Imagine that, just before you read this article, you received an email from a financial institution where you have a substantial trading account…
The email said other accounts had been hacked, but not yours. Nevertheless, the financial institution was deducting 36% of your holdings and replacing them with shares in its parent company — shares that you can’t trade. You just have to hold them and hope for the best.
How would you feel? How do you feel just imagining it?
Probably a lot worse than the clients of Cypriot banks, who had to forfeit between 6.75% and 9.9% of their account holdings as part of the infamous “bail-in” of 2013. Besides the fact that the percentage is much larger, your bail-in was totally unexpected. Nobody saw it coming.
And there’s nobody to whom you can complain. The financial institution is unregulated. There’s no backstop and no clear rules. You’re entirely on your own.
That’s the situation increasing numbers of us are in these days … a situation we were promised wouldn’t happen.
Bitter Bitcoin Irony
The “genesis block” of bitcoin — the very first block of that cryptocurrency’s blockchain — contains the following statement in hexadecimal code: “The Times 03/Jan/2009 Chancellor on brink of second bailout for banks.” That was the London newspaper’s headline on that date.
The reference is unmistakable: Fiat currencies and mainstream banks are unsafe. If something goes wrong, your money may be on the hook. Bitcoin is the answer. As one analyst put it:
Bitcoin presented a choice that has never existed before. Its mysterious creator Satoshi Nakamoto described it as “a distributed system with no single point of failure” where “users hold the crypto-keys to their own money and transact directly with one another, with the help of the P2P network to check for double-spending.” The white paper published under pseudonym was a promise. Bitcoin, which became operational in 2009, was its fulfillment. The promise was to build security through cryptographic proof, replacing third-party trust and creating networks resilient to counter-party risk.
That promise is surely a bitter irony for customers of Hong Kong-based bitcoin exchange Bitfinex, who have lost more than one-third of their money as a result of a hack.
Stealing From Clients: Not Just for Banks Anymore
On August 2, Bitfinex said that hackers had stolen 119,756 bitcoins from some clients’ accounts. It was the second-biggest such hack in dollar terms, after the 2014 hack of bitcoin exchange Mt. Gox.
Bitfinex later said it would spread the losses across all its customers, whether or not they had been hacked — or even held bitcoin. Customers would forfeit 36% of their holdings. As compensation, they’d receive “BFX tokens” that could be redeemed by the exchange someday, or converted to shares in its parent company.
It’s exactly the same sort of “haircut” that Cypriot bank customers received in 2013, with one essential difference: It’s unilateral and not governed by any law. Bitfinex just made it up.
Bitfinex’s terms of service say “bitcoins in your multi-signature wallets belong to and are owned by you.” That’s a clear statement of a banking relationship with its clients, in terms of which “the depository … is obligated to return, on demand, the same monetary objects deposited.” The 36% haircut of its clients, in other words, is “theft” as defined by Bitfinex.
Moreover, compensatory “tokens” redeemable by the exchange or convertible to shares are something between a bond and a security. In the U.S. at least, that requires licenses that Bitfinex doesn’t have.
Free Markets Can Be Costly…
So what are Bitfinex clients to do?
Unregulated cryptocurrency exchanges like Bitfinex exist in the free-market nirvana we’re told is the solution to all of our problems. Bitfinex is free to innovate … as it has clearly done in response to this hack.
In this regulation-free context, Bitfinex clients have the choice of accepting the company’s 36% fait accompli or suing. But if just one client goes to court, the company will almost certainly be placed in receivership, and all accounts will be frozen pending the outcome. Given that clients of cryptocurrency exchange Mt. Gox — which suffered the biggest bitcoin theft of all time in 2014 — are still waiting to be made whole pending ongoing court proceedings, that isn’t much of a choice.
…But They Remain the Only Answer
Many of us love bitcoin and other cryptocurrencies. They promise the freedom we all desire.
But large-scale trading of cryptocurrencies has recreated the exact problem bitcoin was meant to solve: a “single point of failure.” Instead of “users hold(ing) the crypto-keys to their own money and transact(ing) directly with one another,” the global cryptocurrency market is dominated by massive exchanges that operate exactly like banks, except that they are unregulated and make their own rules.
A while back I wrote an article about the looming danger of blockchain-based currencies. They promise to do away with banks, but would be vulnerable to arbitrary government interference … and confiscation.
What are we to do, then?
As one cryptocurrency analyst has put it: “Problems of centralization cannot be solved through the same modes of thinking that created them. Instead, solutions require innovation from below.”
As I write, and as you read, developers are working furiously to create a mechanism for ordinary people to trade cryptocurrencies without centralized exchanges that function exactly like banks, with all their vulnerabilities. Theirs is an open-source project that can be studied, modified and freely shared, not a private money-making business. Until they succeed, my advice is to keep your bitcoin and other cryptocurrency investments modest.
Unless, of course, you fancy a 36% haircut out of the blue.
Editor, The Bauman Letter