Bitfinex’s missing $851m has been located. It has been seized by assorted governments including the U.S.’s Department of Justice. The unlicensed money processor, Crypto Capital Corporation, with which Bitfinex placed the money is accused of money laundering on a global scale, and two people have already been charged with fraud.
But this doesn’t solve Bitfinex’s immediate problem. It is still $851m down, and the money is not coming back any time soon – if at all. So Bitfinex’s parent company, iFinex, has come up with a brilliant scheme to plug the gaping hole in its balance sheet. Why not sell some new tokens? Rather a lot of tokens, in fact – a cool 1 billion of them.
This is not the first time Bitfinex has plugged a hole in its balance sheet by issuing tokens. In 2016, it raised about $72m by part-replacing customer deposits with BFX tokens after funds were stolen in a hacking. That was supposed to be a temporary solution: when the money was recovered, the tokens would be bought back and burned. The money was never recovered, but Bitfinex redeemed the BFX tokens from profits. The last ones were burned in April 2017.
This latest scheme is also “temporary.” So temporary, in fact, that some might question why Bitfinex needs to do it at all, since it doesn’t seem to be short of profits: according to The Block, it earned $404m last year and paid out $261m in dividends. But as we shall see, there is a very good reason for Bitfinex’s owner, iFinex, to embark on this scheme. The U.S. authorities are on its case. It needs to make some changes – and quickly.
As yet, there is no official prospectus for the new token issue. There is only a three-page marketing document issued by Bitfinex’s shareholder Zhao Dong, who is at pains to insist that it is “not a whitepaper.” Despite this, the company claims to have already raised $600m in private pledges.
So how will this token work? Well, imagine a bank holding company whose principal trading subsidiary has just lost $851m in a dodgy deal with a shadow bank. Another subsidiary – a cash investment fund – has lent it money from its own reserves to cover the losses. But this has left a hole in the investment fund’s own balance sheet. Customers who thought their investment was fully backed by cash reserves to ensure they could withdraw their money whenever they want are up in arms. And now, the New York Attorney General has issued an injunction to prevent the investment fund lending any more money to the distressed trader. What to do?
Both the trader and the investment fund need new capital. And although banks create money when they lend, they can’t create money to recapitalize themselves. They have to persuade someone to give or lend them the money. For the bank holding company, the obvious solution would be a rights issue, though it could also issue a form of debt that can be converted to equity: preference shares, for example, or “contingent convertible” (Co-Co) bonds.
But iFinex, which owns both Bitfinex and Tether, isn’t a bank holding company. It is the owner of a bunch of cryptocurrency issuers and exchanges. And for a crypto company, rights issues and convertible debt are SO last century. What iFinex wants to do is raise money from investors without creating any new obligations or diluting its existing shareholders (it is telling that the “marketing document” for the token scheme has been issued by one of those shareholders). Hence the token scheme.
At first sight, the token scheme appears to be about raising new money to recapitalize Bitfinex and Tether. But a little digging reveals that this isn’t the plan. Banks – and cryptocurrency companies that behave like banks – can recapitalize themselves in other ways. Some of them would not be tolerated by regulators, and some are downright illegal. But hey, who is regulating a cryptocurrency issuer?
The plan is to create a new iFinex subsidiary for the sole purpose of issuing the new LEO tokens. LEO are to be bought with USDT, which you will recall is the token issued by Tether. Tether is owned by iFinex. So iFinex would not be raising any new money at all. It would simply be exchanging old lamps for new – on its own balance sheet. How could this recapitalize Bitfinex and Tether?
Let’s look at Tether first. Calling in 1m USDT is more than enough to restore 100% USD reserve backing for the remainder. Indeed, it would leave Tether with some free cash, which as it would not be encumbered by USDT issues, could potentially be lent to Bitfinex without breaking the NY AG’s injunction.
But it doesn’t look as if iFinex plans to burn the USDT it is calling in. Rather, it seems to intend to leave them on LEO’s balance sheet. Or perhaps transfer them to Bitfinex, to repay Tether’s loan. After all, LEOs will be unsecured. Customers will have no claim on LEO’s assets, as they do on Tether’s.
Tether’s loan to Bitfinex is currently collateralized by shares in DigFinex, which is iFinex’s ultimate owner. But because iFinex owns both Bitfinex and Tether, the “arms-length” loan is a fake and the self-collateralization is potentially fraudulent. And the NY AG knows this. iFinex needs to get rid of the loan in a hurry.
I suspect this is what LEO is really about. Recapitalizing Bitfinex and eliminating the claim on Digfinex shares. And writing off Tether’s loan to Bitfinex.
But why would punters exchange USDT, which if not fully reserved is at least backed by a notional claim on the $851m “lost” by Bitfinex, for a completely unsecured token? Why would they draw down their holdings of USDT, which is an established cryptocurrency and very widely traded, to buy a completely new coin from the same issuer? What is the incentive for investors to participate in this asset swap?
Ordinarily, if you swap secured for unsecured you have to do so at a discount, because unsecured is riskier than secured. iFinex isn’t offering a discount on the token price, as far as we know, but traders who buy the coin will benefit from assorted discounts on trading services through iFinex’s exchanges, including Bitfinex. The question is whether these discounts will be sufficient to encourage traders to unload USDT and buy the new coin.
Because of the discounts, iFinex describes LEO as a “utility coin”. Usually, such a coin would be a form of marketing: buy our coin, get discounts on our exchange. But this coin has a built-in buy-back-and-burn schedule. iFinex will purchase a proportion of LEOs monthly from its profits, then destroy them. If Bitfinex’s missing $851m is ever recovered, at least 95% of it would also be used to buy back and destroy LEOs. And – even more unlikely – 80% of any recovered proceeds from the 2016 Bitfinex hack would also be used for this purpose. For a “utility” coin to be designed to self-destruct in this way is bizarre.
The buy-back-and-burn schedule suggest that like the 2016 BFX tokens, this coin is intended merely as a temporary solution to iFinex’s capital shortfall. It is therefore in no sense a real “utility coin”. The discounts aim to attract traders who otherwise would have no incentive to buy the coin. But issuing at a hefty discount would have a similar effect. I wonder if iFinex has opted for a “utility” coin because a coin issued purely to recapitalize Bitfinex and Tether might fail the U.S.’s Howey test? The The fact that the marketing document specifically bars U.S. investors from buying the new coin suggests this could be the case.
In 2016, Bitfinex got away with issuing tokens to cover its losses due to fraud. In 2019, it seems to be trying to do so again. But if iFinex were actually a bank holding company, would it get away with this? Perhaps it is time that cryptocurrency issuers and exchanges were subject to the same regulation as traditional banks and exchanges.