Pricing Bitfinex Default Risk

Bitfinex’s secret sauce was their P2P margin lending platform. Users could borrow and lend USD, XBT, LTC, ETH and recently ETC. The ability to support leveraged trading with a liquid borrow market is what vaulted Bitfinex to the top spot.

The USD lending book was the largest. Approximately $38 million was lent out with an additional $4 million of unused cash. The interest rates were very high when compared to USD sitting in a bank account earning 0% interest.

Many users deposited USD at Bitfinex and lent it out to earn 30% to 40% per annum (pa) returns. This was not a risk free trade. USD lenders now acutely understand the meaning of counterparty risk.

With bank deposit rates at 0%, the 30% pa return could be seen to represent the default risk of Bitfinex plus the rate of unsecured USD funding.

It is scary how closely the average pa funding rate was to the final 36% haircut number.

If Bitfinex is to resurrect itself, it will need a healthy and liquid USD loan book. Given the haircut lenders just received, what is the minimum interest rate they should accept going forward?

We can calculate Bitfinex’s new default risk this with some confidence.

If their self-reported numbers are to be believed, Bitfinex now has 125,424 XBT ($75.75 million) and $52.83 million of all other assets. That brings their total deposit base to $128.58 million. Bitfinex’s cold storage amounts to 58.91% of all assets. That is the capital at risk of being hacked, and will now serve as the proxy for the default severity if Bitfinex was hacked once more.

Without a plan to secure the existing funds in daily use, the probability of another hack is high. Going forward, USD lenders should not accept less than 58.91% interest pa, or 0.16% per day.

Another measure of Bitfinex default risk is the premium at which digital currencies trade vs. competing exchanges. Given that Bitcoin is their marquee product, traders should watch the Bitfinex Bitcoin premium closely.

Bitcoin will trade at a premium on Bitfinex, because traders are afraid that their USD withdrawals will not get processed, or by the time they do (it takes 5 to 7 days to withdraw USD) the exchange has experienced another credit event, or their Taiwanese bank has received a court injunction to freeze all assets.

If Bitcoin withdrawals are functioning properly, traders can withdraw their money immediately. The time preference will result in a premium.

In the lead up to the collapse of MtGox, Bitcoin traded at a 10% to 20% premium. Traders who believe USD withdrawals will function correctly (and those who have a special relationship with Bitfinex) will buy Bitcoin cheap on a competing exchange. They can then sell it for more on Bitfinex, then wire the USD out of Bitfinex. Wash, rinse, repeat.

The premium represents the five to seven day default risk of Bitfinex. For USD lenders to arrive at a minimum lending rate, they should divide the Bitfinex Bitcoin premium by 5 to 7 to arrive at a minimum daily rate.