commercial paper". iFinex does not disclose which companies issued the debt making it impossible to tell if the paper is more than something to wipe your ass with. This breakdown came not from a proper financial audit but from the "assurance opinion" of a company called Moore Cayman²².

Despite the release of this opaque transparency report, Tether continues to maintain its peg to the Dollar. It seems that the market relies so heavily on the conveniences of Tether that it is content to ignore the red flags and look the other way. Tether is Schrödinger’s Coin. We don't want the vault to be empty, so we don't look in it.

Now, a year after the agreement, the Department of Justice announces they have control of the stolen funds from the 2016 hack. Both RRT and LEO spiked on the news:

Buyers of these tokens are betting that the DOJ will give the coins to Bitfinex enabling them to redeem outstanding RRTs and buy up large amounts of LEOs. But will the DOJ give them the coins? Why should they? Afterall, they belonged to the users not the exchange. Those 120,000 coins worth $70 million in 2016 are now worth almost $5 billion. iFinex snapshotted their users so why shouldn't they receive the same treatment? If the DOJ is really serious about not allowing "cryptocurrency to be a safe haven for money laundering or a zone of lawlessness within our financial system"¹ then they will not give billions of dollars in assets to a company that does not perform KYC/AML processes on all its users, has sold 3 different unregulated debt instruments to bail themselves out, and prints digital Dollars that make money laundering considerably easier¹⁸.

While I won't go so far as to say that iFinex has operated with malicious intent, it is far too shady to remain at the core of a space that prides itself in transparency and openness. Ideally, coins are returned directly to the individuals impacted by the hack. Unfortunately, because many of them were not required by Bitfinex to go through identity verification processes, determining who they are may be impossible. Besides the non-US citizens who are still holding RRTs, giving the coins to iFinex only helps LEO speculators and iFinex themselves. A more productive use of the recovered assets would be to enable further investigations into bad actors and fraudulant activity in the cryptocurrency space.