Update August 30, 2015: After one year Bitfinex might not have defaulted, but the platform is struggling in some areas. The site’s continuous poor performance has caused numerous losses, while the exchange also got hacked in May 2015 losing 1,400 BTC. These events largely confirm the risk of trading at the platform as argued below. A full review on the exchange can be found here.
Bitfinex is a cryptocurrency exchange that markets itself as the most “advanced financial place in the Bitcoin world.” But a close look at one of the services offered by the exchange, the possibility for providing liquidity, reveals that users have a very good reason to be cautious or even avoid using the exchange operated from the British Virgin Islands (BVI).
On Bitfinex users can take on loans for a default period of 30 days, at a rate of currently 0.1078 percent per day. They can be used by traders to leverage trading positions in margin trading. The loans are offered by other users who want to earn money in a safe way, by providing liquidity. If a trader’s position loses money, then a margin call will trigger and eventually lead to a force-closure of the position. This happens well before the funds required to pay back loans are even touched. For the lender, this results in a risk free return. The lender has no other obligations towards the trader.
As all offered loans and respective interest rates can be observed, it becomes possible to derive some information from the rates involved. To this purpose, the credits spreads have to be taken into consideration. These would be equal to the difference between the return on a 30 day loan via Bitfixed and the return on 1 month Treasury Bills. The latter return is considered the risk-free interest rate over this period, currently equal to 0.03 percent. Treasuries are considered risk-free because they are backed by the U.S. government.
Loans made on Bitfinex are also risk-free according to the platform. Even so, the interest rates are a lot higher than 0.03 percent for 30 days. In fact, the rate was 0.1078 percent per day. For 30 days, this comes down to 3.29 percent rather than 0.03 percent. Liquidity providers pay 15 percent of their income to Bitfinex, hence effectively interest rates are 2.79 percent. This might seem odd, as higher returns must be directly related to higher risk, but is mainly caused by the fact that loans made on Bitfinex are not as risk-free as the platform claims they are. After all, if the exchange suddenly defaults or disappears, then all money present on the platform might be gone as well. Since there is no counterparty risk on the traders due to the exchange’s system, the full credit spread is caused by counterparty risk on the exchange itself.
Implied Default Probability
To give further meaning to this, it is required to know that a credit spread is equal to the probability of default times the loss given default. In reality, only the credit spreads can be observed. By estimating the loss given default, it is possible to derive the implied default probability. In other words, the market derived probability that Bitfinex will default over a certain period of time.
For 30 days, the credit spread on Bitfinex loans is equal to 2.79 percent minus the 0.03 percent risk-free rate. To get the implied default probability, the remaining 2.76 percent has to be divided by the loss given default. This would be the percentage of money lost if a default actually occurs. This is another estimation, but given that Bitfinex is based in Hong Kong, retrieving any money is likely to be difficult in the event of a default. Because of this, it is a fair assumption to estimate losses at either 100 percent or 75 percent (the standard percentage applied by ISDA for subordinated debt) if Bitfinex defaults. The probability of default of Bitfinex over a period of 30 days can then be determined at 2.76 percent or 3.68 percent respectively.
Note that the probability of default increases if the loss given default decreases in this calculation. This is due to the fact that the credit spreads in reality follow from default probabilities, and not the other way around. If the probability of default would remain static, a decrease in the loss given default would result in a lower credit spread.
Using the same methodology, the annualized interest rates on Bitfinex loans would be equal to 39.70 percent. The risk-free rate for 1 year Treasuries is just 0.11 percent, hence the both the credit spread and implied probability of default would be 39.59 percent. If a loss given default of 75 percent is assumed, then the implied probability of default would be 52.79 percent over a one year period.
Given the previous, the markets imply a substantial chance that Bitfinex will default over the coming year. Simply holding Bitcoins is actually a lot less risky. The current 1 day volatility of Bitcoin, based on the past 30 days, is just 1.15 percent. This can be annualized by multiplying with the square root of 365 (days), which results in nearly 22 percent. This figure implies a 16 percent chance that Bitcoin will lose more than 22 percent over a one year period. A loss of more than 66 percent will statistically only have a 0.135 percent probability. The conclusion is that providing a USD loan via Bitfinex is a lot more risky than holding Bitcoins, not to mention trading and holding Bitcoins via Bitfinex.